A cross-collateral, or “dragnet” clause, is a valuable tool for any mortgagee aiming to secure after-acquired property, future-advances or other existing debt. Because these clauses allow creditors such a broad reach of assets upon default, Illinois courts disfavor cross-collateral clauses and will uphold such clauses only when they are unambiguous.1 Thus, particularly in Illinois, drafting is paramount and can mean the potential loss or gain of hundreds of thousands of dollars or more for your client.
Despite this insistence on precision, Illinois courts have not clarified what makes cross-collateral clauses unambiguous and thus enforceable. Still, recent case law suggests practitioners drafting cross-collateral clauses should include at least three elements in their mortgage document to ensure its effectiveness:
- A conspicuous cross-collateral clause on the first page of the document that refers to all debt then or thereafter arising, related or unrelated to the principle debt;
- A definition of indebtedness that includes the note amount and all amounts that may be indirectly secured by the Cross-Collateralization provision; and
- A maximum amount of indebtedness that is equal to or double the principle debt.
I. The Road Map: Peoples National Bank v. Banterra Bank
The above list comes from Peoples National Bank v. Banterra Bank2, in which the Seventh Circuit held that effective cross-collateral clauses put subsequent lenders on inquiry notice as to the existence of additional first-lender debt.
In 2004, the Banterra debtors obtained an original loan for $214,044.26 from Peoples National Bank. In 2008, the debtors obtained a construction loan, secured by the same property, for $296,000.00 from Banterra Bank. Unbeknownst to Banterra Bank, the debtors had obtained a second loan of $400,000.00 from Peoples National Bank in 2007, secured by separate real property.
In 2010, the debtors filed for bankruptcy and received permission to sell the property securing the 2004 and 2008 loans. The property sold for $388,500.00, and the balance due on the 2004 Peoples National Bank loan was $115,044.26. Peoples National Bank argued that it was entitled to proceeds satisfying the 2004 loan balance and, due to the cross-collateralization clause in the 2004 mortgage, to additional proceeds satisfying a portion of the 2007 loan balance.3
II. Cross-Collateralization Clarity
To defeat Peoples National Bank’s claim, Banterra Bank argued that the cross-collateralization clause was ineffective to create inquiry notice because of the mortgage’s “inherent contradictions and ambiguities.” The court disagreed. In support of its position, the court discussed three clarifying elements of the mortgage.
First, the cross-collateralization clause itself was located on the first page of the mortgage and stated that the collateral secured the obligations under the note as well as “all claims by Lender against Grantor or any one or more of them, whether now existing or hereafter arising, whether related or unrelated to the purpose of the Note…”4 Second, the mortgage’s indebtedness definition specifically referenced the cross-collateralization provision: “Specifically, without limitation, Indebtedness includes all amounts that may be indirectly secured by the Cross–Collateralization provision of this Mortgage.”5 Finally, the mortgage contained a maximum lien clause stating that “[a]t no time shall the principal amount of the Indebtedness secured by the Mortgage, not including sums advanced to protect the security of the Mortgage, exceed $214,044.26.”6
The court reasoned that the cross-collateral clause and express definition of “Indebtedness” expressly contemplated the possibility of additional debt then or arising sometime in the future. Further, the court rejected Banterra Bank’s claim that the maximum lien amount implied no additional debt existed because it was equal to the initial loan amount. Conversely, the court concluded that the debt amount would decrease from the date of the first payment, so no logical reason for such maximum lien amount existed except the contemplation of additional debt. Thus, the court held that the cross-collateral clause was unambiguous, effective, and put Banterra Bank on inquiry notice of the 2007 Peoples National Bank loan.
III. Open Questions: How High (or Low) Should You Go?
Despite the Banterra decision, questions remain. In particular, the Seventh Circuit did not explain whether the maximum lien amount must exist, or if so, how high or low the maximum amount can be. Banterra seems to suggest that if Peoples National Bank had set its maximum lien amount higher than the original loan amount, the bank could have received and applied more sale proceeds to the 2007 loan balance. Boldly, some practitioners propose forgoing a maximum lien amount altogether. However, such an omission may run afoul of public policy and is in fact barred in many states for policy reasons.7
An alternative exists: Customarily, Illinois mortgage drafters have set maximum lien amounts for double the amount of the original loan. Had Peoples National Bank’s counsel used this drafting custom, it could have secured its client the amount of the property sale proceeds remaining after payment of the balance of the first mortgage debt, minus costs, which could have been an additional $273,455.74 rather than the approximately $99,000.00 that was awarded ($214,044.26 less $115,044.26). Since drafting risks can mean big client losses, perhaps the end lesson here is another conventional adage: it’s better to draft safe than to make your client sorry.
1 In re Swanson, 104 B.R. 1, 4 (Bankr. C.D. Ill. 1989) (quoting 1 Gilmore, Security Interests in Personal Property, § 35.5 (1965)). Stannish v. Community Bank of Homewood-Flossmor, 24 B.R. 761, 763 (Bankr. N.D. Ill. 1982).
2 Peoples National Bank, N.A. v. Banterra Bank, 719 F.3d, 608 (7th Cir. 2013).
7 Robert Kratovil, Modern Mortgage Law and Practice §111, §119 (1972) (describing the need for debt amount precision in mortgages containing dragnet clauses; discussing eight state variations on maximum lien requirements for any future advances).