Memo RM1994-9
From: William D. Grant Jr., General Counsel
Date: March 1, 1994
RE: Dragnet Clauses; Legal Lending Limits; Cross-Collateralization.
Summary:
Historically, dragnet clauses have been rejected by the courts as over-reaching and against public policy. Statutory and case law developments have caused courts, in a limited number of jurisdictions, to establish narrow exceptions which would allow the enforcement of dragnet clauses against past or future debts. Due to the narrow, unsettled nature of these exceptions, this agency will not consider dragnet clauses to be an acceptable means of cross-collateralization for the purpose of a bank qualifying for the expanded lending limits provided by K.S.A. 9-1 104(a)(3) (livestock, seed, grain, etc.) or 9-1 104(a)(5) (real estate).
Analysis:
A dragnet clause is a provision contained in a mortgage or security agreement granting a security interest for past (antecedent) and/or future debts as well as the present indebtedness. Historically, at common law, dragnet clauses have been scorned, disfavored, carefully scrutinized, and strictly construed by the courts. See Emporia State Bank and Trust Co. v. Mounkes, 214 Kan. 178, 519 P.2d 618 (1974). However, with the passage of the Uniform Commercial Code (relating to secured transactions involving non-real property) and the development of case law, the courts, in a limited number of jurisdictions, have begun to adopt a liberalized view of the enforceability of dragnet clauses. Despite this trend toward relaxation of the courts' consistent aversion to the use of dragnet clauses, the tests enumerated by the courts, the tests enumerated by the courts fail to establish a precise standard for determining the validity of a particular dragnet clause. Although a few specific exceptions have been developed which would allow the enforcement of a dragnet clause, the courts' continue to maintain general aversion to their use except in very narrow, fact sensitive circumstances. For these reasons, this agency continues to reject the use of dragnets to establish the cross-collateralization required for expansion of a bank's legal lending limit pursuant to K.S.A. 9-1104(a)(3) and (a)(5). This memo is not intended to be an analysis of the validity or invalidity of a particular dragnet clause used in a particular transaction, but is drafted for the purpose of exposing the high degree of uncertainty surrounding use of this type of clause to secure antecedent or future debt.
Presently, a great deal of fragmentation in the courts' approaches is caused by the unequal treatment of dragnets securing future loans verses those clauses securing antecedent debt.
Future Advances:
Section 9-204(3) of the Uniform Commercial Code (codified in Kansas at K.S.A. 84-9-204(3)) lends validity to dragnet clauses asserted against future advances. However, the courts do not interpret the U.C.C. provision to be a universal validation of the clauses with regard to subsequent loans. The leading case interpreting the scope of authorization provided by the U.C.C. is Kimbell Foods, Inc. v. Republican Natl. Bank, 440 U.S. 715 (1979). The Kimbell court found the language in section 9-204(3) authorized the use of a dragnet clause to capture future debt only if the future debt was of the same class as the original debt covered by the security agreement. In other words, the subsequent debt must be so closely related to the primary obligation secured by the security instrument that the debtor's consent to the collateral attaching to the latter debt is easily inferred.
At least since the Mounkes case, the Kansas courts have also enforced dragnet clauses in the context of future advances. However, like the U.S. Supreme Court the Kansas Supreme Court's acceptance of the validity of the dragnet is not automatic. In First National Bank in Wichita v. Fink, 241 Kan. 321 (1987) the court cites Mounkes to articulate the present Kansas rule. Under the Fink rule, the dragnet will capture future advances only if (1) a subsequent note specifically references the prior security instrument, or (2) the subsequent debt is shown to be of the same kind or character as or part of a series of transactions with the original debt secured by the security instrument.
Thus, to evaluate the effectiveness of a dragnet clause in securing future loans, a subjective analysis is required, taking into account the facts surrounding the multiple transactions. Due to the uncertainty of the law, in those cases in which the lender and borrower disagree as to the effect of the dragnet provision, final settlement of the dispute will often be a result of litigation.
Antecedent Debt:
The development of the court's willingness to enforce a subsequent dragnet clause to antecedent debt has been more restrained. Review of the case law reveals that until recently the courts have flatly held dragnet clauses which apply to prior obligations to be against public policy. It was long held that any antecedent debt intended to be secured by the security instrument should be described with specificity on the face of the instrument. See First National Bank and Trust Co. v. Lygrisse, 7 Kan. App 2d 291, (1982); and In re Swanson 104 B.R. 1 (Banker, C.D. III. 1989).
The issue has become less settled based upon the opinion from Bank of Kansas v. Nelson Music Co., 949 F.2d 321 (10th Cir. 1991). This court relied upon K.S.A. 84-9-201 of the U.C.C., which states that "a security agreement is effective according to its terms between the parties", to rule that a specific reference to the antecedent debt is unnecessary so long as the terms of the dragnet clause clearly and unambiguously apply to the prior debt.
The Nelson court scoured the U.C.C. and determined the code contains no general policy against the use of dragnet clauses. The court examined the factors forming the basis for the longstanding distaste, at common law, for subsequent dragnet clauses attaching collateral to prior debt. These factors include: (1) transactions between unsophisticated parties with unequal bargaining strength, (2) unrelated, dissimilar, or distant obligations, and (3) inconspicuous clouding of real estate titles. Because the transactions in Nelson did not offend these three considerations, did not violate general U.C.C. policy, and the clause was sufficiently clear and unambiguous to meet the requirements of K.S.A. 84-9-201, the court enforced the dragnet clause against the antecedent debt.
While this case clearly represents a departure from the traditional approach taken in the past, it hardly signifies a complete acceptance of the use of dragnet clauses to capture antecedent debt. In fact, the opinion issued by in Nelson implies that had the transactions (1) been between unsophisticated or unequal parties, (2) involved unrelated, dissimilar or distant obligations or (3) resulted in the clouding of a real estate title, the dragnet clause would have failed.
As with future advances, the move is away from an unrelenting denial of dragnet clause validity in the context of antecede debts, however, the exception carved by the Nelson court is narrow. The intricacy of the exception lends itself to wide debate as to how it applies to a particular transaction and the surrounding facts. Again, while it is quite possible a lender may wield the Nelson decision to successfully enforce a disputed dragnet clause, the issue quite likely may require litigation.
As previously stated, this discussion is not intended to articulate a position regarding a bank's use of a dragnet clause to secure a particular loan or obligation. The enforceability of these types of provisions is a matter to be discussed with bank counsel to assure appropriate use in light of the bank's operational and underwriting requirements. However, this department's consistent approach to aspects of the legal lending limits of K.S.A. 9-1104, has been to require a heightened degree of care on the part of the bank when structuring lines of credit that exceed the base 15% limit. In particular, the terms of this memorandum are germane to a bank's efforts to cross-collateralize a borrower's "total" liability, which is required to utilize the expanded lending limits provided by K.S.A. 9-1104(a)(3) (grain, cattle, etc.) and K.S.A. 9-1104(a)(5) (real estate). This department has consistently held that the expanded limits provided by these two subsections are based upon recognition of the quality, marketability and accessibility of these types of collateral. To allow the use of dragnet clauses to tenuously tie quality collateral to lines of credit that are quite large in relation to the size of the institution, would diminish the motivational factor behind the legislative allowance of the additional limits provided by subsection (a)(3) and (a)(5).
Conclusion:
Developments in the case law surrounding dragnet clauses have, at best, given lenders a few small points with which to argue the validity of a dragnet clause. However, the argument is far from settled. Therefore, in the context of exceeding the 15% legal lending limit, dragnet clauses will not be deemed an effective means of cross-collateralization. For legal lending limit and cross-collateralization purposes, any security instrument purporting to capture antecedent debt should list the specific obligation on the face of the instrument. Any instrument evidencing future loans or obligations to which a prior dragnet clause is meant to apply should specifically reference the security instrument to insure proper cross-collateralization.
