Security agreement: when drafting you better say what you mean
Blog Bankruptcy Real Estate Insights
Pepper Hamilton LLP
USA June 10 2015
State Bank of Toulon v. Covey (In re Duckworth), 776 F.3d 453 (7th Cir. 2014) –
A chapter 7 trustee sought to treat a secured lender as unsecured based on an error in the security agreement. The lender argued that the error was subject to reformation to conform to the intent of the parties. The bankruptcy court and the district court found in favor of the lender, and the trustee appealed to the 7th Circuit.
A security agreement dated December 13, 2008 granted a security interest to secure the "Indebtedness," which was defined as indebtedness evidenced by the "Note or Related Documents." In turn "Note" was defined as "the Note executed by [the debtor] in the principal amount of $________ dated December 13, 2008, together with all renewals of, extensions of, modifications of, refinancing of, consolidations of and substitutions for the note or credit agreement."
Unfortunately for the lender, the note was dated December 15, 2008, and all parties acknowledged that a December 13 note never existed. The reference to "Related Documents" did not help the lender because they were defined as documents executed in connection with the "Indebtedness," which referenced the nonexistent December 13 note. So, read literally, the security agreement secured only the nonexistent December 13 note.
In addition to parol evidence of the parties' intent, the lender relied on the December 15 note, which referenced the security agreement, as evidence of the parties' intent. It argued that (1) parol evidence was admissible since it aided in interpretation of an ambiguous document, and (2) under the "composite document rule" under applicable state law the security agreement and note should be read together since they were executed as part of the same transaction. In both cases, the lender was attempting to use external evidence to interpret the security agreement.
The 7th Circuit freely acknowledged that it was clear there had been a mistake made in drafting the security agreement, and the lender would have been able to obtain reformation against the original borrower. However, in this case the trustee was exercising "strong arm" powers. According to the court: "The strong-arm power is a 'blunt information-generating tool' that encourages lenders to give public notice of their security interest by harshly punishing penalizing those who fail to do so."
Although the lender argued that the trustee had constructive notice, so facts could be imputed to a trustee even in exercising strong arm powers, the court noted that this was a concept specific to real property law and was applicable only to a trustee exercising the power of a good faith purchaser of real property. In this case the trustee was acting as a hypothetical judicial lien creditor, and thus was not subject to constructive notice.
The net result was that the court determined that the trustee was entitled to rely on the actual language of the security agreement despite the clear mistake. The 7th Circuit previously applied this concept in the context of a lender attempting to overcome the fact that a security agreement failed to include inventory and accounts receivables in the list of collateral. In the prior case it was also clear that this was contrary to the intent of the parties. However it was more important to promote economy and certainty in secured transactions. A "rigid rule allows later lenders to rely on the face of an unambiguous security agreement, without having to worry that a prior lender might offer parol evidence (which would ordinarily be unknown to the later lender) to undermine the later lender's security interest." Allowing parol evidence or requiring review of additional documents would increase the cost and uncertainty of transactions.
The court also pointed to a similar decision by the 1st Circuit dealing with the issue of the description of the secured debt. In that case the security agreement referenced a specific note, while the lender was attempting to assert that the security interest secured subsequently issued notes. Apparently the security agreement did not include a dragnet clause providing that the lien secured future advances. Under applicable state law, the intent to secure future advances must be explicit in the agreement to be enforceable. Thus a technical reading of the security agreement meant that it did not secure the subsequent notes.
In this case the lender also tried arguing that this was just a "small error that should be overlooked because it was easy to discover." The court was not persuaded that there was a basis for distinguishing between big and small errors.
In a last ditch attempt to save the day, the bank argued that the transaction satisfied the requirements for an enforceable security interest under the Uniform Commercial Code. Specifically, UCC §9-203(b) provides that a security interest is enforceable if (1) value has been given, (2) the debtor has rights to the collateral, and (3) the debtor has authenticated a security agreement that describes the collateral. The court's response was that the security interest created by the security agreement must be enforced as written.
Consequently, the 7th Circuit reversed, holding that the mistaken date could not be corrected and in exercising strong arm powers the trustee was entitled to treat the unambiguous security agreement as meaning what it said, even if that is not what the parties intended.
This case offers a good object lesson in the importance of paying attention to details. In the rush to close a transaction, it can be easy to overlook finalizing cross references between documents. It is relatively easy to remember to fill in the date on the first line of a document (although it is not unheard of to see a document dated month [____], year), but it can be harder to catch dates buried in the recitals or definitions. If all documents have the same date, the simplest approach may be to refer to everything as "of even date herewith" in the body of a document, but that may not always be applicable – as was the case here.
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