Financial Institutions Advisory
Published by Howard & Howard Attorneys PLLC

  
 H&H Logo Resized
  

May 23, 2013

Greetings! 

  
Thank you for taking the time to read this Howard & Howard Financial Institutions Advisory.  We think it is beneficial to provide our financial institution clients and friends with periodic updates on issues, industry developments, and regulatory changes to help you address the challenges facing the banking industry.  As always, if you have any questions, please feel free to contact any of the Howard & Howard Financial Services Practice Group.

Cross-Collateralization Clauses in Commercial Mortgages are Effective Against Junior Lien Holders

 

The Seventh Circuit Court of Appeals recently rejected over 100 years of Illinois law that required a real estate mortgage to contain a description of the amount of the indebtedness secured by it.  The Court declared that broad cross-collateralization clauses in commercial mortgages are effective against junior lien holders based upon the doctrine of inquiry notice.  Peoples National Bank, N.A. v. Banterra Bank, No. 12-3079 (May 20, 2013). 

 

The most significant effect of this decision is that junior mortgages held by a different lender than the first mortgage lender will be worthless if the first mortgage contains a broad cross-collateralization clause.  The Court declared:  "As a general matter, we should think that prudent lenders would do well to exercise caution before accepting a second mortgage on real property that has been cross-collateralized."

 

Illinois state courts are not required to follow this federal court decision interpreting Illinois law.  Nevertheless, the opinion will have a significant impact on how future mortgage loans must be documented. If the lender believes that there is equity in the real estate to support a junior mortgage, the lender must first read the senior mortgage to determine if there is a cross-collateralization clause. If the first mortgage contains such a clause, then the lender must obtain an inter-creditor agreement before accepting a junior mortgage on the purported equity.

 

This affects all commercial real estate lending.  Most consumer mortgages, on the other hand, do not contain cross-collateralization clauses.  (See e.g. the standard Fannie Mae form.)

 

The facts are straightforward. 

  1. The plaintiff bank's (Peoples) mortgage on 10 Acres to be subdivided was recorded in 2004 and included a cross-collateralization clause which provided that the real estate would also serve as collateral for any future obligations arising between debtors and plaintiff up to a limit of $214,044.26 defined in the "Maximum Lien" clause of the mortgage.
     
  2. In 2007, the debtors obtained a second loan from Peoples in the amount of $400,000, which was secured by eight separate parcels of real estate.  This mortgage did not list or reference any of the lots in the subdivision as collateral.
     
  3. In 2008, the debtors obtained a loan from Banterra Bank to build a speculation house on one of the subdivision lots subject to the first mortgage.  Banterra Bank was aware of the first mortgage but the debtors failed to disclose that it had another loan from Peoples in the amount of $400,000.
     
  4. In 2009, the debtors refinanced the construction loan with Banterra Bank for $295,956.84, and subsequently lived in the house as their principal residence. 
     
  5. In December of 2010, the debtors filed a voluntary Chapter 11 bankruptcy case and, in May of 2011, the property was sold for $388,500.  The parties agree that the first mortgage was to be paid in full and after it was paid, the net sales proceeds of $353,263.79 were placed in escrow. 

Peoples claimed that the debt under its other loan was also secured by the first mortgage up to the $214,044.26 limit of the "Maximum Lien" clause even though Banterra Bank was unaware of the 2007 mortgage at the time it made the construction loan to the debtors. The first mortgage included the following cross-collateralization clause:

 

CROSS COLLATERALIZATION.In addition to the Note, this Mortgage secures all obligations, debts and liabilities, plus interest thereon, of Grantor to Lender, or any one of them, 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, whether voluntary or otherwise, whether due or not due, direct or indirect, determined or undetermined, absolute or contingent, liquidated or unliquidated whether Grantor may be liable or jointly with others, whether obliged as guarantor, surety, accommodation party or otherwise and whether recovery upon such amounts may be or hereafter may become barred by any statute of limitations and whether the obligation to repay such amounts may become otherwise unenforceable.

 

It was this clause appearing on the first page of the recorded mortgage that the Court found to be determinative.  The Court held: 

 

"Here, we find that the Bankruptcy Court correctly identified the dispositive question presented by these facts when it asked "whether actual notice of a cross-collateralization clause in a mortgage imparts inquiry notice as to the existence of other obligations that may be covered by the security instrument." In re Jones, 2011 WL 6140686, *8 (Meyers, Bankr. J.). On these facts, we hold that it does."

 

The only limit on the cross-collateralization clause in this case was the "Maximum Lien" clause.  At minimum, when these clauses are included in a mortgage, every lender should declare a "Maximum Lien" in excess of the fair market value of the land so as to secure all of its value.  Alternatively, lenders may choose to eliminate these clauses so they do not limit the lien amount.

 

The immediate impact of this case is that every commercial real estate lender must review its mortgage loan documents and procedures as soon as possible.

 

If you have any questions or need assistance, please feel free to contact Tim Howard, Scott Frost, Grace Mata, or Dan Rubin .

About Howard & Howard
H&H Building
Our focused expertise allows us to offer specialized legal services to businesses and business owners, and to master the industries we serve.  Our results-oriented approach to practicing law is a beacon for business owners in search of intelligent counsel that aligns with their business goals. Howard & Howard has assembled experts from all legal disciplines who have the sound judgment, creativity and vision to assist businesses with their projects from conception to completion.  We work as a team -- and win for you.  Learn more about Howard & Howard here
  
HH Logo

Chicago, Peoria, Detroit, Ann Arbor, Las Vegas

In This Issue
- Cross-Collateralization Clause in Commercial Mortgages are Effective Against Lien Holders
- About Howard & Howard
Attorney Spotlight
  
 

Timothy J. Howard is a Member of Howard & Howard Attorneys PLLC and concentrates his practice in business, commercial, real estate and trust litigation, and bankruptcy law.
Attorney Spotlight
  
 

Scott C. Frost is a Member of Howard & Howard Attorneys PLLC and concentrates his practice in the areas of business litigation, corporate law, finance and commercial litigation.
Attorney Spotlight
  
   

Grace Mata is a Member of Howard & Howard Attorneys PLLC and concentrates her practice in creditors' rights, business, commercial, and real estate litigation as well as labor and employment law.
Attorney Spotlight
  
  

Daniel S. Rubin is a Member of Howard & Howard Attorneys PLLC and concentrates his practice on business and financial reorganizations, commercial and real estate litigation, and secured lending and insolvency litigation.
This Advisory is intended for informational purposes only, and is not offered as legal advice.  Please call a qualified attorney for counsel related to your particular situation.