Sharp Thinking

No. 91    Perspectives on Developments in the Law from The Sharp Law Firm, P.C.     May 2013

Cross-Collateralization Clauses in Commercial

Mortgages Are Enforceable, 7th Circuit Rules                      

            By John T. Hundley, 618-242-0246, Jhundley@lotsharp.com

            Those cross-collateralization clauses common in commercial mortgages are enforceable and put subsequent lenders on inquiry notice of other debts brought within the scope of the mortgage by such clauses, the Seventh Circuit U.S. Court of Appeals ruled last week. 

            Rejecting an argument that enforcement of the cross-collateralization or “dragnet” clause would chill second-mortgage lending, the court said that failing to enforce such clauses would merely transfer the chilling effect from prospective second-mortgage lenders to prospective first-mortgage lenders.  In apportioning that risk, the court said that “only one outcome has the virtue of being consistent with the plain contractual language that the parties agreed upon, and we think it more sensible to allow sophisticated parties to contract as they wish.  If cross-collateralization clauses are in the end too costly to borrowers, they need not agree to them.”  Peoples Nat’l Bank v. Banterra Bank, No. 12-3079, __ F.3d __, 2013 WL 2150820 (7th Cir. May 20, 2013).[1]

            The court added that as a general matter “prudent lenders would do well to exercise caution before accepting a second mortgage on real property that has been cross-collateralized.”                          

            In Peoples, Peoples made a commercial loan against certain real estate with a mortgage that said the property also was to serve as collateral for all other “obligations, debts and liabilities, plus interest thereon, of Grantor to Lender . . . whether now existing or hereafter arising, whether related or unrelated to the purpose of the [original] Note” (the cross-collateralization clause).  Thereafter, Banterra Bank took a second mortgage on the same property, but only after Peoples had lent the debtors an additional $400,000 secured by other property.

            Believing that Banterra had no actual knowledge of Peoples’ second loan, the court said the presence of the cross-collateralization clause in the mortgage of which Banterra concededly had knowledge put Banterra on “inquiry notice” with a duty to make reasonable inquiry as to whether any cross-collateralized loans existed.  If the second-mortgage lender “fails to make (such) inquiry, he is nonetheless chargeable with knowledge of facts that a diligent inquiry would have disclosed, the same as if he had acquired actual knowledge of those facts,” the court said.

            Noting that a name search of Jefferson County land records would have revealed the existence of Peoples’ second loan and that Banterra offered no evidence that that loan could not have been discovered upon reasonable investigation, the court rejected arguments that that siding with Peoples would impose a duty of endless investigation stretching to the land records of other states.  “[T]he law requires reasonable investigation, not endless investigation,” the court said.  “[W]here to draw that line will be a question of fact for the trier of fact” in cases where allegedly reasonable inquiry has been made. 

            The court also rejected arguments that Peoples’ mortgage (a form LaserPro document) had “inherent contradictions and ambiguities” which did not create a duty of inquiry in the first place, an argument which had led the District Court to award judgment to Banterra.  Peoples Nationals [sic] Bank, N.A. v. Jones, 482 B.R. 257 (S.D. Ill. 2012).  In that regard, the Seventh Circuit specifically ruled that a maximum lien clause equal in amount to the original note did not create an implication that only the original note was covered by the mortgage.  “The mortgage is not susceptible of two meanings,” it said in reversing the District Court judgment. 

            By relying on the doctrine of inquiry notice, the court avoided deciding whether Peoples’ mortgage was insufficient to impart record notice of the second loan under § 11 of the Illinois Conveyances Act (765 ILCS 5/11).  The District Court had ruled that because Peoples’ mortgage had failed to state the maturity date, interest rate and other terms of the cross-collateralized loan, it was insufficient to give record notice to third parties under that act.  Noting that several Illinois courts have appeared to rule that the elements set forth in § 11 are mandatory for record notice purposes, but that the text of § 11 and a recent statutory amendment (P.A. 97-1164 § 20) suggest § 11 is only permissive, the court said it saw “no need to enter this fray.” 

            In so ruling, the panel likely was cognizant that two other appeals on the Seventh Circuit’s docket more directly raised the § 11 issue and had been stayed pending resolution of Peoples v. Banterra.  See Richardson v. Gifford State Bank, No. 13-1518, and Bruegge v. Farmers State Bank of Hoffman, No. 13-1277.  In both, lower courts have held that the language of § 11 is permissive.  See In re Crane, 487 B.R. 906 (C.D. Ill. 2013); In re Klasi Properties, LLC, 2013 WL 211111 (Bankr. S.D. Ill. 2013).  See also Sharp Thinking No. 87 (April 2013); In re HIE Effingham, LLC, __ B.R. __, 2013 WL 1334282 (Bankr. S.D. Ill. 2013) (similar; appeal pending before the U.S. District Court for the Southern District of Illinois (WBCMT 2007 C-33 Mid-America Lodging v. Bruegge, No. 13-cv-00439-WDS)). 

            Two other observations also might be offered concerning Peoples v. Banterra.                 

            First, the ruling is of doubtful precedent in non-commercial cases – but cross-collateralization clauses are rare in consumer mortgages anyway.

            Second, the court enforced the cross-collateralization clause notwithstanding a provision that the cross-collateralized debt need not be related to the purpose of the original note.  Whether the court rejected cases which have said the original and cross-collateralized debts must be similar in purpose, or whether the court accepted Peoples’ arguments that in the instant case they were, is unclear.

[1] The Sharp Law Firm, P.C. represented the successful appellant in Peoples. 

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