iIn a little-noticed November opinion, the Seventh Circuit greatly expanded the ability of a bankruptcy trustee to avoid a security interest for documentation errors under section 544(a)(1) of the Bankruptcy Code. See State Bank of Toulon v. Covey (In re Duckworth), 776 F.3d 453 (7th Cir. 2014).
In Duckworth, the written security agreement stated that it secured a note “dated December 13, 2008,” but the note was not signed until two days later — so it was dated December 15. Although everyone testified that the security agreement was intended to secure the debt evidenced by the December 15 note, the Court held that the strong arm power allowed the trustee to rely on the written terms of the agreement. Since there was no December 13 note, there was no secured debt that could support the bank’s security interest and the bank was left unsecured.
The section 544(a) strong arm power gives the trustee the powers of a hypothetical lien creditor and is regularly used to attack defects in a UCC financing statement. In that context, errors in the debtor’s name or the collateral description may lead to avoidance of a security interest. However, minor errors that are not seriously misleading are excused. See UCC § 9-506(a).
Duckworth enlarges the strong arm power into a tool that can attack errors in the security agreement and, apparently, there is no room for even minor mistakes. It does this by announcing a bankruptcy version of the D’Oench Duhme doctrine that a trustee is bound only by the written agreement. Compare D’Oench Duhme & Co. v. FDIC, 315 U.S. 447 (1942) (establishing that a federal receiver is bound only by the written records of a failed bank).
The Duckworth court seemed unaware of how revolutionary its approach was. It relied upon the old 1968 First Circuit opinion of Safe Deposit Bank & Trust Co. v. Berman, 393 F.2d 401 (1st Cir. 1968), as though it was applying well-settled established law. While Berman might be distinguished on the basis that it involved a missing “other indebtedness” clause (section 9-204(c) requires these be express), it does include language that supports the Duckworth result. However, if Berman established such an important rule, one would expect it to have been widely cited in the intervening five decades. It hasn’t been. In the past 25 years, only three cases other than Duckworth have even cited the relevant part of the Berman opinion. Prior to Duckworth, Berman’s reasoning was adopted by one court and rejected by one court.
Duckworth may upset a number of generally-accepted principles of secured transactions law. First, UCC § 9-203(b)(3)(A) appears to require that only the collateral be described in writing, with other security agreement terms open to oral agreement or oral modification. Duckworth extends the writing requirement to the description of the secured indebtedness and possibly all other terms. Duckworth also ignores the important distinction between reliance parties like later lenders who advance new credit in reliance on a prior lender’s misleading written security agreement and a non-reliance lien creditor or bankruptcy trustee. Equitable principles might prevent reformation of an erroneous written security agreement to the detriment of a reliance party, but not a lien creditor.
Of far greater importance, Duckworth holds that the “composite document” rule does not apply to a bankruptcy trustee. The “composite document” rule allows a secured party to supplement an incomplete or erroneous written security agreement (usually missing an adequate collateral description) with other related documents to create a composite security agreement where the missing description is supplied by one of the other documents. Collateral description errors are probably far more common than erroneous debt references and many reported bankruptcy cases apply the composite document rule in the description context. If generally accepted, the Duckworth approach will likely have its greatest impact here.
