The inclusion of so-called “dragnet clauses” in loan and security documents is often the subject of much discussion and negotiation when a loan transaction is documented. Should the loan documents and specifically the security documents include a dragnet clause?
Should the clause be limited to future advances on the loan being advanced or all loans past, present and future to the borrower? Do previously existing security documents such as a security agreement, pledge or real estate mortgage secure a new loan made by a lender to a borrower without having to amend those documents to specifically reference the new obligation? In the brief discussion that follows, we will try to clarify some of these complicated issues. Our discussion will focus on dragnet clauses only in commercial loan documents as the enforceability of dragnet clauses in consumer loan documentation is far more limited and beyond the scope of this discussion.
What is a dragnet clause?
A dragnet clause is a clause in a collateral document that purports to expand the scope of the obligations being secured by such collateral to all debts of the borrower to the lender, whenever and however arising. Although dragnet clauses are commonly used to secure future advances on a loan commitment, they can also cover any and all other loans involving the same parties. Ordinarily a dragnet clause will provide language such as: “The security granted hereby secures all obligations of the borrower to the lender, whether now existing or hereafter arising, of whatever nature and kind.”
Often disputes regarding the scope and applicability of dragnet clauses arise in the context of a bankruptcy of a borrower and challenges by either a bankruptcy Trustee or a junior lien holder to the scope of the senior lender’s collateral. How dragnet clauses are treated differs somewhat in regard to asset-based lending as opposed to obligations secured by a real estate mortgage. The UCC governs asset-based loans. UC.C. § 9-204(c) provides:
Future advances and other value. A security agreement may provide that collateral secures, or that accounts, chattel paper, payment intangibles, or promissory notes are sold in connection with, future advances or other value, whether or not the advances or value are given pursuant to commitment.
Comment 5 to this provision states:
Future Advances; Obligations Secured. Under subsection (c) collateral may secure future as well as past or present advances if the security agreement so provides. This is in line with the policy of this Article toward security interests in after-acquired property under subsection (a). Indeed, the parties are free to agree that a security interest secures any obligation whatsoever. Determining the obligations secured by collateral is solely a matter of construing the parties’ agreement under applicable law. This Article rejects the holdings of cases decided under former Article 9 that applied other tests, such as whether a future advance or other subsequently incurred obligation was of the same or a similar type or class as earlier advances and obligations secured by the collateral.
Given the broad language of the UCC, the primary restraint on a secured creditor’s rights to enforce a dragnet clause in a security agreement is the duty of good faith including the standard of commercial reasonableness applicable to all transactions governed by the UCC[1]. Worth also noting is the fact that a dragnet clause contained in a security agreement for a previously repaid note may well remain active in regard to a subsequent loan, as the security agreement would not automatically terminate after the prior loan was repaid, unless this is specifically provided in the security agreement.
A dragnet clause in a mortgage attempts to secure other loans to the borrower from the lender with the real estate described in the mortgage. Because the UCC does not govern real estate mortgages, different rules apply to such dragnet clauses in Massachusetts[2]. In Massachusetts, the enforceability of dragnet clauses is limited in two very important respects: (1) the dragnet clause will be interpreted to apply only to other debts of the same general kind as that specifically secured by the mortgage; and (2) any future, new obligation must be referred to in the mortgage or have been contemplated by the parties at the time the mortgage was granted. While a dragnet clause can secure future advances by the lender, as a result of “both the principle of narrow construction of dragnet clauses and that of the general priority of intervening lienors … if lenders intend to retain priority under a dragnet clause for future advances as against intervening lienors, the language effecting that intent should be explicit.” NAB Asset Venture III, L.P. v. Brockton Credit Union, 62 Mass. App. Ct. 181, 185 (2004). In other words, the best practice to make sure new loans are fully secured by the existing collateral is to amend the existing loan documents to specifically reference the new loan and to evidence the intent of the borrower that the existing collateral secures the new loans.
Given the potential uncertainty in regard to how much protection and priority a lender may have in regard to future advances, the best practice for making sure that future advances or new loans are fully secured by the existing mortgages would be to update the titles on each mortgaged property to make sure there are no intervening liens. In addition, if reliance is to be made on a previously recorded mortgage to secure a new loan it would be best to record mortgage amendments for any such mortgage specifically stating it secures such new loan. (This of course may involve quite a bit of additional legal work, title and tax diligence and title endorsements to the existing title policies.) Finally, if a construction loan is involved, regardless of the presence of a future advances or dragnet clause, title must be rundown and executed lien waivers obtained before every advance from the general contractor (and subcontractors, as applicable), since the Massachusetts Mechanic’s Lien Statute provides special protections and priorities for contractors and subcontractors, which in the absence of lien waivers will likely give any valid mechanic’s lien priority over a further advance by a lender under a construction loan.
Dragnet clauses are powerful tools to protect a lender’s exposure on defaulted loans. They also have somewhat complicated rules relating to enforceability and scope. Whenever a new loan or even a future advance on an existing loan is contemplated by a lender, it would be a good practice to discuss the issue of applicability of existing security to such new loan or advance with the bank’s lawyers.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.
[1] For example, if a lender misrepresented the scope or applicability of a previously executed dragnet clause to a borrower when a new loan is made, that might lead to a good faith challenge to enforcement of such a clause.
[2] Because mortgage laws differ from state to state it should not be assumed that the laws of other states are identical or similar to those discussed here in regard to Massachusetts.
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