Court Rules That a Promissory Note is a Security
 
July 11, 2007
 
Michael Weissman - Chicago

Universal Guaranty Life Insurance Co. v. Coughlin, 481 F.3d 458 (2007), involved a contest over the applicability of a dragnet clause.

In the 1990s Health Management Limited Partnership borrowed from National City Bank and granted National City a mortgage on a Springfield, Illinois, hospital and a priority security interest on its tangible operating assets. Later, National City assigned its position to Universal Guarantee Life Insurance Company.

In 1999 Marine Bank of Springfield granted Health Management a $4,000,000 line of credit secured by a second mortgage on the hospital and security interest in its other assets including its accounts.

A security agreement Health Management signed with Marine Bank in 2002 stated that the bank had a first position in Health Management’s accounts receivable to secure all of Health Management’s obligations to the bank. The word “obligations” was defined to include indebtedness “now existing or hereafter arising.” The security agreement also provided that it could not be modified, amended or terminated except by a written agreement signed by Health Management.

In a series of promissory notes that Health Management signed between 1999 and February 2003 it was reiterated that the notes were secured by the debtor’s accounts receivable.

Health Management had, by January 10, 2003, overdrawn its line of credit by $150,000. Marine Bank agreed to lend it an additional $250,000 so long as it was secured by a personal guarantee of Health Management’s partners. However, when the note came due, Marine Bank used collections from Health Management’s accounts to satisfy the loan.

In March 2003 Health Management wanted another $250,000 loan to meet its payroll. Marine Bank agreed to make the advance on condition that it was fully cash-collateralized. One of the staff physicians, William Coughlin, provided the cash collateral. There was no mention of the Marine Bank’s security interest in Health Management’s accounts in the March 2003 loan documents.

In April 2003 Marine Bank took possession of Dr. Coughlin’s $250,000 after learning that Health Management was depositing funds in another bank. Health Management then filed a petition for relief in bankruptcy.

The bankruptcy court entered a cash collateral order that was agreed to by National City, Marine Bank and Universal Guarantee. The order stated that Marine Bank was owed $3,600,000. The order sustained Dr. Coughlin’s position that the March 2003 loan was included in the $3,600,000 debt. The effect of the ruling was to prevent Universal from collecting $250,000 worth of Health Management’s accounts and to sustain Dr. Coughlin’s position as the holder of a $250,000 claim against the bankruptcy estate of Health Management.

Marine Bank liquidated its claim against Health Management from funds collected on the debtor’s accounts.

Universal challenged Marine Bank’s collection of Health Management’s accounts arguing that the accounts did not secure the March 7, 2003, $250,000 loan. Dr. Coughlin argued that the accounts did secure the loan and that the April 30, 2002, dragnet clause meant that all of Health Management’s debts were secured by its accounts.

The court ruled in favor of Marine Bank. The court framed the issue as whether a dragnet clause in an earlier security agreement was obviated by a subsequent loan agreement between the same parties that did not refer to the dragnet clause.

The court said that since the purpose of a dragnet clause is to protect a creditor against the possibility that it might forget to execute a security agreement in connection with a subsequent loan, it made no sense to penalize Marine Bank for failing to mention its security interest in the March 7, 2003, loan documents. It also said that the dragnet clause was part of the April 2002 security agreement and stated that the agreement could only be terminated by a written instrument. There was no such instrument.

 

What’s the Point?

The court’s conclusion is correct. The effectiveness of a dragnet clause is not diminished or extinguished simply because a subsequent loan document doesn’t mention it.

For more information, e-mail Michael L. Weissmann at michael.weissmann@hklaw.com or call toll-free, 1-888-688-8500.