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Enforceability And Priority Of "Dragnet" Clauses In Mortgages

Are cross-collateralization, or “dragnet” clauses in mortgages enforceable in Kentucky? If so, what priority is afforded additional indebtedness secured by a dragnet clause vis-à-vis an intervening lien-holder?

A. Enforceability of dragnet clauses in general.

The enforceability of dragnet clauses in general appears to vary from state to state. According to both AmJur Mortgages §55 and Restatement 3d Property (Mortgages) §2.4, dragnet clauses are generally looked upon unfavorably by courts, primarily because the mortgagor may not be specifically aware that a clause exists in the mortgage that purports to grant the mortgage as security for all debts to the mortgagee of any kind or nature; in essence, some courts find that they are too sneaky. However, according to both the Restatement and AmJur, dragnet clauses are generally enforceable.

Under the Restatement view, “a mortgage may secure future advances that are not made in connection with the transaction in which the mortgage is given, and that are not specifically described in the mortgage or other documents executed as part of that transaction;” provided, however, that “the parties must have agreed that such future advances will be secured; and “the advances must be made in a transaction similar in character to the mortgage transaction, unless (1) the mortgage describes with reasonable specificity the additional type or types of transactions in which advances will be secured; or (2) the parties specifically agree, at the time of the making of the advances, that the mortgage will secure them.” Restatement 3d Property (Mortgages) §2.4. According to the comments to this section of the Restatement, the dragnet clause itself can constitute the specific agreement.

B. Enforceability of dragnet clauses in Kentucky.

The enforceability of dragnet clauses in Kentucky appears to be an open question, but the state of the law on future advance and additional indebtedness clauses may be a good indication of what appears to be a fairly liberal attitude in Kentucky’s courts with respect to the extent to which a mortgage can secure future advances in general.

So-called “additional indebtedness” or “future advance” clauses are clearly enforceable in Kentucky, both by statute and under applicable case law. Kentucky Revised Statutes (“KRS”) §382.520 provides that a mortgage “may secure any additional indebtedness, whether direct, indirect, existing, future, contingent, or otherwise, to the extent expressly authorized by the mortgage, if the mortgage by its terms stipulates the maximum additional indebtedness which may be secured thereby.” KRS §382.520(2). Kentucky courts have accordingly held that:

"Under the common law and under the decisions of this Court, the rule is that a mortgage may be drafted, if given in good faith, so as to secure future extensions and renewals as well as a present debt. It is sufficient if the mortgage clearly shows it is to stand as security for both an original loan and for such additional indebtedness as may arise from future dealings between the parties… Future liabilities intended to be secured should be described with reasonable certainty. If the nature and amount of the encumbrance is so described that it may be ascertained by the exercise of ordinary discretion and diligence, that is all that is required."

Bank of Maysville v. Brock, 375 S.W. 2d 814, 816 (Ky. 1964).

So long as the additional advance clause in the mortgage is clear, unambiguous, and describes the maximum amount of future indebtedness to be secured by the mortgage, Kentucky cases have demonstrated a willingness to enforce such clauses broadly.

In First Commonwealth Bank of Prestonsburg v. West, 55 S.W. 3d 829 (Ky. App. 2000), the Kentucky Court of Appeals found that a future advance clause in a married couple’s home mortgage was sufficient to secure subsequent debts incurred by the husband alone for business purposes without the consent of the wife. In In re Polley, 219 B.R. 205 (Bankr. W.D. Ky. 1998), the United States Bankruptcy Court for the Western District of Kentucky, applying Kentucky law, also held that a future advance clause in a mortgage securing a home loan note executed by husband and wife was enforceable to secure subsequent advances made to the husband for business purposes. In re Polley, 219 B.R. 205 (Bankr. W.D. Ky. 1998). Despite the fact that the subsequent advances in both cases were made for purposes entirely unrelated to the original loan transaction, the court found the future advance clauses enforceable to secure such advances.

To date, no Kentucky court has examined the enforceability of a dragnet clause in a mortgage that does not provide any cap on future advances to be secured by the mortgage; however, several courts have examined the enforceability of such clauses in the context of security agreements governed by the Uniform Commercial Code. In First Natl. Bank of Grayson v. Citizens Deposit Bank and Trust, 735 S.W. 2d 328 (Ky. App. 1987), the Kentucky Court of Appeals found that very broad dragnet clauses were enforceable to secure all future advances made to the debtor. In In re Shemwell, 378 B.R. 166 (Bankr. W.D. Ky. 2007), the bankruptcy court, finding that a clear and unambiguous dragnet clause in a security agreement was enforceable, noted that “dragnet clauses are more broadly enforced than future advance clauses.” Id. at 167.

An examination of Kentucky’s case law on future advance clauses in mortgages and dragnet clauses in security agreements indicates that Kentucky has a fairly liberal attitude toward the concept of future debts being secured under existing security instruments, provided that the clause in question is sufficiently clear an unambiguous. The court in Shemwell even suggests, but does not absolutely state, that the language in the agreement should have put the debtor on notice, so his failure to read it or be aware of it had no effect on enforceability. Id. at 168. Accordingly, if Kentucky were to find dragnet clauses in mortgages enforceable, it does not necessarily appear that a Kentucky court would adhere to the requirements of the Restatement that the nature or character of the future advances be spelled out in the mortgage, and that any future indebtedness be of a related character.

Based on Kentucky’s apparently liberal attitude with respect to enforceability of future advance clauses in mortgages and dragnet clauses in security agreements, it appears possible that a dragnet clause in a mortgage would be found enforceable in Kentucky, but obviously, until a court actually considers the question, it is impossible to determine with any certainty whether a dragnet clause would actually be found enforceable.

C. Priority of future advances under a dragnet clause vis-à-vis intervening lien-holders.

Assuming that a Kentucky court would find a dragnet clause in a mortgage to be enforceable, the question remains as to what the respective priorities are between a subsequent advance made under a dragnet clause and an intervening lien-holder.

Under the Restatement view, if the dragnet clause is enforceable, any future advances made under that clause have the same priority as the original mortgage. Restatement 3d Property (Mortgages) §2.3. Courts in Texas and Tennessee have generally reached that same conclusion, although the Tennessee court relied heavily on a Tennessee statute in reaching that determination. Home Federal Bank, FSB, of Middlesboro, Kentucky v. First Natl. Bank of LaFollette, Tennessee, et al., 110 S.W. 3d 433 (Tenn. App. 2002), and suggested that if the original lien-holder had actual notice of the intervening lien before making the subsequent advance, the result might be different.

Kentucky has examined the question in the context of a security agreement governed by the provisions of the Uniform Commercial Code. In First Natl. Bank of Grayson v. Citizens Deposit Bank and Trust, 735 S.W. 2d 328 (Ky. App. 1987), a junior lien-holder argued that its lien had priority over subsequent advances made by the first lien-holder based on the fact that the financing statement filed by the first lien-holder made no reference to the existence of a dragnet clause. The Court held that (i) the first lien-holder had first priority for all sums advanced pursuant to the dragnet clause; (ii) the financing statement was not required to disclose the existence of the dragnet clause; and (iii) the security agreement itself provided actual notice to any subsequent creditor that future advances were covered by the lien. Id. at 329-330.

Based on the Restatement approach, and the Kentucky court’s decisions with respect to the priority of advances made under dragnet clauses in security agreements, it is certainly possible that a Kentucky Court, when faced with the question, would find that future advances made pursuant to a dragnet clause in a mortgage would take priority over an intervening lien-holder; however, until that precise question is addressed by a Kentucky court, it is impossible to determine how such a dispute would ultimately be resolved.

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Christopher C. Tieke is an associate in Frost Brown Todd's Louisville office, focusing his practice on business litigation. He graduated from the University of Cincinnati College of Law, with magna cum laude honors; served as an Associate Member of the University of Cincinnati Law Review; and participated in the Entrepreneurship and Community Development Clinic.