Seventh Circuit Punishes Secured Creditor for Scrivener’s Error Seventh Circuit Punishes Secured Creditor for Scrivener’s Error

Seventh Circuit Punishes Secured Creditor for Scrivener’s Error

Drafting mistakes in loan documentation are an all-too-common occurrence.  Although it may be possible to correct such errors in court (to the extent they cannot be corrected with borrower consent), the best course is to take care to avoid them.  In In re Duckworth,[1] the United States Court of Appeals for the Seventh Circuit held that a mistaken date reference in a security agreement to the note to be secured thereby resulted in the secured creditor having no debt that was secured and thus no security interest.  The court also held that parol evidence could not be introduced to correct the drafting error as against the bankruptcy trustee even though such evidence could have been used in a proceeding between the secured creditor and the borrower.
Background.  In December 2008, David Duckworth borrowed $1,100,000 from the State Bank of Toulon.  He executed a promissory note and a security agreement.  Under the security agreement, Duckworth granted the bank a security interest in crops and farm equipment.  The security agreement, which was dated December 13, 2008, said that it secured a note dated December 13, 2008.  The promissory note, however, was actually dated December 15, 2008.
Duckworth filed a Chapter 7 petition in 2010.  The bankruptcy court held, on summary judgment, that the bank had a valid security interest.  There was testimony from the bank officer who prepared the documents and from the borrower that made clear that the security agreement contained a mistaken date.  The bankruptcy trustee appealed, and the district court affirmed.  The trustee appealed to the Seventh Circuit, arguing that the security agreement secured only a nonexistent debt.  The Seventh Circuit reversed and remanded.
Analysis.  The Seventh Circuit examined the security agreement, and concluded that, on its face, the security agreement did not secure a note dated December 15th.  The bank argued that it should be permitted to use parol evidence—evidence of the actual note-- to demonstrate that the parties intended for the security agreement to secure the note dated December 13th.  Although the court stated that it was confident that the bank would have been able to obtain judicial reformation of the security agreement in a case between the bank and the borrower, it held that this remedy was not available against a bankruptcy trustee exercising its strong-arm power under Section 544(a) of the Bankruptcy Code.  The court conceded that the result was “harsh,” but stated that it was necessary to hold as it did in order to protect the ability of subsequent creditors to rely on unambiguous security agreements.
Under Sections 544(a)(1) and (2), the sections applicable in Duckworth, a bankruptcy trustee has the same ability to avoid transfers as that of a hypothetical judicial lien creditor or a hypothetical creditor with an unsatisfied execution.  Although the Seventh Circuit cited precedent in support of its holding,[2] there are also countervailing arguments that a bankruptcy trustee exercising its strong-arm powers can be made subject to contract reformation to the same extent as the borrower on the basis that a judicial lien creditor is a different kind of creditor than a creditor that takes a consensual lien, a difference the Seventh Circuit’s opinion did not examine.[3]
Under general contract law, if there is a mutual mistake (of which a scrivener’s error may be one type),[4] a court may, at the request of any party to the contract, reform the contract to correct the mistake.[5]  Although courts will generally not examine parol evidence to construe an unambiguous contract,[6] parol evidence is admissible in evidence to establish a mistake.[7]  The remedy of reformation is equitable, and a court may withhold the remedy on equitable grounds.[8]
According to Section 155 of the Restatement (Second) of Contracts, a court may not grant reformation “to the extent that rights of third parties such as good faith purchasers for value will be unfairly affected.”  However, official comment f. to Section 155 notes that judgment lien creditors and trustees in bankruptcy are not among those third parties whose rights are to be considered for this purpose.  The comment states that the third-party rights to be considered are those of “good faith purchasers for value and other third parties who have similarly relied on the finality of a consensual transaction in which they have acquired an interest in property.”  The comment also makes clear that its reference to “purchasers” includes “purchasers” as defined in the Uniform Commercial Code, which includes pledgees, mortgagees and other holders of voluntary liens.[9]
The Seventh Circuit in Duckworth sought to protect the ability of subsequent creditors to rely on security agreements of prior creditors.  However, the situation of a subsequent secured creditor making a loan, where the secured creditor can be expected to examine its lien position with some care prior to advancing its loan, is different from a judicial lien creditor’s situation, where the creditor would not take its judgment lien in reliance on the existing state of facts.  This perhaps explains the distinction drawn by the official comments to the Restatement.
Thus, while it may be inappropriate for a court to reform a security agreement if a subsequent third party lender would be harmed by the reformation, some courts have determined that they have more flexibility to reform a security agreement if the only rights that would be harmed thereby were rights of a judicial lien creditor or bankruptcy trustee.[10]
We note that under Section 544(a)(3) of the Bankruptcy Code, in addition to the lien avoidance powers of a judicial lien creditor, as noted above, a trustee is also given the lien avoidance powers of a bona fide purchaser of real property, other than fixtures, of the debtor.  In a case involving such real property, it would seem that the exclusion reflected in official comment f to Section 155 of the Restatement would not apply.[11]
It can be a difficult matter to fix a drafting mistake through judicial reformation, and courts have been inconsistent in terms of their willingness to consider parol evidence as to the existence of such mistakes.  In Duckworth, the Seventh Circuit determined that judicial reformation -- which might have been an option for the bank in a case against the borrower--was not available as against the bankruptcy trustee in its capacity as judicial lien creditor.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances. 

[1]  2014 WL 6602521 (7th Cir. Nov. 21, 2014)
[2]  The Seventh Circuit cited two federal circuit court cases as precedent, Safe Deposit Bank & Trust Co. v. Berman, 393 F.2d 401 (1st Cir.1968), which held that a creditor could not introduce parol evidence in a bankruptcy proceeding that would expand a security agreement’s reference to the indebtedness secured to cover subsequent promissory notes, and In re Martin Grinding and Machine Works, Inc., 793 F. 2d 592 (7th Cir. 1986), which held that a creditor could not introduce parol evidence in a bankruptcy proceeding that would expand an unambiguous security agreement’s collateral description to cover inventory and accounts receivable that had been inadvertently omitted.  The district court below in Duckworth noted in a footnote that the Grinding case was one of many cases dealing with collateral description errors, but its holding “does not govern the outcome in this case.” Toulon v. Covey (In re Duckworth), 77 UCC Rep. Serv. 2d 156, 2012 WL 986766 (Bankr. C.D. Ill.)
[3]  The court referred to the trustee as a “hypothetical subsequent creditor” and as a “hypothetical later lien creditor.”  The court also stated that the trustee could “stand in the shoes of other subsequent creditors.”
[4]  “Mistake” is defined in Section 151 of the Restatement (Second) of Contracts to mean “ a belief that is not in accord with the facts.”
[5]  Restatement (Second) of Contracts §155.  Article 9 of the Uniform Commercial Code governs security agreements covering personal property, and requires in most cases that a security agreement be entered into containing a description of the collateral for a valid security interest to be created.  UCC §9-203.  UCC §1-103 allows principles of other law to supplement the UCC, and general contract law is one such principle that would be applied to determine the contents of a security agreement.
[6]  Restatement (Second) of Contracts §213.
[7]  Restatement (Second) of Contracts §214(d).  
[8]  Restatement (Second) of Contracts §155, comment d.
[9]  See UCC §§ 1-201(a)(29), (30). 
[10] See In re Owen, 101 B.R. 266 (D. Kan. 1989) (cited comment (f) to Restatement (Second) of Contracts §155in support of the principle that a judgment lien creditor is not able to override the right to reformation); see also 79 A.L.R.2d 1180 (sections 12 and 20).
[11] See In re Cunningham, 48 B.R. 509 (Bankr. M.D. Tenn. 1985).

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