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Cross collateralization survives court review

The lesson we learned from watching Star Wars or John Wayne movies-that good ultimately triumphs over evil-was reflected in a recent decision from the Fifth U.S. Circuit Court of Appeals in New Orleans, which has jurisdiction over federal appeals in the states of Louisiana, Mississippi, and Texas. The court reversed a district court and bankruptcy court ruling that a cross-collateralization clause in a Texas credit union loan document was unenforceable.

The bankruptcy court judge and the district court judges, all apparently wearing black hats and standing with their backs to the setting sun, decided that the credit union's cross-collateralization clause was unenforceable because it was not referenced on the front of the loan document.

The appeals court judges, obviously wearing white hats with a surrounding halo, restored law and order by reversing the bad guys' decision.

FACTS IN THE CASE

This Texas case arose because of the following facts:

In May 1992, the credit union member purchased a 1989 Cadillac Sedan DeVille automobile and financed the purchase through his credit union. The member signed a promissory note with the required Truth in Lending (TIL) disclosure and security agreement. The loan document contained two cross-- collateralization clauses dealing with security interests. The first of these clauses (also called an "after-acquired property' clause) provided that the loan was secured by current and future shares and deposits as well as collateral securing other loans. The front of the loan document referenced this particular clause.

The second cross-collateralization clause (also called a "future advance" clause) provided that the automobile offered as security for the loan also secured any other existing or future loans or other amounts owed to the credit union by the member. The second clause was not referenced on the front of the loan document in the TIL area.

Two months later, the member obtained a MasterCard from the credit union and within a few years had a balance over $7,000. About this time, the member paid off the original automobile loan and requested the title from the credit union, then a month later filed bankruptcy and again asked the credit union to release the automobile title. The credit union refused to release the automobile title because it claimed the cross-collateralization clause in the automobile loan document gave them a valid lien on the vehicle to secure payment of the MasterCard debt. The member then filed a complaint in bankruptcy court challenging the validity of the vehicle lien.

COURT FINDS CLAUSE UNENFORCEABLE

Although numerous courts in various states (ineluding Texas) have upheld the validity of cross-collateralization clauses, the bankruptcy court decided that the clause in this case was not enforceable because it was not referred on the front of the loan document in the TIL area. Under Texas law, cross-collateralization clauses apply only to debts which are reasonably within the contemplation of the parties at the time the security agreement was signed. The court believed that the MasterCard debt was not within the contemplation of the parties since there was no ref erence to the future advance clause in the TIL area. The credit union appealed to the district court, which upheld the bankruptcy court's decision.

APPELLATE COURT RULES IN CU's FAVOR

The credit union then appealed to the U.S. Court of Appeals. The appeals court overruled the district court's judgment and ruled in favor of the credit union because the plain language of the loan document clearly indicated that the automobile could serve as collateral for future indebtedness to the credit union. Therefore the "future advance" clause was within the contemplation of the parties. The appeals court stated that since the parties did not litigate the validity of the TIL disclosures, whether or not the parties complied with TIL regulations, was not an issue in the case.

If TIL compliance had been an issue, the decision from the appeals court might have been entirely different. Although Regulation Z, section 226.6 (c) titled "Security Interests," does not clearly indicate that the existence of cross-- collateralization clauses has to be disclosed, the Regulation Z Commentary suggests otherwise. In the section (at 226.6 (c) (3.) titled "Spreader clause"), the commentary indicates:

"The fact that collateral for pre-existing credit extensions with the institution is being used to secure the present obligation constitutes a security interest and must be disclosed. (Such security interests may be known as `spreader' or `dragnet' clauses or as `cross-collateralization' clauses.) A specific identification of that collateral is unnecessary, but a reminder of the interest arising from the prior indebtedness is required. This may be accomplished by using language such as `collateral securing other loans with us may also secure this loan.'"

WHAT COULD THE CU HAVE DONE DIFFERENTLY?

What could the credit union have done differently to increase its chances of a favorable decision in the bankruptcy court, and to eliminate the unnecessary time and expense of filing two appeals? (And what can any credit union do to increase its chances of success in a similar situation?)

First, as the bankruptcy court pointed out, the future advance clause was not referenced in the TIL area of the loan document. This issue seems to occupy a large portion of the court's analysis. If the credit union had referenced this particular clause as suggested by the Regulation Z Commentary, then the bankruptcy court could have easily decided in favor of the credit union.

Additionally, the bankruptcy court stated that it had no evidence as to whether or not the cardholder agreement contained any provision concerning an intent of the parties that the MasterCard debt would be secured by the automobile. If the cardholder agreement contained such a provision, then it should have been introduced into evidence. However, if the cardholder agreement did not contain such a provision, the credit union should immediately add the required language.

Any credit union that uses cross-collateralization clauses and wants to have its members' credit card obligations secured by collateral under either "future advance" or "after-acquired property" clauses should insure that proper language is added to its cardholder agreement. Finally, the credit union should make sure that all cross-collateralization clauses are referenced in the TIL area of the loan documents.

If these suggestions had been followed, the bankruptcy judge could have been wearing a white hat from the beginning.

FYI...

NCUA amended Part 701.21(c)(3) of the agency's regulations to permit federal credit unions to advance money to members to cover overdrawn accounts without having a credit application from the member on file if the credit union has a written overdraft policy. The overdraft policy must: set a cap on the total dollar amount of all overdrafts the credit union will honor consistent with the credit union's ability to absorb losses; establish a time limit not to exceed 45 calendar days for a member either to deposit funds or obtain an approved loan from the credit union to cover each overdraft; limit the dollar amount of overdrafts the credit union will honor per member; and establish the fee and interest rate, if any, the credit union will charge members for honoring overdrafts. The rule is effective July 1, 2000.

The Federal Reserve Board revised its Official Staff Commentary to Regulation Z to clarify that shortterm cash advances commonly known as "payday loans" constitute credit for purposes of the Truth in Lending Act. The new comment appears at Section 226.2(a)(14)-2. A fee charged in connection with such a transaction may be a finance charge, regardless of how the fee is characterized under state law. Where the fee charged constitutes a finance charge under section 226.4 and the person advancing funds regularly extends consumer credit, that person is a creditor and is required to provide disclosures consistent with the requirements of Regulation Z. This rule was effective March 24, 2000; however, compliance is optional until Oct. 1, 2000.

By Mike McLain

Assistant general counsel and senior compliance counsel CUNA & Affiliates