The Enforceability of Dragnet Clauses
Courts have long struggled with the enforceability of "dragnet clauses." This is especially the case in consumer bankruptcies where the disparity in bargaining power perhaps leads the court to be more sympathetic to a consumer than to a commercial borrower. Several recent cases—a Texas bankruptcy court decision and two Wisconsin bankruptcy court decisions—illustrate how courts analyze the issues.
Though the issue predates the Uniform Commercial Code (UCC), reference must be made to that statute as a starting point. UCC §9-204 (1972 version) provides the following:
- Except as provided in subsection (2), a security agreement may provide that any or all obligations covered by the security agreement are to be secured by after-acquired collateral.
- No security interest attaches under an after-acquired property clause to consumer goods other than accessions (§9-314) when given as additional security unless the debtor acquires rights to them within 10 days after the secured party gives value.
- Obligations covered by a security agreement may include future advances or other value whether or not the advances or value are given pursuant to commitment.
The official comment indicates that this section was intended to explicitly reject pre-Code case law that limited the effectiveness of after-acquired property clauses, as well as future-advance clauses. Comment 1 to UCC §9-204 indicates that the section explicitly rejects Code limitations on after-acquired property clauses. Comment 5 states:
In line with the policy of this article toward after-acquired property interests, this subsection validates the future advance interest, provided only that the obligation be covered by the security agreement.
As the statute indicates, one must distinguish between after-acquired property clauses and future-advance clauses. After-acquired property clauses provide that later-acquired property secures earlier liabilities or commitments. Future-advance clauses provide that the described collateral or security agreement will secure later liabilities. The after-acquired property clause is frequently referred to as a "floating lien," with the "dragnet" designation sometimes being reserved for the future-advance clause.
Notwithstanding UCC §9-204, its official comment and its policy to make the law uniform, some courts have had difficulty giving up pre-UCC ideas that placed extra-contractual limits on the effectiveness of dragnet clauses, especially future-advance clauses. The issue arises with respect both to personal property collateral and to real estate collateral. The issue frequently appears in the bankruptcy courts, sometimes in lift stay motions with respect to the extent and value of collateral, sometimes in objections to claims, and sometimes in preference actions.
Procedurally, Bankruptcy Rule 7001 requires an adversary proceeding to determine the validity or extent of liens. If the issue arises out of an objection to a claim based on Rule 3007, the matter becomes an adversary proceeding, but not all courts insist that it actually be converted to an adversary proceeding. See In re Robinson, 217 B.R. 527, 529-530 (Bankr. E.D. Texas 1998). Three recent cases have brought the issue to the forefront and exemplify the different approaches that courts take.
Wisconsin Bankruptcy Courts Uphold Dragnet Clauses
The effect of a dragnet clause in a consumer context was upheld in the case of In re James, 221 B.R. 760 (Bankr. W.D. Wis. 1998). The debtors had signed a security agreement that stated that the security interest was to secure "all of any debtor's present and future debts, obligations and liabilities whatever in nature" to the lender. The security agreement had been signed at the time the debtor purchased a car.
The debtors were also obligated to the lender for credit card debt. The bank's credit card regulations provided that the credit card debts would be secured by all collateral held for other loans when the credit card balance exceeded $1,000. The bank claimed that its credit card regulations, as well as the security agreement, provided that the credit card balance was also secured by the car.
The court analyzed cases interpreting Wisconsin law as well as bankruptcy court cases interpreting other states' laws. The court was critical of, or at least questioned, those cases that require that a future debt be "related" to the prior debt in order to be secured by a prior security agreement, stating:
Imposing a requirement of "relatedness" even when a debt clearly falls within the literal language of an agreement precludes the use of any dragnet clause for otherwise unrelated debts when no such prohibition has been set forth in Article 9 of the Uniform Commercial Code.
Id. at 763.
The Wisconsin court noted that courts that apply a relatedness standard frequently cite a test that the debt "be of the same class as the primary obligation secured by the instrument and so related to it that the consent of the debtor to its inclusion may be inferred," but noted that this test was far from illuminating. In James, the lender claimed that the debts were related because they were both consumer debts, whereas the debtor claimed that they were not related because the car loan was a closed-end credit and the credit card was an open-end credit.
The James court concluded that the credit card debt was secured by the car. First, the language in the security agreement itself was clear in the breadth of its reach. Second, the credit card regulations themselves, even if not read by the debtors, notified the debtors of the cross-collateralization of the credit card debt to the car. Finally, even if a "same-class" or "relatedness" test were applied, because both the car loan and the credit card debt were consumer debts, they met both tests.
Ultimately, the court buttressed its conclusion on an "intent of the parties" and "plain meaning" basis. The language of the security agreement was clear. If the debtors were to prevail, they would simply have been escaping otherwise valid, express agreements by saying they had not read them or understood their effect. Notwithstanding that the debts were consumer debts, the court concluded that fairness did not permit the debtors to avoid their side of the bargain.
Another Wisconsin bankruptcy case enforced future advance language in a mortgage based both on the language of the mortgage and the fact that if a "same class" of debt test were applied, it would be met. In re Hill, 210 B.R. 1016 (Bankr. E.D. Wis. 1997). In the Hill case, the dragnet issue was whether a mortgage on the debtor's homestead and a vacant lot covered credit card debt, reserve account (check overdraft protection) debt and/or vehicle loan debt. The credit card application pre-dated the mortgage, and the reserve account agreements post-dated the mortgage. The lot had been sold prior to the case filing and its proceeds were applied against the credit card debt, reserve account debt, real estate taxes, a vehicle loan and the mortgage note within the 90 days before the filing. If the funds were improperly applied, the bank would have received a recoverable preference.
The Hill court noted the reason for judicial scrutiny of future-advance clauses:
The original basis for their concern was the ingenious but perhaps devious practice of some creditors who, having obtained a future-advances clause from the debtor, would then go around to the debtor's unsecured creditors, purchase their rights, and then argue that the purchases were future advances to the debtor and therefore secured.
Citing Matter of Kazmierczak, 24 F.3d 1020, 1021 (7th Cir. 1994). This concern was the basis for Grant Gilmore's suggestion that pre-UCC cases were not overruled by §9-204(3). See 2 Grant Gilmore, Security Interests in Personal Property, pp. 931-932, sec. 35.5 (1965), where he proposed that although vague, the "same class," "relatedness" or "similarity of debt" tests could be used to curb such abuses.
The mortgage in the Hill case included an extensive future advance, dragnet paragraph (the standard language of mortgage forms used in Wisconsin by many lending institutions). The court concluded that (i) the abuse that Gilmore feared was not present; (ii) the credit card debt had not been covered previously by the mortgage because, as to consumer debt, the mortgage by its express terms only covered future consumer debt and the credit card application pre-dated the mortgage; (iii) the reserve account debt was covered by the mortgage because the reserve account agreements post-dated the mortgage and contained language stating that they were secured "by all security agreements of borrower now or hereafter held or acquired by bank." If a "same class" or "relatedness" test applied to subsequent debt, that test was met because both the mortgage debt and the reserve account debt were consumer debts; and (iv) the vehicle loan was covered by the mortgage because the vehicle note said it was secured by all existing and future security agreements between the lender and the debtors.
In both Wisconsin cases, the courts fundamentally upheld the dragnet clause based primarily on its language.
Texas Bankruptcy Case Invalidates Dragnet Clause
A Texas case, In re Robinson, 217 B.R. 527 (Bankr. E.D. Texas 1998), invalidated a cross-collateralization type of dragnet clause in a case that also involved a vehicle and credit card debt. The vehicle loan had been originated in 1991 by a dealer, and it appears that the Retail Installment Sales Contract and Security Agreement was signed by the dealer and assigned to the credit union, as the creditor's name that appeared on the contract was that of the car dealer. The security agreement provided that "...all collateral which is given to secure this loan also secures all other obligations of yours with CU [credit union]." The credit card application had been approved in 1989 prior to the vehicle loan. The application contained no provision regarding collateral.
After referencing Texas' version of §9-204, the Texas bankruptcy court concluded that the credit card debt did not meet the test "reasonably within the contemplation of the parties" at the time the security agreement was signed. In this case, while the credit card agreement said nothing about collateral, and notwithstanding that the security agreement provided that the vehicle also secures all other obligations of the debtors, the court concluded there was an ambiguity. Based on this, the court found that there was no "clear and unambiguous intent of the parties to offer the vehicle as security for the credit card indebtedness."
In its analysis, the Texas court referred to several cases where the security agreement at issue had not originated with the creditor who was attempting to enforce its dragnet provisions. As with those cases, in Robinson it was a third party who was attempting to include within the intent of the car dealer/signatory to the contract debt that had not originated with that signatory.
What lessons can be learned from these cases? First, as to future advances, some expression—or lack of it—in the document evidencing the later loan of an intent (even generally stated) for the later loan to be secured by an earlier security agreement is given significance.
Second, the attempt to require a "relatedness," "same-class" or "similarity of debt" test to future-advance issues proves difficult because it may clash with the language of the security agreement. The UCC doesn't require these tests and they serve, even in the words of §9-204(3), only to reach a conclusion of whether the debt was intended to be "covered by a security agreement."
Finally, when the person who holds the security agreement changes, and the subsequent holder tries to claim that the debt originated by that person is covered under a future advance clause, it appears that the subsequent holder faces an uphill struggle.