Page 17 - John Hundley 2013

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-
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3079, __ F.3d __, 2013 WL 2150820 (7th Cir. May 20, 2013).

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.” Hundley

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.

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

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