Lender Beware: The Pitfalls of Narrowly Defined Secured Obligations

Jonathan M. Schalit

schalit, jonathan M. (2)A recent decision by the United States Court of Appeals for the Seventh Circuit underscores the substantial risks secured lenders take when they narrowly define the obligations intended to be secured by their borrowers’ assets.  State Bank of Toulon v. Covey (In re Duckworth), 2014 U.S. App. LEXIS 22054 (7th Cir. Ill. Nov. 21, 2014)

Duckworth involved a farmer (the “Borrower”) who borrowed $1,100,000 (the “Loan”) from the State Bank of Toulon (the “Bank”) on December 15, 2008. The Borrower pledged his crops and farm equipment as collateral (collectively, the “Collateral”) to secure his obligation to repay the Loan and executed two documents: (1) a promissory note dated December 15, 2008 (the “Note”), and (2) an Agricultural Security Agreement dated December 13, 2008 (the “Security Agreement”).

The Security Agreement adequately described the Collateral as required under Section 9-108(b)(2) of the Uniform Commercial Code (the “UCC”) and the Bank filed a UCC-1 Financing Statement (the “Financing Statement”) with the Illinois Secretary of State in accordance with Sections 9-301 and 9-501 of the UCC.  The Financing Statement correctly identified the collateral, as required under Section 9-502(a)(3) of the UCC, however, the Security Agreement incorrectly described the Borrower’s obligation as arising under a note dated December 13, 2008 rather than the correct date of the Note, December 15, 2008.

In 2010, the Borrower defaulted on the Loan and filed a petition for bankruptcy protection under Chapter 7 of the Bankruptcy Code. Addressing two separate appeals brought by the bankruptcy trustee appointed in the Borrower’s bankruptcy case (the “Trustee”), the Court of Appeals reversed the bankruptcy court and the district court and held that the Security Agreement did not give the Bank a security interest in the Collateral that could be enforced against the Trustee. Consistent with this holding, the court found that the Trustee was able to exercise his “strong-arm power” under Section 544(a) of the Bankruptcy Code to invalidate the purported grant of a security interest in the Collateral, and the Bank was therefore left with an unsecured claim in the Borrower’s chapter 7 case. In sum, the court concluded that by mistakenly identifying a promissory note with a different date than the actual date of the Note, the Security Agreement referred to an obligation that did not exist and, therefore, the Collateral described in the Security Agreement did not secure the Loan evidenced by the Note because the Security Agreement referenced a note with a different date.

The Bank argued that it held a valid and enforceable lien on the Collateral because (1) the Financing Statement put the Trustee on notice of the Bank’s asserted lien on the Collateral, (2) the Borrower had no grounds to object to the validity of the lien, and (3) the Note and relevant testimony proved that the mutual intent of the Bank and the Borrower was that the Collateral secured the Note.

The  court, however, ruled that the Note and testimony were inadmissible parole evidence, affirming its prior holding in In re Martin Grinding & Machine Works, Inc., 793 F.2d 592, 595 (7th Cir. 1986) (holding that a secured lender cannot use parol evidence against a bankruptcy trustee to correct a mistaken description of collateral in a security agreement).  In so holding, the Seventh Circuit also aligned itself with the First Circuit in Safe Deposit Bank & Trust Co. v. Berman, 393 F.2d 401, 402–03 (1st Cir. 1968) (holding that a lender cannot use parol evidence against a bankruptcy trustee to change or add to the debts secured by the security agreement).

In light of Duckworth and Berman, secured lenders should draft security agreements to cover all obligations of their borrowers, whether such obligations then exist or thereafter arise, and regardless of what documents or instruments may evidence such obligations from time to time.  Otherwise, a seemingly minor mistake, like having one digit wrong in the identification of a borrower’s obligation, may leave a would-be secured creditor with an unsecured claim.