2nd Mortgage Holder Screws Itself When Making Loan Without First Inquiring As To Existence Of Prior Undisclosed Loans Secured By Existing 1st Mortgage Containing Cross-Collateralization Clause Appearing Conspicuously On Face Of Instrument

From a Justia.com Opinion Summary:

• Peoples Bank loaned Debtors $214,044, secured by a mortgage recorded in 2004 ["Peoples Loan 1].
  
  In 2008, Debtors obtained a $296,000 construction loan from Banterra, secured with a second mortgage on the same property.
  
  Banterra was aware of the first mortgage, but did not know was that in 2007, Debtors obtained a second loan from Peoples, for $400,000, secured by another mortgage on a different piece of property. ["Peoples Loan 2"]
  
  The 2004 Peoples mortgage contained a cross-collateralization provision, stating that “In addition to the Note, this Mortgage secures all obligations … of Grantor to Lender … now existing or hereafter arising,” and a provision that “At no time shall the principal amount of the Indebtedness secured by the Mortgage … exceed $214,044.26 … “Indebtedness” … includes all amounts that may be indirectly secured by the Cross-Collateralization provision.”
  
  In 2010 Debtors filed a Chapter 11 bankruptcy petition. The balance due on Peoples 2004 loan [Peoples Loan 1] was then $115,044.26.
  
  Debtors received permission and sold the property for $388,500.00. Out of these proceeds, Peoples claimed the balance due on the 2004 loan plus partial payment of the 2007, up to the cap. The Bankruptcy Court found in favor of Peoples.
  
  The district court reversed.
  
  The Seventh Circuit reversed, upholding the “plain language” of the cross-collateralization agreement.(1)

Source: Opinion Summary: Peoples Nat'l Bank v. Banterra Bank.

For the court ruling, see Peoples Nat'l Bank v. Banterra Bank, No. 12-3079 (7th Cir. May 20, 2013).

(1) Some of the 7th Circuit's analysis and reasoning in applying the law of Illinois (the state in which the deal took place) as to why Banterra, the 2nd mortgage holder, had an obligation to discover the existence of the undisclosed People's Loan 2 when making its secured loan to Debtors follows:

• It is undisputed that Banterra did not have actual notice or knowledge of Peoples Loan 2. It is similarly undisputed that Banterra did have actual notice and knowledge of Peoples Loan 1, the mortgage securing it, and the cross-collateralization clause that it conspicuously[1] contained. The dispute is over the legal significance of these two facts.

***

• Like record notice, inquiry notice is essentially a form of constructive notice. See Pelfresne v. Village of William Bay, 965 F.2d 538, 542 (7th Cir. 1992); National Family Ins. Co. v. Exchange Nat. Bank of Chicago, 474 F.2d 237, 241-42 n.1 (7th Cir. 1973); 112 Am. Jur. Proof of Facts 3d 419 § 12 (2013) (collecting cases); 1 PATTON AND PALOMAR ON LAND TITLES § 12 (3d ed. 2012) (collecting cases).
  
  Record notice rules treat a subsequent creditor with no actual knowledge of a prior interest as having actual notice if the prior interest was properly recorded. A subsequent creditor receives no quarter for having failed to search the relevant real estate records, so long as the interest was properly recorded. Inquiry notice operates under a similar principle.
  
  Inquiry notice describes the situation where the transferee has been made aware of facts or circumstances from which the existence or possibility of a prior claim might reasonably be inferred.
  
  If so, the purchaser then has a duty to verify or dispel the inference through further inquiry.
  
  If he fails to make 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. In re Shara Manning Properties, Inc., 475 B.R. 898, 906 (Bankr. C.D.Ill. 2010); see Smith v. Grubb, 402 Ill. 451, 464-65 (1949); 112 Am. Jur. Proof of Facts 3d 419 § 12 (collecting cases).
  
  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.
  
  Banterra concedes its actual notice of Peoples Loan 1 and the mortgage securing it. The cross-collateralization clause is conspicuously placed on the first page of the mortgage, discoverable with just a cursory review of the document. Id.
  
  The clause states expressly that, in addition to Peoples Loan 1, the collateral secured all debts of the grantor to the lender "now existing or hereafter arising."
  
  Of this Banterra was aware and "from [this] the existence or possibility of a prior claim might reasonably be inferred." Moreover, it is clear that a reasonable investigation would have disclosed this prior claim.[3]

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• The cross-collateralization clause expressly contemplates debts arising in the future, when Debtors may well have paid down some of the initial loan, creating room under the cap. Nothing in the case explains why this entirely plausible scenario (indeed, it is precisely what happened) should be outside the set of possible outcomes considered by anyone reading the document. Because it is self-evident that the parties intended that the amount of indebtedness under the initial loan would be paid down by Debtors over time, we cannot agree that setting the maximum amount of indebtedness equal to the amount of the initial loan "evidence[s] an intent that the mortgage not secure any other debt." Peoples Nationals Bank, 482 B.R. at 264.

***

• Finally, as a matter of policy Banterra laments that the position we adopt today will chill lending and commerce, making it more difficult for third-party lenders like Banterra to confidently approve loans secured by property that has been cross-collateralized.
  
  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. But the more salient response to Banterra's concern is that adopting its position will not in any event dispel the chilling effect—it will merely transfer it between the parties.
  
  A cross-collateralization clause makes a given security interest more valuable to the grantee. The position Banterra urges would reduce that value, shifting it away from the initial grantee and to prospective subsequent grantees.[5] In either case, one lender's incentive to lend is increased, while the other's is reduced. Between the two, however, 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.

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In footnote 3 of the ruling, the appeals court reminds us that the duty to inquire in a case like this is limited to the making of 'reasonable inquiry':

• It is undisputed that a name search of the Jefferson County land records would have revealed the existence of Peoples Loan 2. Banterra wonders skeptically whether, under Peoples' theory, the investigation required of one put on inquiry notice might entail searching records, not just in Illinois counties, but in every county in neighboring states as well.
  
  But the law requires reasonable investigation, not endless investigation, and a party allegedly on inquiry notice can rebut the argument by showing that a reasonable investigation did not yield discovery of the relevant information. Jesko v. American-First Title & Trust Co., 603 F.2d 815, 818-19 (10th Cir. 1979); 112 Am. Jur. Proof of Facts 3d 419 § 12 (2013) (collecting cases); 1 PATTON AND PALOMAR ON LAND TITLES § 12 (3d ed. 2012) (collecting cases).
  
  Ultimately, where to draw that line will be a question for the trier of fact. Here, however, the Bankruptcy Court found, and the parties do not dispute, that the investigation required to have discovered Peoples Loan 2 was within the bounds of reasonableness. See In re Jones, 2011 WL 6140686, *9.