Banks: Got Collateral? Maybe Not

This article originally appeared in the online edition of Arkansas Business.

Collateral is important for all financial institutions and a recent Arkansas Court of Appeals decision should be setting off alarm bells at financial institutions across the state of Arkansas.

Consider these circumstances. The bank makes a loan to a borrower secured by a mortgage on real property. A pretty simple transaction. Almost four years later, the bank entered into a separate note with the same borrower that was secured by the borrower’s furniture and fixtures. The cross collateralization provision in the security agreement related to the second note with the borrower provided, in part, that “In addition to the Note, this Agreement secures all obligations, debts and liabilities. . .” Notable, the cross collateralization provision did not make specific reference to any prior debt. Most banks would argue that the language “all obligations” in this cross collateral provision is sufficient to identify the first promissory note. Not so fast, says the Arkansas Court of Appeals.

In Equity Bank v. Southside Baptist Church of Lead Hill, 2020 Ark. App. 199, the Court appears to restrict the application of a general cross collateral provision contained in a mortgage or security agreement on the basis that the subsequent mortgage/security agreement did not adequately describe the pre-existing debt that was being secured by the subsequent security agreement. Specifically, the Court held that when a mortgage is given to secure a specifically named debt, the security will not be extended to antecedent debts unless the instrument specifically provides for it and identifies those debts intended to be secured in clear terms. In other words, a general cross collateralization provision without specific references to older debts may no longer be valid.

So what is the point?

There are three general practice points to consider. First, commercial loan officers should engage counsel and not rely on forms when making loans that are substantial to the bank. A common and honest mistake will likely be significantly costlier than the attorneys’ fees to review a loan agreement. Second, be specific! Cross collateralization provisions should expressly reference the prior debt and any other debt that you intend to secure by a subsequently executed mortgage or security agreement. Last, in the context of mortgages, the bank should have filed a modification of the original mortgage referencing the second debt as opposed to solely relying on the original mortgage and the general cross collateralization provision. Got collateral? I hope you do.