Opinion ID: 2754360
Heading Depth: 2
Heading Rank: 2

Heading: Parol Evidence Against the Trustee?

Text: To cure the mistaken date in the security agreement and connect it to the December 15 promissory note, the bank relies primarily on parol evidence, from outside the four corners of the document. The bank relies on the December 15 promissory note itself and testimony regarding the bank’s and the borrower’s intentions. The bank offers two related theories for reading the security agreement as securing the December 15 note. First, the bank contends that parol evidence is generally admissible to assist in interpreting the security agreement, which it asserts is ambiguous. Second, the bank argues that we should use the composite document rule to read the security agreement and the December 15 note together because the two documents were executed as part of the same transaction. See, e.g., Tepfer v. Deerfield Savings & Loan Ass’n, 454 N.E.2d 676, 679 (Ill. App. 1983) (documents executed by same parties in course of same transaction are “construed with reference to one another because they are, in the eyes of the law, one contract”). Both arguments attempt to justify the use of evidence external to the security agreement itself. 2 2 It is not at all clear that Illinois courts would apply the composite document rule against the trustee. Illinois courts apply this rule in disputes between the contracting parties: “Accordingly, as between the same parties, a note may be affected by a separate writing.” Main Bank of Chicago v. Baker, 427 N.E.2d 94, 99 (Ill. 1981) (emphasis added). The trustee was not a party to the transaction here. For all the reasons set forth in the text, we 8 Nos. 14-1561 and 14-1650 The testimony of both the bank officer who prepared the documents and borrower Duckworth makes clear that the bank made a mistake in preparing the security agreement. We are confident that the bank would have been able to obtain reformation—even of an unambiguous agreement— against the original borrower if he had tried to avoid the security agreement based on the mistaken date. See Fisher v. State Bank of Annawan, 643 N.E.2d 811, 814 (Ill. 1994) (reformation action available where clear and convincing evidence shows parties made a mutual mistake); Suburban Bank of Hoffman‐Schaumburg v. Bousis, 578 N.E.2d 935, 939 (Ill. 1991) (same); Harley v. Magnolia Petroleum Co., 37 N.E.2d 760, 765 (Ill. 1941) (same). A bankruptcy trustee is in a different position, however. A bankruptcy trustee is tasked with maximizing the recovery of unsecured creditors. See In re Vic Supply Co., 227 F.3d 928, 931 (7th Cir. 2000). To assist in this task, trustees may exercise the so‐called strong‐arm power: the trustee is deemed to be in the privileged position of a hypothetical subsequent creditor and can avoid any interests that a hypothetical subsequent creditor could avoid “without regard to any knowledge of the trustee or of any creditor.” See 11 U.S.C. § 544(a). The strong‐arm power is a “blunt information‐generating tool” that encourages lenders to give public notice of their security interests by harshly penalizing those who fail to do so. Jonathan C. Lipson, Secrets and Liens: The End of Notice in Commercial Finance Law, 21 Emory Bankr. Dev. J. 421, 450‐51 (2005) (criticizing the strong‐arm power, conclude that the error could not be corrected against the trustee, who was a stranger to the original loan. We have nothing further to add on the composite document rule. Nos. 14-1561 and 14-1650 9 “a necessary evil,” as perhaps “more troublesome for its over‐ and under‐inclusiveness than for its basic goals”); see also Barkley Clark & Barbara Clark, The Law of Secured Transactions Under the Uniform Commercial Code § 6.02(1)(a) (3d ed. 2011) (“The strong‐arm clause is the ultimate Article 9 enforcer.”); id., § 6.02(1)(b) (“As a matter of public policy, the [strong‐arm] rules penalize secret liens and encourage lenders to give public notice of their security interests.”). The bank argues that constructive notice may still be imputed to a trustee using the strong‐arm power. The concept of constructive notice comes from state real property law and defines the property rights of good faith purchasers. See In re Crane, 742 F.3d 702, 706–07 (7th Cir. 2013). A good faith purchaser cannot avoid the claims of creditors who have complied with state recording laws that provide public notice of the ownership of and liens on property. For that reason, constructive notice constrains a trustee who seeks to use the specific strong‐arm power of a good faith purchaser of property. See 11 U.S.C. § 544(a)(3); In re Sandy Ridge Oil Co., 807 F.2d 1332, 1336 (7th Cir. 1986). But the trustee here does not need to assume the role of a good faith purchaser to avoid the lender’s interest. The trustee can use other strong‐arm provisions and stand in the shoes of other subsequent creditors, to which the limitations of constructive notice do not apply. The trustee may avoid the bank’s security interest by acting as a hypothetical judicial lien creditor. 11 U.S.C. § 544(a)(1). Such a trustee, unconstrained by constructive notice, may “void a security interest because of defects that need not have misled, or even have been capable of misleading, anyone.” In re Vic Supply Co., 227 F.3d at 931. 10 Nos. 14-1561 and 14-1650 We therefore must treat the trustee as if he were a hypothetical later lien creditor and ask if the bank has a valid security interest that could be asserted against such a creditor. We conclude that the bank’s asserted security interest is not valid against such a later creditor. Such a creditor would be 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. We find guidance principally from our prior decision in Martin Grinding and the First Circuit’s decision in Safe Deposit Bank and Trust Co. v. Berman. Those decisions emphasize the importance of third parties’ ability to rely on unambiguous documents—even if the original parties can show they contain mistakes—to determine the validity and priority of security interests. In Martin Grinding, we held that parol evidence about the original parties’ intentions could not be used to correct a mistake in a security agreement by adding, over a bankruptcy trustee’s objection, to the agreement’s written list of the collateral securing a loan. The lender had failed to list inventory and accounts receivable as collateral in the security agreement. We enforced the unambiguous security agreement according to its terms: That the security agreement omits any mention of inventory and accounts receivable is unfor- tunate for the Bank, but does not make the agreement ambiguous. Since the security agreement is unambiguous on its face, neither the financing statement, nor the other loan documents can expand the Bank’s security in- Nos. 14-1561 and 14-1650 11 terest beyond that stated in the security agree- ment. 793 F.2d at 595. We recognized that the result was contrary to the intentions of the original parties. We explained, though, that the result should promote economy and certainty in secured transactions more generally, a central goal of Article 9 of the Uniform Commercial Code. Id. at 596 (Article 9 was intended to enable “‘the immense variety of present-day secured financing transactions … [to] go forward with less cost and with greater certainty.’”), quoting Ill. Rev. Stat. ch. 26, ¶ 9‐101 Uniform Commercial Code Comment (comment to version of UCC in effect in 1986). The rigid rule allows later lenders to rely on the face of an unambiguous security agreement, without having to worry that a prior lender might offer parol evidence (which would ordinarily be unknown to the later lender) to undermine the later lender’s security interest. Martin Grinding, 793 F.2d at 596–97. On the other hand, if parol evidence could enlarge an unambigu- ous security agreement, then a subsequent creditor could not rely upon the face of an un- ambiguous security agreement to determine whether the property described in the financ- ing statement, but not the security agreement, is subject to a prior security interest. Instead, it would have to consult the underlying loan documents to attempt to ascertain the property in which the prior secured party had taken a security interest. The examination of additional documents, which the admission of parol evi- dence would require, would increase the cost 12 Nos. 14-1561 and 14-1650 of, and inject uncertainty as to the scope of pri- or security interests, into secured transactions. See California Pump & Manufacturing Co., 588 F.2d [717, 720 (9th Cir. 1978)]; H & I Pipe & Sup- ply Co., 44 B.R. [949, 951 (Bankr. M.D. Tenn. 1984)]. Therefore, although the rule excluding parol evidence works results contrary to the parties’ intentions in particular cases, it reduces the cost and uncertainty of secured transac- tions generally. Id. at 597 (footnote omitted). In these appeals, the bank would have us limit Martin Grinding to prohibit use of parol evidence to correct mistakes only in identifying collateral but to allow its use to correct mistakes in identifying the debt to be secured. The bank notes that such identification of collateral is expressly required by the Illinois enactment of the Uniform Commercial Code, see 810 Ill. Comp. Stat. 5/9‐203(b)(3)(A), while the statute does not similarly require identification of the debt to be secured. We reject the bank’s suggested limitation, finding persuasive guidance from our colleagues in the First Circuit in Safe Deposit Bank and Trust Co. v. Berman, 393 F.2d 401, which addressed a mistake in identifying the debts to be secured. In that case the borrower took out a series of loans over several years. All the promissory notes referred to the same original security agreement for collateral. The problem was that the original security agreement itself identified only a single promissory note as the debt to be secured. By the time the borrower declared bankruptcy, that single promissory note had been paid off. By the terms of the security agreement Nos. 14-1561 and 14-1650 13 itself, therefore, there was no debt to be secured and thus no security interest. Like the bank here, the lender argued that the notes showed that the parties intended to create a security interest securing all the later loans. The bankruptcy and district courts had agreed with the trustee, however, that the lender could not use parol evidence against the trustee to show that it had a security interest in the collateral to assure payment of the later loans. The First Circuit affirmed, albeit “reluctantly because the result is commanded not by fireside equities but by the necessary technicalities inherent in any law governing commercial transactions.” 393 F.2d at 402. The First Circuit noted that collateral could be used to secure future debts if the security agreement provided as much. (A so‐called “dragnet” clause in a security agreement can include such later loans to the borrower, see UCC § 9‐204(c) (security agreement may provide that collateral secures “future advances or other value”), but the intent to secure later loans must be explicit in the security agreement.) The First Circuit held that the absence of such language could not be cured by parol evidence, at least as against the bankruptcy trustee. This was so even if the evidence showed that the original parties had intended to include such language. In other words, parol evidence could not be used to add a dragnet clause where the original security agreement did not include one. Recognizing that its decision was contrary to the evident intent of the original parties to the loans, the First Circuit concluded that the more general effects of the lender’s proposed cure would be worse than sticking to the text of the security agreement: 14 Nos. 14-1561 and 14-1650 In a commercial world dependent upon the ne- cessity to rely upon documents meaning what they say, the explicit recitals on forms, without requiring for their correct interpretation other documents not referred to, would seem to be a dominant consideration. If security agreements which on their face served as collateral for spe- cific loans could be converted into open-ended security arrangements for future liabilities by recitals in subsequent notes, much needless uncertainty would be introduced into modern commercial law. 393 F.2d at 404; accord, Texas Kenworth Co. v. First Nat’l Bank of Bethany, 564 P.2d 222, 226 (Okla. 1977) (refusing to interpret security agreement as securing future advances of credit; “potential creditors who do inquire should be able to rely upon the security agreement itself in determining what obligations are secured”). In both Safe Deposit Bank and Trust and the case before us, the lender made a mistake and failed to ensure that the security agreement properly identified the debt to be secured. We do not see a sound basis for distinguishing between the mistaken identification of the debt in our case and the mistaken failure to add a “dragnet” clause in Safe Deposit Bank and Trust. The bank points out that even a hypothetical later lender who finds the recorded financing statement has a duty to inquire further to see the security agreement itself. That is certainly correct, as far as it goes. But the bank argues that the later lender would be obliged to inquire still further. We see no basis for imposing on the later lender a legal duty to Nos. 14-1561 and 14-1650 15 inquire beyond the face of an unambiguous security agreement, at the risk of losing the priority of its lien based on parol evidence concerning the dealings between the original parties. The bank argues, though, that if it had been asked for the security agreement, it surely would have shown the later lender both the security agreement and the promissory note of December 15, despite the erroneous date in the security agreement. That reasoning is not consistent with Martin Grinding or Safe Deposit Bank and Trust. We also rejected the same argument in Helms v. Certified Packaging Corp., 551 F.3d 675, 680 (7th Cir. 2008), where we reaffirmed that a subsequent creditor is justified in relying on the security agreement alone. In that case, the publicly filed financing statement listed collateral that was not specified in the security agreement itself. We held that the security agreement controlled. A creditor need look no further than the security agreement: “A prudent potential creditor would have requested a copy of the security agreement because that, and not what an employee of an existing creditor might tell the potential creditor over the phone, is the security interest that the parties to the security agreement had agreed to create.” Id. That argument applies with even more force where the parol evidence that a party seeks to use to enlarge the security interest consists of a separate and private document (the note of December 15) that is not identified in the security agreement, rather than a publicly available financing statement as in Helms. See also Caterpillar Financial Services Corp. v. Peoples Nat’l Bank, N.A., 710 F.3d 691, 696 (7th Cir. 2013) 16 Nos. 14-1561 and 14-1650 (explaining that between two conflicting descriptions of the collateral, the “security agreement is controlling”). The bank also argues that we should overlook the erroneous date in the security agreement because it was just a small error that would have been easy to discover. We disagree. We find no limiting principle that would allow the courts or parties to distinguish reliably between small errors and big ones. Under the reasoning of Martin Grinding, Helms, and Safe Deposit Bank and Trust, parol evidence cannot be used to correct even the seemingly minor clerical error in the security agreement. We must hew to the “necessary technicalities inherent in any law governing commercial transactions,” even when the result is harsh. Safe Deposit Bank & Trust Co., 393 F.2d at 402. We therefore do not think that parol evidence, contemporaneously executed or not, can be used to undermine the ability of later lenders (or bankruptcy trustees) to rely on unambiguous security agreements.