Dragnet Clauses and Priority
July 22, 2016
David L. Allen
Partner, Jaburg & Wilk
A “Dragnet Clause” in a Deed of Trust is a provision that states that the Deed of Trust secures any and all future debt owed by the borrower to the lender, in addition to whatever debt the Deed of Trust originally secured. The use of the terminology “dragnet” symbolizes that such a clause causes the Deed of Trust to “spread” like a net, so as to “capture” within its security all existing loans. This would apply to additional “advances” made by the lender to the debtor at a point in time after the making of the original loan.
The Courts in Arizona, and in other states, have long debated the enforceability of these types of clauses, especially given that most borrowers who sign a Deed of Trust containing such a clause are not aware of its existence, and even if aware of it, do not really understand how it operates. Although many Courts have expressed that they do not favor such clauses, most Courts have found them to be generally enforceable. However, even when enforceable, an issue often arises as to the “priority” given to the security. Take for example, the following common scenario: Lender A lends $100,000 to Borrower, secured by a first position Deed of Trust containing a Dragnet Clause. Thereafter, Lender B lends $50,000 to Borrower, secured by a second position Deed of Trust. And finally, Lender A lends another $25,000 to Borrower, secured by its original Deed of Trust per the Dragnet Clause. If Borrower later defaults, and Lender A commences foreclosure proceedings, does its $25,000 advance, made after Lender B had made its loan, take priority over Lender B’s loan? To answer that question, an Arizona Court looked to whether the later advance, which was the $25,000 in the above example, was “obligatory” or “optional.” In other words, did the original promissory note or loan agreement between Lender A and Borrower obligate Lender A to make the additional $25,000 loan to Borrower when requested, or did Lender A have the option of either making that additional loan, or declining to do so? If it was “obligatory,” then it would have priority over the $50,000 loan made by Lender B. However, if it was “optional,” then it would only have priority over the $50,000 loan made by Lender B if Lender A did not have “actual notice” of the loan that was made by Lender B. And “constructive notice,” which is imputed by reason of the public recordation of documents, including Deeds of Trust, is not sufficient to establish that Lender A had the requisite actual knowledge required to preclude it from asserting a priority position.
What then, can or should Lender B have done to protect itself in the above example? The simple answer is that upon making its intervening loan to Borrower, it should have taken affirmative action to provide Lender A with actual notice that it had made such a loan. If Lender A thereafter wished to make an optional additional loan to Borrower under the Dragnet Clause, to maintain its priority on the additional loan, it would have had to obtain a subordination agreement from Lender B whereby Lender B affirmatively acknowledged Lender A’s superior security interest.