On December 15, 2008, David L. Duckworth (the “Borrower”) obtained a loan from the State Bank of Toulon (“Bank”) in the amount of $1.1 million (the “Loan”). The Loan was evidenced by a promissory note executed by the Borrower in favor of Bank dated December 15, 2008 (the “Note”) and secured by a security agreement dated December 13, 2008 (the “Security Agreement”). Pursuant to the Security Agreement, the Borrower granted to the Bank a security interest in his farm equipment and crops. While the Note correctly referred to the Security Agreement, the Security Agreement mistakenly identified the Note by stating that the note it was securing was “dated December 13, 2008” (the correct Note was dated as of two days later). In 2010, the Borrower filed a petition for bankruptcy protection under Chapter 7 of bankruptcy code and a trustee of the bankruptcy estate was appointed (the “Trustee”). Following the filing of the bankruptcy petition, the Bank filed two complaints in the bankruptcy court (the “Bankruptcy Court”) to initiate adversary proceedings. In cross‑motions for summary judgment, the Bankruptcy Court held that the mistaken date in the Security Agreement did not defeat the Bank’s security interest and the Bankruptcy Court issued two decisions in favor of the Bank with respect to the proceeds form the sale of the crops and the farm equipment. The Trustee appealed both of these decisions to the district court (the “District Court”). Although the appeals were assigned to different judges, the District Court affirmed the Bank’s valid security interest in the proceeds from the sales of the crops and the farm equipment. The Trustee then appealed to the Seventh Circuit Court of Appeals (the “Circuit Court”) arguing that the Security Agreement unambiguously identified the debt to be secured, but did so only for non‑existent debt and therefore failed to grant a security interest to secure the Note. The Trustee further argued that even if the mistake in the Security Agreement might be corrected as between the original parties to the Loan, parol evidence of such a mistake cannot be used against the Trustee to save the faulty Security Agreement. The Bank argued that the Security Agreement is enforceable against the original Borrower and therefore should be enforceable against the Trustee. Relying on the terms of the Security Agreement, parol evidence of the parties’ intent and a “composite document” concept under Illinois law, the Bank contended that the security interest in the crops and farm equipment is valid and enforceable.
In evaluating the case at hand, the Circuit Court first looked to the terms of the Security Agreement and concluded that, based exclusively on the terms therein, the Security Agreement could not be construed to secure the Note. The Security Agreement clearly defined the note it related to as one that was dated December 13, 2008, which the parties agree was a note that never existed. The Bank argued that the definition of “Related Documents” that the Security Agreement secured covered the correct note as it was defined to include documents “executed in connection with the Indebtedness.” However, the Circuit Court held this argument was ineffective as it led to circularity because the definition of Indebtedness turned to the debt evidenced by the “Note” or Related Documents.
Next the Circuit Court evaluated the Bank’s arguments that the parol evidence indicated that the security interest granted under the Security Agreement was intended to secure the Note. While the Circuit Court acknowledged that parol evidence can be used to reform a contract between the two original parties in some instances and that the Bank would likely have been able to obtain reformation against the original Borrower, the Circuit Court noted that the Trustee is in a different position than the original Borrower. Namely, the duty of a bankruptcy trustee is to maximize the value of unsecured creditors to a debtor. The Circuit Court noted that, to assist this endeavor, a bankruptcy trustee is equipped with a strong power pursuant to which the trustee is placed in the position of a hypothetical subsequent creditor and can avoid any interests that a subsequent creditor could avoid “without regard to any knowledge of the trustee or of any creditor”. The Circuit Court noted that this power is intended “to encourage lenders to give public notice of their security interests by harshly penalizing those who fail to do so” (or in this case, fail to do so properly). Relying on its decision in In re Martin Grinding & Machine Works, Inc., 793 F.2d 592, 595 (7th Cir. 1986) and guidance from the First Circuit in Safe Deposit the Bank & Trust Co. v. Berman, 393 F.2d 401, 402‑403, the Circuit Court found that third parties should be able to rely on unambiguous contractual agreements to determine the enforceability and priority of security interests. Thus the public policy supporting the preferred position of a bankruptcy trustee also supports the decision to not allow parol evidence to reform the Security Agreement against the Trustee. Accordingly, the use of parol evidence in connection with the Security Agreement was inappropriate and unpermitted.
Finally, the Bank argued that UCC §9‑203(b) provides that the Security Agreement created an enforceable security interest in the farm equipment and crops because its satisfied the three‑prong test of the statute. UCC §9‑203(b) provides that a security interest is valid against a debtor and third parties if (1) value has been given; (2) the debtor has rights in the collateral; and (3) the debtor has authenticated a security agreement that provides a description of the collateral. The Bank asserted that all three were satisfied as the Bank gave value, the Borrower had rights in the farm equipment and crops and the Security Agreement described the collateral and accordingly, the security interest was enforceable. The Trustee argued that UCC § 9‑201, which provides that the terms of a security agreement must be enforced as written, is dispositive. The Circuit Court agreed with the Trustee stating that although UCC §9‑203(b) provides for the minimum requirements to enforce a security interest, the underlying security interest is enforced according to the underlying agreement. In this instance, the Circuit Court held that because the Security Agreement mistakenly identified the Note, the Security Agreement failed to secure the underlying debt evidenced by the Note. Accordingly, the Circuit Court reversed the decisions of the District Court and remanded the case for proceedings consistent with the opinion. State the Bank of Toulon v. Covey (in re Duckworth), 2014 U.S. App Lexis 22054 (7th Cir. 2014).