Cross-Collateralization: Beware the Intricacies of Local Real Estate Law

Hari Aum, LLC v. First Guar. Bank (In re Hari Aum), 714 F.3d 274 (5th Cir. 2013) –

A debtor and its lender sought a determination of whether a mortgage on the debtor’s motel secured only a loan to the debtor, or also a loan by the lender to a second affiliated entity.  The bankruptcy court granted the mortgagee’s motion for summary judgment, and on a direct appeal to the 5th Circuit, it agreed that the cross-collateralization in the mortgage was effective, and the lien on the debtor’s motel secured both its loan and the loan to an affiliate.

This case was governed by Louisiana law. For those of you (like me) who are mystified by Louisiana mortgage documentation, the 5th Circuit’s description of a traditional collateral mortgage (which involves the pledge of a note secured by a mortgage) is enlightening:

It “consists of at least three documents, and takes several steps to complete:  first there is a promissory note, usually called a collateral mortgage note…  The collateral mortgage note is secured by a mortgage, the so-called collateral mortgage.  The mortgage provides the creditor with security in the enforcement of the collateral mortgage note…  [M]oney is not directly advanced on the note that is paraphed for identification with the act of a mortgage.  Rather the collateral mortgage note and the mortgage which secures it are Pledged [sic] to secure a debt.”

As further explained, a “paraph” is a signature (typically a notary’s signature), and when a note is “paraphed for identification with a mortgage” that means that the note is specifically linked to the mortgage through this signature.

However, a newer form of mortgage was introduced in the early 1990s – referred to as a “multiple indebtedness mortgage”(MIM), “future advance mortgage,” or “equity line mortgage” – to provide a more convenient mechanism for securing obligations that are not currently identifiable.

Under the statute establishing this type of mortgage (Article 3298), a mortgage may secure future advances and the priority with respect to third parties will relate back to the time that the mortgage is recorded.  A promissory note secured by a MIM does not need to be paraphed for identification and need not recite that it is secured by the mortgage.  Article 3298 provides:

  • The mortgage must be granted in favor of a specifically named and designated mortgagee.
  • The mortgage must provide that it is being granted to secure present and future indebtedness of the borrower in favor of the specified mortgage.  (Consequently there is no need for a specific pledge agreement.)
  • The definition of indebtedness in the MIM must contemplate present and future indebtedness.
  • The MIM must specify a maximum amount of debt to be secured.
  • It should reference the statute.
  • It should provide a procedure for canceling the mortgage.  (A MIM that secures future advances continues in effect until it is terminated, even if there is no outstanding indebtedness.)

In this case the debtor executed a MIM to secure its “Indebtedness,” which included debt that “may now be existing or that may arise in the future” including its “covenants and agreements in any present or future loan or credit agreement or any other agreement,” and any liabilities that it “may now and/or in the future owe to and/or incur in favor of [lender], whether direct or indirect, …  and whether now existing or hereafter arising… whether [debtor] is obligated alone or with others on a ‘solidary’ or ‘joint and several’ basis, as a principal obligor or as a surety, guarantor, or endorser of every nature and kind whatsoever.”  The debt secured by the mortgage was capped at $50 million.

The mortgage was recorded in February 2005.  In 2006, the sole managing member of the debtor obtained a commitment from the lender to finance the purchase of another hotel through another wholly owned and managed entity.   The commitment stated that the new loan would be secured by both the debtor’s hotel and the hotel to be acquired by the new entity.

In 2009, both loans were refinanced.  At that time the managing member executed (1) a resolution on behalf of the debtor that broadly authorized the member to pledge the debtor’s real property, and (2) the debtor’s Acknowledgment of Existing Multiple Indebtedness Mortgage.  Among other things, the resolution ratified and approved all past acts, and the acknowledgment confirmed that the 2005 MIM secured both the debtor’s and its affiliate’s obligations to the lender and that both entities were jointly and severally liable for all of the indebtedness.

The debtor argued that the 2005 mortgage by itself was not sufficient to secure future loans without recording further documents associating the mortgage with those loans.  While it appears that the debtor’s position would have been correct if the 2005 mortgage had been a traditional collateral mortgage, given that that mortgage met the requirements for a multiple indebtedness mortgage, the 5th Circuit determined that nothing further was required.

In particular, the 5th Circuit rejected the debtor’s arguments that this approach would be inconsistent with the public records doctrine (i.e. instruments involving immoveable property have effect against third persons only after they are filed for registry in the parish where the property is located).  The court did not view Article 3298 as “trumping” the public records doctrine, but rather as incorporating it.  Article 3298 makes it clear that a MIM continues in effect even if there is no outstanding obligation until the parties affirmatively cancel the mortgage.  Since there was no increase in indebtedness above the cap and the cross-collateralized loan constituted “Indebtedness” as defined in the mortgage, the 2005 recorded mortgage was sufficient.

There was an additional issue:  Under Louisiana law a managing member of an LLC may act as its agent in all matters in the ordinary course of business except encumbrance of immoveables, which generally requires a majority vote of members.  The debtor argued that there was no valid written authorization of the pledge of the debtor’s motel to secure the affiliate’s loan.  However the sole member signed both the resolution and the acknowledgment, which the court viewed as sufficient to satisfy the requirement for approval by a majority of members.

This case involved application of Louisiana law, and everyone expects Louisiana law to be peculiar.  However, it is worth remembering that as a general matter real estate law is far from uniform.  When trying to cross-collateralize affiliate loans or secure future advances, it is important to have somebody knowledgeable about applicable state law confirm that appropriate documents and procedures are used.  See Mortgagees Beware: Your Dragnet May Have a Hole In It for another example.  (Although
this case was recently reversed by the 7th Circuit, it remains an example of the potential pitfalls in enforcing cross-collateralization provisions.)

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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