Dragnet Clauses: Sometimes They Don’t Work as Hoped, and Sometimes They Do

In re Presser, 504 B.R. 452 (Bankr. S.D. Ohio 2014)

A judgment lien creditor objected to a joint debtors’ chapter 11 plan of reorganization based on a dispute with a mortgagee about whether its mortgages secured guaranty obligations of one of the debtors. This issue determined who should receive payments under the plan.

The debtors’ obligations evolved as follows:

  • 1992: The joint debtors (Millard and Jennifer Presser) executed a $160,000 note in favor of a bank secured by an open-end mortgage covering various real estate.
  • June 1996: A business of one of the debtors (Presser’s Auto Parts) executed a $75,000 Business Line of Credit Promissory Note in favor of the bank secured by the business’s personal property. Millard guaranteed all debts owed to the bank by Presser’s Auto Parts. This first guaranty included a box that was checked indicating that the guaranty was “not supported by other security documents.”
  • July 1997: The debtors granted a second mortgage to the bank to secure a $200,000 note. This mortgage referenced the debtors and Presser’s Auto Parts as the obligors.
  • July 1998: Presser’s Auto Parts executed another $75,000 note that was identified as a renewal and extension of the first business note. This note was also guaranteed by Millard. This second guaranty did not indicate one way or the other whether it was secured.
  • September 2007: A judgment lien creditor filed a Certificate of Judgment for a $150,000 judgment plus interest, which created a lien against all real property owned by Millard and Presser’s Auto Parts in the applicable counties.

Since the mortgages were recorded first, all parties agreed that the lien of the mortgages was senior to the judgment lien. The question for the bankruptcy court was whether Millard’s guaranty liability was secured by the mortgages. The judgment lien creditor argued the guaranty liability was not secured because (1) the mortgages secured only joint liabilities of the debtors and not their individual liabilities, and (2) the bank failed to indicate in the guarantees that they were secured by the mortgages.

Both mortgages included language stating that they secured: “OTHER DEBTS. Payment by Mortgagor to Mortgagee of all other liabilities and indebtedness, direct or contingent, now or hereafter owing by Mortgagor to Mortgagee.”

As a preliminary matter, the court noted that bankruptcy courts look to state law to determine the existence and nature of property interests. An open-end mortgage secures advances made subsequent to the grant of the mortgage. In this case a state statute specifically authorized open-end mortgages and provided that if a mortgage meets certain requirements – including: (1) the words “open-end mortgage” are inserted at the beginning, (2) the mortgage indicates that it secures future advances, and (3) a statement of the maximum amount secured by the mortgage is included – then to the extent that the secured debt does not exceed the maximum amount, priority relates back to the date the mortgage is recorded. However, if the post-recording advances are not obligatory, intervening liens (i.e. liens arising between the date the mortgage was recorded and the date the subsequent advance is made) may obtain senior priority if appropriate notice is given to the mortgagee.

The mortgages complied with the statute by identifying the mortgages as open-end mortgages and including a stated maximum amount of debt; and the advances were made and liabilities incurred prior to the judgment lien, so there was no issue of the judgment lien obtaining senior priority senior priority as an intervening. Accordingly, the issue was whether the mortgages even secured Millard’s guaranty liability.

The court was clear that the plain language of the mortgages was sufficient to cover the guarantees. Although the judgment lien creditor argued that only joint liabilities were secured, the term “Mortgagor” was defined to include “the joint and several liability of not only the person signing this Mortgage, but also any person or persons who hereafter may assume payment of any or all of the indebtedness.” Thus, by definition, liability of “Mortgagor” included both joint and individual liability.

The judgment lien creditor also argued that the guaranty was not secured because it did not reference the mortgages. It cited two unreported state court appellate decisions in support of its position.

In one case, the state court addressed disposition of proceeds from a foreclosure sale. It determined that an intervening lienholder had priority over a subsequent advance by the mortgagee evidenced by a note that did not reference the mortgage. As described by the bankruptcy court, the state court concluded “without citation to any authority, that ‘[b]y its very formation, it is clear that an open-end mortgage and the flexibility it allows requires that any subsequent note given that is to be secured by the mortgage, must at the very least reference and demonstrate the relationship with the mortgage under which it was issued.’”

In the second case cited by the lienholder, a state court similarly held that a note that did not reference an open-end mortgage was not secured by that mortgage. However, in that case the loan was to a third party and was not even guaranteed by the property owners. Consequently, the bankruptcy court found the case was distinguishable.

The bankruptcy court itself raised an earlier state supreme court decision that held that “whether a prior mortgage secures discretionary future advances is a question of intent.” In that case the state supreme court concluded that in order to show that a discretionary advance was secured, the mortgagee “must allege that such advance was made either in reliance upon or on the faith of the security of the mortgage.”

However, the state supreme court decision was issued before the state statute was enacted. The bankruptcy court decided that the state legislature intended to provide a comprehensive set of rules for open-end mortgages. Since the statute did not include any requirement for a reference to the mortgage or any independent evidence of an intent that the future advance be secured by the mortgage, the bankruptcy court concluded that the element of establishing intent is no longer required.

Consequently, the court determined that the obligations under Millard’s second guaranty of Presser’s Auto Part debt were secured by the debtors’ joint mortgages, so the mortgagee’s guaranty claim was senior to the judgment lienholder’s claim.

In this case, the court determined that a dragnet clause was effective to cover future contingent liability as contemplated by the plain language of the mortgages. However, it is not a foregone conclusion that this will be the result. See, for example, Mortgagees Beware: Your Dragnet May Have a Hole In It and Cross-Collateralization: Your Dragnet Clause May Have at Least a Little Hole In It.

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).
This entry was posted in Financing, Real Estate and tagged , , , . Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s