Section 9-204(c) of the Uniform Commercial Code makes it possible to secure future advances, even if the advances are not made pursuant to a commitment.  However, the security agreement creating the security interest must “provide that collateral secures . . . . [such] advances.”  A March 22, 2012 decision of the United States Bankruptcy Court for the Central District of Illinois (State Bank of Toulon v. Covey, Trustee) construed this provision of the UCC with the result that the lender bank lost the collateral for a $950,000 loan.

The Borrower obtained $1,100,000 loan and gave a promissory note dated “December 15, 2008” referencing a “Security Agreement dated December 13, 2008” (more on the date discrepancy later).  In January, 2010 the Borrower obtained a second loan giving a $950,000 note again referencing a “Security Agreement dated December 13, 2008.”

The court parsed the defined terms in the Security Agreement (e.g., “Indebtedness,” “Note” and “Related Documents”) and found that despite containing an estimated 10,000,000 words in 6 pages of single-spaced text, the Security Agreement had no language which would extend the security interest to future advances (a so-called “dragnet clause”).  The Bank argued that a careful reading of the defined terms and the fact that the second note contained a reference to the December 13, 2008 Security Agreement, revealed a clear intention to secure the second note.

The court rejected the Bank’s arguments finding that the circular definitions limited the secured indebtedness to the first note and that a simple reference to the earlier security agreement in the second note could not overcome the failure to include a future advance clause.

Another issue raised by the Trustee was the date discrepancy—the December 15 Note which referenced the December 13 Security Agreement.  The Trustee argued that the Bank’s security interest was invalid because it provided that it secured a debt evidenced by a note that did not exist (i.e., a note dated December 13, 2008) and therefore no “value” was given as required by Article 9 of the UCC.

The court found that the $1,000,000-plus that was advanced to the Borrower was “value” and the security interest was enforceable against the Borrower (and third parties as well).  While avoiding this potentially fatal finding, the inconsistencies in the documentation and simple clerical errors (e.g., leaving the “$_________________” blank when defining the “Note”) nearly cost the bank the loss of all of the collateral in which the security interest was granted.