Daily Development for Friday, November 14, 2003 by: Patrick A. Randolph, Jr. Elmer F. Pierson Professor of Law UMKC School of Law Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu MORTGAGES; FORECLOSURE; NOTICE: Holder of dragnet clause mortgage need not indicate in private foreclosure notice that it is attempting to collect on debts other than the principle debt described in the mortgage. Home Federal Bank v. First National Bank, 110 S.W.3d 433 (Tenn. Ct. App. 2003). In addition to the $235,000 commercial loan that was the subject of its deed of trust, the lender included a "dragnet clause" that stated that the deed of trust was given"to secure the full, prompt and final payment of any and all indebtedness, principal, interest, attorney's fees and costs, as may be provided in instruments evidencing such indebtedness, or otherwise, now or hereafter owing directly or indirectly, or as endorser or guarantor for others to First National Bank . . . ." This type of future advance provision is sometimes known as a "dragnet clause." The subject property was several subdivision lots. Later, the lender made an additional $50,000 loan to the same borrower for personal purposes, secured by a deed of trust on other property. When the borrower went into default on both loans, the lender brought a private foreclosure on the $235,000 first loan. It sent notice of the foreclosure to the holder of a recorded second deed of trust on the subdivision lots. Tennessee law requires that a foreclosure notice set forth the names of "parties interested," a term defined to include holders of junior liens. The second deed of trust holder, however, was not named as a "party interested." In addition, the notice failed to state specifically that the foreclosure was being brought to collect any debt other than the $235,000 debt specifically mentioned. The notice stated that the first deed of trust "describe[s] real estate, to secure the payment of the following indebtedness: one note of even date executed by [borrower] in the original amount of $235,000." It also said that "default has ben made in the payment of said indebtedness and other provisions of the Trust Deed have been violated," and that the holder "has declared the entire amount due and payable as provided in said deed of trust." The notice stated, finally, that the proceeds would be "applied iin accordance with the provisions of the above described Deed of Trust." The sale produced a surplus over the balance owed on the $235,000 loan, and the first lienholder sought to apply the surplus to satisfaction of $50,000 loan later made to the same borrowers. The junior lienholder argued that it did not receive proper notice that the lender was intending to collect the $50,000 lien in this foreclosure. It noted that, although it received notice of the foreclosure, it did not attend, arguing that this demonstrated that it believed that there would be a surplus to which it would have access. [Why exactly this would have led the junior not to attend the foreclosure sale isn't made clear.] The court acknowledged that there was a technical failure to comply with the Tennessee notice requirements, but nevertheless upheld the sale, holding that the junior lender had an obligation to review the terms of the first deed of trust and to anticipate that any other loans owed to the senior lender might also be collected as part of the procedure. "[T]hird parties are charged at their peril to inquire of the lender and prior secured creditors." Comment 1: The editor have seen a number of other judicial decisions that are far more punctilious about the notice requirements, but usually they impose rigorous review when they conclude that some unfairness resulted. Here, it appears that the court did not believe the junior lender's story that it didn't attend the foreclosure because if felt that there would be a surplus produced to which it would have access. How could the junior lender properly have anticipated such a development? In fact, it would appear that the junior might well have gone into court arguing for equitable marshalling to further protect its lien, as the $50,000 was also secured by other property. Comment 2: The above having been said, the editor still is dubious about the proposition that the junior should have anticipated that the senior had other loans that it was collecting in this foreclosure. The court mentions no specific cross default clause in the senior mortgage. Although the court doesn't say so, however, there probably was a clause that said that foreclosure could be had in the event of a default on "any indebtedness secured by this deed of trust." This is extremely vague, however. Without actually checking with the senior lender, the junior had no way of anticipating that other sums were at stake. Consider the situation where the first deed of trust secures an original loan of, say $100,000 and contains a dragnet clause. But there is another, later loan, of $5,000,000, secured by other property, which the lender has concluded is in default. Would the notice give here properly appraise all concerned (even the borrower) that the foreclosure is to collect a $5,000,000 debt? More to the point, if the answer is that there was not adequate notice, what harm would result? Certainly, if the borrower isn't aware, the borrower could be dutifully arranging to satisfy the $100,000 default and redeem from the foreclosure, only to discover at the last minute that the task was larger than anticipated. Similarly, other lenders could be negotiating with the borrower as to any foreclosure surplus, and again these negotiations would lead to nothing. It does seem that regular and accurate notice is desirable. Certainly compliance with the statute ought to be a bare minimum. One would think that an appeal would have been in order. But the case was decided September 10, 2003, and as of this writing, November 14, 2003, no appeal has been docketed. MORTGAGES; PRIORITY; FUTURE ADVANCES: First mortgage holder has priority over intervening second mortgage holder as to optional future advance made by first mortgage holder pursuant to dragnet provision in first mortgage without actual notice of second mortgage holder's lien. Home Federal Bank v. First National Bank, 110 S.W.3d 433 (Tenn. Ct. App. 2003). discussed further under the heading: "Mortgages; Foreclosure; Notice." Defendant bank made a commercial loan to a borrower secured by a first mortgage lien on approximately 12.58 acres of real property. The recorded mortgage stated that it secured repayment of a $235,040 commercial loan, but also provided that the mortgage was made "to secure the full, prompt and final payment of any and all indebtedness, principal, interest, attorney's fees and costs, as may be provided in instruments evidencing such indebtedness, or otherwise, now or hereafter owing directly or indirectly, or as endorser or guarantor for others to First National Bank . . . ." This type of future advance provision is sometimes known as a "dragnet clause." The borrower later secured a $100,000 loan from plaintiff bank and granted plaintiff bank a second mortgage on the same property that secured the defendant bank's loan. Then, defendant bank made an optional advance to the borrower in the amount of $50,000. This advance was secured by other property, but of course fell within the literal meaning of the security provisions of the dragnet clause. Later, borrower defaulted on defendants loans. Defendant foreclosed on the 12.58 acre parcel and sold the property at foreclosure. It attempted to apply monies resulting from the foreclosure sale to satisfaction of both the original debt, and, to apply the $38,000 surplus remaining to reduce the balance on the second, $50,000 loan, which was also in default. Plaintiff objected that it had a prior claim on the surplus. The court held that dragnet provisions in general are enforceable under Tennessee common law. Tennessee has a special statute on future advance provisions, but most of the statute deals with consumer loans. The parties had stipulated that the statute did not apply, but the Tennessee court concluded that parts of the statute were more broad in their application and defined priority for other kinds of future advance provisions. This statute recapitulates the common law "optiona/obligatory" test, but says that optional advances are primed by subsequent interests arising when the holders have no actual knowledge of the prior interest. Based on this statute the court concluded that defendant bank had priority over plaintiff bank as to its optional advance if defendant bank made that advance without actual notice of plaintiff bank's mortgage. It remanded for a determination on the question of notice. Comment 1: Note that the Restatement of Mortgages advocates an abandonment of the common law "optional/obligatory test," even though few states have rejected that test as part of the common law. The rationale of the Restatement, in part, is that many state statutes have preempted the common law and have abandoned the test. It is interesting to note that the Tennessee statute in fact preserves the common law test for commercial loans, and also to note that the court upholds the validity of dragnet clauses in commercial loans - another concept that is under attack in the Restatement and elsewhere. Comment 2: Note that, even under this issue, the defendant lender is not out of the woods. The first mortgage, containing the dragnet clause, was recorded. If the second lender got a title report, this report would have shown that mortgage. Even if it didn't read the mortgage, it had actual knowledge of it simply from the fact that its agent, the title insurer, picked it up on the report. Readers are encouraged to respond to or criticize this posting. Items reported on DIRT and in the ABA publications related to it are for general information purposes only and should not be relied upon in the course of representation or in the forming of decisions in legal matters. 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