By Jones Osborn II

Most mortgages and deeds of trust contain a so-called "dragnet clause." This is a provision stating that if the lender loans additional money to the borrow pursuant to a new promissory note which recites that it is secured by the existing mortgage or deed of trust, the additional loan will in fact be secured by that mortgage or deed of trust.

Arizona courts have long held that dragnet clauses are valid. Therefore, additional loans may be secured by an existing deed of trust with a dragnet clause. However, that's not the end of the story--even though the additional loan is secured, the real question is whether it is secured with the same priority as the original loan.

Example. As an example, assume Original Lender lends Borrower $100,000 in Year 1. The loan is secured by a deed of trust with a dragnet clause. In Year 2, Different Lender loans Borrower $200,000 and secures it with a second deed of trust against the same property. In Year 3, Original Lender lends Borrower an additional $300,000 using a promissory note stating that the additional loan is secured by the original deed of trust. Clearly, the total of $400,000 lent by Original Lender is secured by the original deed of trust. The real question, however, is whether the last $300,000 lent by the Original Lender is senior or junior to the intervening $200,000 loan. The answer to this question can be critical if the value of the property is only $400,000. If it's senior, the Original Lender has adequate security. If it's junior, he doesn't.

In answering this question, the law first asks whether the additional loan by the first lender--sometimes called a "future advance"--is optional or obligatory. An optional advance is one the lender is not contractually required to make. An obligatory advance is one the lender is contractually required to make. An example of the latter might be a revolving line of credit where the lender is required to make additional advances from time to time as requested by the borrower up to a predetermined limit.

Obligatory Advances. If the advance is obligatory, the additional advance will have priority over any intervening deed of trust if, and only if, the recorded senior deed of trust discloses the lender's obligation to make obligatory advances. This is true even if the lender has actual knowledge of the junior encumbrance. This makes sense, because a lender who agrees to

make additional advances must know in advance that he will not have his security prejudiced by a junior lender. On the other hand, if the requirement to advance additional funds is not disclosed in the deed of trust, any additional advance made after an intervening lien is recorded will be junior to that lien. This also makes sense, because it provides assurances to the junior lender that his priority will not be defeated by additional obligatory advances made by the senior lender.

Optional Advances. If the advance is optional, its priority depends on whether the original lender had actual knowledge of the intervening lien. If the original lender was aware of the intervening lien, his additional advance will be junior to it. If he was not aware of the intervening lien, his additional advance will be senior to it and will have the same priority as the original loan. It is important to note that constructive knowledge is not adequate in this situation. The courts require actual knowledge. Therefore, since recording provides constructive notice, it makes no difference whether the intervening lien is recorded. If the original lender has no actual knowledge of the intervening lien, even if it is recorded, his additional advance will be senior. The rationale offered by the courts is that a lender whose deed of trust contains a dragnet clause should not have to check the public records when making additional optional advances. Anyone making a secured loan which is junior to a deed of trust with a dragnet clause is therefore on notice that he must make sure the senior lender has actual notice of his loan.

The foregoing discussion assumes that there has been an intervening lien between the senior lender's first and second advances. If, however, the first lender's additional advance occurs before the new third party loan, the first lender's additional advance will always be senior so long as the senior deed of trust contains a dragnet clause.

The Lessons. We can derive several lessons from these principles. First, if you are a lender who has agreed to make additional obligatory advances, make sure this is disclosed in your deed of trust so that the additional advances will retain the same priority as the original loan. Second, if you are a lender considering an optional advance, be sure that your deed of trust contains a dragnet clause, and even if it does, be aware that your additional advance will be junior to any intervening liens of which you have knowledge. (And even though actual knowledge is required for this purpose, it is good practice to get a title report to make sure there are no junior liens so that you do not have to fight the battle over whether you had or did not have actual knowledge). Third, if you are a lender considering a loan which will secured by a junior deed of trust, make sure you read the senior deed of trust to determine whether it provides for obligatory advances because your loan would become junior to any additional advances by the senior lender. Fourth, if you are a lender whose deed of trust is junior to a deed of trust with a dragnet clause which does not provide for obligatory advances, (a) find out from the senior lender how much is then secured by the senior deed of trust because you will be junior to all then existing loans secured by that deed of trust, and (b) also give the senior lender actual written notice of your lien so that he cannot prejudice your position by making optional advances that would, in the absence of his actual knowledge of your loan, be senior to your deed of trust.

________________________________

See La Cholla Group, Inc., v. Timm, 173 Ariz. 490, 844 P.2d 657 (Ariz. App. 1993).