12.01.14

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Minor “Clerical Error” in Security Agreement Defeats Lender’s Security Interest

A recent Seventh Circuit case, In re Duckworth, 776 F.3d 453 (7th Cir. 2014) serves as a cautionary tale to all commercial lenders, particularly if they use “form” loan documents and eschew drafting oversight by a capable secured transactions attorney.

In Duckworth, a bank loaned the debtor $1.1 million, evidenced by a promissory note dated December 15, 2008.  The debtor granted the bank agricultural liens and a security interest in farm equipment through an Agricultural Security Agreement dated December 13, 2008.  “The security agreement said that it secured a note ‘in the principal amount of $_______ dated December 13, 2008.’”  Id. at 455 (emphasis in original).  The obvious problem was that the note was dated December 15, 2008, not December 13, 2008.  There was no dispute that the bank lent the debtor money, the debtor intended to pledge the collateral, and the referenced date of the note was simply in error.

Unfortunately for the bank, this two days’ difference in dates proved critical.  After the debtor filed a chapter 7 bankruptcy case in 2010, the bank initiated two adversary proceedings bearing on its rights as a secured creditor.  The bankruptcy court ruled for the bank in both cases, finding that the security agreement of December 13, 2008 secured the note of December 15, 2008.  Id.  The district court affirmed.  Id.  The Seventh Circuit reversed, holding that the mistake in the security agreement defeated the bank’s security interest in the debtor’s crops and farm equipment.  Id.  The court held that, “although the evidence could have supported reformation of the security agreement as between the original parties, the evidence cannot be used against the bankruptcy trustee to reform the security agreement or otherwise to correct the mistaken identification of the debt to be secured.”  Id. at 456.

The security agreement did not secure a valid debt because the referenced December 13 promissory note did not exist.  The bank could not rely on the “Related Documents” stock language in the security agreement to fix the mistake, either.

The security agreement grants the bank a security interest “to secure the Indebtedness,” which is defined as “the indebtedness evidenced by the Note or Related Documents.”

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The relevant definitions in the security agreement are essentially circular.  The definition of “Indebtedness” points the reader to “Related Documents,” which are defined as documents “executed in connection with the Indebtedness.”  The “Indebtedness” is defined in turn as the debt evidenced by the “Note or Related Documents,” and the Note again is defined as “the Note executed … dated December 13, 2008.” These circular definitions thus offer no escape from the mistaken date.  On its face, the security agreement secures only a December 13 promissory note that never existed.

In re Duckworth, 776 F.3d 453, 457 (7th Cir. 2014).

The court relied on the trustee’s strong-arm power in section 544(a) of the Bankruptcy Code.  Id. at 458; 11 U.S.C. § 544(a).  Under section 544(a)(1), the trustee, as a hypothetical judgment lien creditor, can avoid security interests based on defects “that need not have misled, or even have been capable of misleading anyone.”  Duckworth, 776 F.3d at 459 (citation and internal quotation omitted).  A judgment lien creditor is “entitled to rely on the text of a security agreement, despite extrinsic evidence that could be used between the original parties to correct the mistaken identification of the debt to be secured.”  Id.

The scope of a creditor’s security interest is defined by the security agreement, and other creditors (or the bankruptcy trustee) are entitled to determine that scope by relying on the unambiguous terms of a security agreement.  Thus, “parol evidence cannot be used to correct even…seemingly minor clerical error in [a] security agreement.  We must hew to the necessary technicalities inherent in any law governing commercial transactions, even when the result is harsh.”  Id.  at 461.

Author:  Hilary Mohr