Court Permits Reformation of Erroneous Document – Lesson is to Make Really Dumb Errors to Prevail

Date: 8/27/2012
 Business Update 8-27-2012

In a recent decision, the 7th Circuit Court of Appeals was faced with a situation that is the bane of any commercial and business attorney. A legal document contained an error. But in this case, the error was so extreme and obvious that the court was willing to reform the document to correct the error, in the face of other cases where courts refused to let parties escape from their mistakes. In re: Equipment Acquisition Resources (7th Cir., No. 1103905 decided on August 9, 2012)

Equipment Acquisition Resources, Inc. (EAR) was a corporation engaged in the sales and service of semiconductor manufacturing equipment. EAR defrauded various creditors in what was apparently a Ponzi scheme. EAR's illegal activity included tricking banks into financing non-existent or grossly overvalued equipment and pledging certain pieces of equipment multiple times to different creditors. After the fraud was discovered, EAR filed for bankruptcy. A person with the exalted title of "Chief Restructuring Officer" assumed control of the operations and decided to abandon a portion of EAR's assets. The Chief Restructuring Officer then commenced litigation so it could pay EAR's unsecured creditors.

The litigation in the instant case involved five equipment leases between EAR and Alliance Commercial Capital under the terms of which EAR granted Alliance a security interest in EAR's equipment. Alliance filed UCC-1 financing statements perfecting its security interest in the leases and other personal property.

Shortly thereafter, Alliance assigned all five leases to Republic Bank of Chicago. Republic and EAR amended the leases. The amendments provided that a) EAR would pay down $4.6 million toward the leases, b) EAR would give a blanket security interest in all its assets to Republic and c) Republic would forebear on claims it had against EAR. But Republic blundered in a major way. The amendment had a typographical error in which Republic, not EAR, granted the security interest to Republic. So, on its face, the amendment granted a security interest to Republic in Republic's own assets, an absurdity and obvious error.

After the bankruptcy, EAR's Chief Restructuring Officer abandoned EAR's equipment, which was auctioned. In an interesting twist, the proceeds of the auction are the subject of separate litigation in the Circuit Court of Cook County. (The 7th Circuit decision did not explain why the bankruptcy court would not have jurisdiction over the proceeds, precluding the Cook County litigation.) In the Cook County litigation, the claimants to the proceeds included Republic, which claimed an interest based on its blanket security interest (in spite of the erroneous amendment) and First Premier Bank, EAR's largest creditor.

The instant case arose through an adversary action EAR filed against Republic in EAR's bankruptcy. EAR sought to avoid the $4.6 million payment made as part of the lease amendment and also challenged Republic's blanket security interest. Several months later, EAR (through its Chief Restructuring Officer) and Republic settled their dispute and sought to end the EAR – Republic adversary litigation in the bankruptcy court. Part of the settlement included a reformation of the lease to correct the typographical error that granted Republic a blanket security interest in Republic's own assets, although the bankruptcy court specifically noted the order approving the settlement was not intended to resolve whether Republic in fact had a lien on EAR's assets.

But First Premier opposed the settlement anyway. It was concerned that the settlement could adversely affect its position against First Republic in the Cook County litigation. In the end, the 7th Circuit upheld the settlement. But it also had an interesting discussion about the effects of these types of errors, which haunt the nightmares and waking hours of every commercial and business attorney.

The settlement purported to retroactively modify the lease to correct the obvious error and to show that EAR (not Republic) was granting the blanket security interest in EAR's assets. First Premier cited the case of In re Martin Grinding & Machine Works, Inc. (793 F.2d 592, 7th Cir. 1986) for the position that the lease could not be modified retroactively to reform a fatal defect. But the 7th Circuit distinguished Martin Grinding. In Martin Grinding, the debtor granted a security interest in its machinery, equipment, furniture, fixtures, inventory and accounts receivable. However, the signed security agreement inadvertently omitted "inventory" and "accounts receivable" (although these missing items of collateral were referenced in other loan documents). The 7th Circuit held that, even though the parties made a mutual mistake, the unambiguous security agreement, as written, controlled. So the creditor lost its security interest in inventory and accounts receivable. The 7th Circuit said the holding in Martin Grinding "promotes confidence in the written terms of secured transactions and allows subsequent creditors to rely on the contents of security interest documents . . . . Martin Grinding stands for the notion that parol evidence may not alter an unambiguous secured transaction." [emphasis in original]

In contrast, the error in the instant case "renders the description of the collateral . . . completely ineffective" unlike Martin Grinding which, although erroneous, was also unambiguous. "Not only is this conveyance [to Republic of Republic's own assets] impossible, it does not make sense, and unlike the agreement in Martin Grinding it cannot stand on its own as an unambiguous conveyance."

There was much more to the case and to the reasons for the court's decision. Basically, EAR and Republic wanted to settle their litigation in the bankruptcy court. First Premier did not want any adverse impact on its separate Cook County litigation against Republic. The 7th Circuit acknowledged that the bankruptcy court was "walking a very fine line." But the bankruptcy court did not have to decide that Republic's argument would prevail or fail. It only had to decide that it was credible enough to justify the settlement both EAR and Republic proposed. The bankruptcy court approved the settlement to "get money in the estate as quickly as we can so dividends can be paid under the liquidating plan." But the bankruptcy court was sensitive to the concerns of First Premier. To address the concerns of First Premier, the bankruptcy court noted that its approval order was not intended to resolve whether Republic had a lien on EAR's assets involved in the Cook County litigation. Noted the 7th Circuit:

"The bankruptcy court's issuance of an order that contains language purporting to reform the lease agreements and simultaneously disclaiming the consequences of that language may be perplexing. However, the representations of Republic at oral argument that the settlement will not be used to limit the litigation positions of First Premier or any other third party are reassuring. The settlement does not reform the lease modifications. It merely stands as an agreement between the two parties that the lease modification agreements are flawed with a typo. Republic does not claim that this agreement binds third parties."

Using this reasoning, the 7th Circuit concluded that the settlement between EAR and Republic in the bankruptcy case did not prejudice First Premier's Cook County litigation and, therefore, the settlement could stand.

Ironically, what saved the settlement for Republic is that the error was so obvious. So the lesson seems to be that, if you make an error, make it a really dumb error so that it makes your document absurd and nonsensical (or at least ambiguous). If you just make an error that leaves your document clear on its face, your chances of reforming the document will suffer.

For more information about this or any other corporate law topic, please contact Stephen Proctor, Chair of the Business Group, at 847.734.8811 or via e-mail at sproctor@masudafunai.com.