Secured transactions typically include two key documents, which are often executed simultaneously: a promissory note memorializing loan and repayment terms executed by the borrower in favor of the lender and a security agreement granting the lender an interest in collateral securing the borrower’s debt owed to the bank. If a borrower ends up filing for bankruptcy, the bank likely will seek to enforce the security agreement against the borrower and recover the collateral. However, as made clear by the U.S. Court of Appeals for the Seventh Circuit’s recent decision in In re Duckworth, Nos. 14-1561 and 14-1650 (7th Cir. Nov. 21, 2014), even the smallest transactional drafting mistakes may impact whether a lender can successfully assert its security interest in a debtor’s collateral.
In Duckworth, a loan extended by the State Bank of Toulon to David Duckworth was documented through a promissory note dated December 15, 2008 in favor of the bank. Duckworth also signed a security agreement dated December 13, 2008, which granted the bank security in Duckworth’s crops and farming equipment.
After Duckworth filed a Chapter 7 bankruptcy case, the bank filed an adversary proceeding to enforce its rights under the security agreement. At issue in the case was whether the security agreement, which mistakenly referred to a December 13 promissory note, properly secured the promissory note that was signed and dated on December 15. Despite the mistaken date, the bankruptcy court ruled in favor of the bank. The trustee of Duckworth’s estate appealed, and the district court affirmed the bankruptcy court’s decision.
On further appeal, the Seventh Circuit reversed and held that the bank could not use parol evidence (extrinsic evidence to modify, explain or supplement a contract at issue) against the bankruptcy trustee to show that the parties to the original loan intended that the security agreement would refer to the promissory note.
The Security Agreement’s Unambiguous Terms and the Composite Document Rule
The Seventh Circuit first concluded that the security agreement could not be construed to secure the December 15 note because the security agreement unambiguously secured debt related to a December 13 promissory note.
The court then dismissed the bank’s argument that the “composite document rule” could be used to read the security agreement and the December 15 note together because the two documents were executed as part of the same transaction. The bank contended that, if the documents were read together as if they were one contract, the security agreement could be read as securing the December 15 note. The court declined to follow the bank’s reasoning and held that the composite document rule could not be used against the trustee, who was a stranger to the original loan, because the rule is enforced only in disputes between contracting parties.
Parol Evidence Is Unusable Against the Strong-Armed Bankruptcy Trustee
Next, the court reviewed whether the bankruptcy court erred when it allowed into evidence the testimony put forth by the bank to support that the security agreement was meant to secure the December 15 note. The court noted that, even with the unambiguous language of the agreement, the bank would have been permitted to utilize such evidence to obtain reformation against the original borrower had he tried to avoid the security agreement based on the mistaken date.
Here though—despite the testimony of both the bank officer who prepared the documents and the borrower, which made clear that the bank made a mistake in preparing the security agreement—the Seventh Circuit determined that parol evidence could not be used against the bankruptcy trustee.
The court explained that the bankruptcy trustee, privileged with strong-arm powers, is deemed to be in the position of a hypothetical subsequent creditor and thus is able to avoid any interests that a hypothetical subsequent creditor could avoid “without regard to any knowledge of the trustee or of any creditor.” 11 U.S.C. § 544(a). The concept of the trustee’s strong-arm powers is said to “penalize secret liens and encourage lenders to provide public notice of their security interests.” The court therefore concluded that the bank’s asserted security interest would not be valid against a later creditor because that creditor would be entitled to rely on the face of the security agreement, “despite extrinsic evidence that could be used between the original parties to correct the mistaken identification of the debt to be secured.”
Minimize Costs and Uncertainty in Secured Transactions
Public policy reasons support the court’s decision to enforce the “unambiguous” security agreement according to its terms because the decision allows later lenders to rely on the unambiguous text of a security agreement without being concerned that a prior lender may offer some unknown parol evidence to challenge the later lender’s security interest. On the flip side, if there is a chance that parol evidence could alter an unambiguous security agreement, a subsequent creditor is obligated to review extraneous documents to investigate the property in which the prior secured party had taken a security interest. Imposing a duty to inquire beyond the face of an unambiguous security agreement creates both increased costs as well as uncertainty in secured transactions.
What about the fact that the erroneous date referenced in the security agreement was a small error and perhaps easy to discover? The Seventh Circuit declined to find a “limiting principle” that would permit courts to distinguish between small and large mistakes. If courts were asked to consider parol evidence after determining that a drafting error was “minor,” the above-mentioned benefits gained from disfavoring parol evidence would be lost.
In Illinois at least, later creditors and bankruptcy trustees may assume that an unambiguous security agreement means just what it says, even if the agreement does not reflect the original parties’ intentions. Duckworth serves as a stern warning to diligently proofread agreements as neither the composite document rule nor parol evidence may be employed to correct a drafting error against a bankruptcy trustee.