Shelby County State v. Van Diest Supply ( 2002 )

In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 01-2250
SHELBY COUNTY STATE BANK,
AN ILLINOIS BANKING CORPORATION,
Appellant,
v.
VAN DIEST SUPPLY COMPANY,
Appellee.
____________
Appeal from the United States District Court
for the Central District of Illinois.
No. 00-C-3326—Jeanne E. Scott, Judge.
____________
ARGUED DECEMBER 5, 2001—DECIDED SEPTEMBER 17, 2002
____________
Before COFFEY, RIPPLE, and DIANE P. WOOD, Circuit
Judges.
DIANE P. WOOD, Circuit Judge. Hennings Feed & Crop
Care, Inc. (Hennings) filed a voluntary bankruptcy peti-
tion under Chapter 11 on August 23, 1999, after Van Diest
Supply Co. (Van Diest), one of its creditors, filed a com-
plaint against it in the Central District of Illinois. Shel-
by County State Bank (the Bank), another creditor of
Hennings, brought this action in the bankruptcy proceeding
against Van Diest and the Trustee for Hennings to as-
sert the validity of the Bank’s security interest in certain
assets of Hennings. Van Diest was included as a defen-
2 No. 01-2250
dant because the scope of Van Diest’s security interest
in Henning’s assets affects the extent of the Bank’s secu-
rity interest. The Bank and Van Diest cross-moved for
summary judgment, and the bankruptcy court granted
the Bank’s motion, finding that Van Diest’s security
interest was limited to the inventory it sold to Hennings
(as opposed to the whole of Hennings’s inventory). Van
Diest appealed that order, and the district court reversed,
finding that Van Diest’s security interest extended to all
of the inventory. Other claims that were at issue in those
proceedings are not relevant to this appeal. The Bank now
appeals. For the reasons set forth in this opinion, we re-
verse the decision of the district court and remand the
case to the bankruptcy court.
I
Hennings, a corporation based in Iowa, was in the
business of selling agricultural chemicals and products.
As is customary, several of Hennings’s suppliers ex-
tended credit to it from time to time to finance its busi-
ness operations, and obtained liens or other security
interests in Hennings’s property and inventory to safe-
guard their advances.
The Bank is among Hennings’s creditors. In December
1997, the Bank extended credit to Hennings for $500,000.
In May 1998, the Bank increased this amount to a revolv-
ing line of credit of some $4,000,000. Hennings in return
granted the Bank a security interest in certain of its
assets, including inventory and general intangibles. Van
Diest, also a creditor, entered into several security agree-
ments with Hennings and its predecessor over the years
to protect its financing of materials supplied to Hennings.
These agreements were covered by the Uniform Commer-
cial Code, which Iowa has adopted (including the revised
Article 9), see Iowa Code §§ 554.9101-554.9507 (1999).
No. 01-2250 3
A financing statement entered into by Hennings and Van
Diest on November 2, 1981, provided for a blanket lien
in “[a]ll inventory, notes and accounts receivable, machin-
ery and equipment now owned or hereafter acquired,
including all replacements, substitutions and additions
thereto.” On August 29, 1983, Hennings and Van Diest
entered into a new security agreement (the Security
Agreement), the language of which is at the core of this
dispute. The Security Agreement was based on a pre-
printed standard “Business Security Agreement” form. In
the field for the description of collateral, the parties en-
tered the following language, drafted by Van Diest, de-
scribing the security interest as being in
[a]ll inventory, including but not limited to agricultural
chemicals, fertilizers, and fertilizer materials sold
to Debtor by Van Diest Supply Co. whether now
owned or hereafter acquired, including all replace-
ments, substitutions and additions thereto, and the
accounts, notes, and any other proceeds therefrom.
The Security Agreement contained a further preprinted
clause providing
as additional collateral all additions to and replace-
ments of all such collateral and all accessories, acces-
sions, parts and equipment now or hereafter affixed
thereto or used in connection with and the proceeds
from all such collateral (including negotiable or non-
negotiable warehouse receipts now or hereafter issued
for storage of collateral).
The bankruptcy court found that the language of the
Security Agreement was ambiguous and susceptible on
its face to two interpretations: under one, the security
interest extended to all of Hennings’s inventory; under
the other, it was limited to inventory sold to Hennings
by Van Diest. Proceeding under Iowa law, that court
applied several canons of contract interpretation to re-
4 No. 01-2250
solve the ambiguity. The upshot was that the court re-
jected the use of parol evidence and concluded that the
Security Agreement extended only to inventory sold to
Hennings by Van Diest.
The district court disagreed. It found that the bankruptcy
court had created an ambiguity out of thin air and that
the language of the Security Agreement supported only
the view that the collateral included all inventory. It re-
lied on the presence of the “after-acquired clause,” which
provides for future inventory to be deemed part of the
collateral. Such a clause ensures that an entity having
an interest in inventory retains the interest even when
the original goods have been sold and replaced in the
course of business, given the natural turnaround of in-
ventory. See, e.g., Larsen v. Warrington, 348 N.W.2d 637,
639 (Iowa 1984). To reach this conclusion, the district
court found that the qualifier phrase mentioning spe-
cific items found in the first paragraph quoted above,
while it concededly modified the term “inventory,” was
mere surplusage. Accordingly, it found that the descrip-
tion of “collateral” must have extended to “[a]ll inventory,”
and reversed the bankruptcy court’s findings.
II
As this case requires the interpretation of a contract,
which is a question of law, we review the district court’s
decision de novo. In re Frain, 230 F.3d 1014, 1017 (7th Cir.
2000); In re: Virtual Network Servs. Corp., 902 F.2d 1246,
1247 (7th Cir. 1990). The facts underlying the contract
interpretation are not disputed in this case.
In accordance with the Security Agreement’s undisputed
choice of law provision, we apply Iowa law.
No. 01-2250 5
A. Ambiguity of the “After-Acquired” Clause
In the process of divining the meaning of a contractual
clause, a court must first establish whether the language
in dispute supports more than one interpretation. The
existence of such an ambiguity is a question of law, and
under Iowa law, “[t]he test for ambiguity is objective:
whether the language is fairly susceptible to two inter-
pretations.” DeJong v. Sioux Ctr., Iowa, 168 F.3d 1115,
1119 (8th Cir. 1999).
The description of the security interest in this case is
a textbook example of ambiguous language: a term
(all inventory) is followed by a qualifier (including all . . .)
and then another (sold to Debtor by Van Diest). It is a
basic rule of English syntax (of all syntax, in fact) that
a modifier should be placed directly next to the element
it aims to modify: placing two modifiers in a row leads
to the question whether the latter one modifies only the
first modifier, or modifies the entire term. In the first
edition of his book on statutory interpretation, Sutherland
described the “doctrine of the last antecedent” as provid-
ing that “[r]elative and qualifying phrases, grammatically
and legally, where no contrary intention appears, refer
solely to the last antecedent.” J.G. Sutherland, Statutes and
Statutory Construction § 267, at 349 (1st ed. 1891).
The Supreme Court recognized the existence of the “last
antecedent” rule as early as 1799 in Sims’ Lessee v. Irvine,
3 U.S. (3 Dall.) 425, 444 n.a (1799) (“The rule is, that ‘such’
applies to the last antecedent, unless the sense of the
passage requires a different construction.”). The Supreme
Court of Iowa has also often endorsed resort to the doc-
trine in an attempt to resolve problems caused by ambigu-
ously placed modifiers. See, e.g., State v. Lohr, 266 N.W.2d
1, 3 (Iowa 1978) (recognizing grammatical as well as
legal origins of the rule); In re Peterson’s Will, 166 N.W.
168, 170-71 (Iowa 1918). The rule is now thought to extend
6 No. 01-2250
generally to the placement of all modifiers next to the
term to be modified. See, e.g., Bryan A. Garner, Guidelines
for Drafting and Editing Court Rules, 169 F.R.D. 176, 195
(1997) (“To avoid ambiguity, place a modifier next to the
word or phrase it modifies.”).
B. Canons of Interpretation and Extrinsic Evidence
As a linguistic matter, therefore, the sentence is ambigu-
ous. As both the Supreme Court and Iowa courts have
recognized (and, indeed, as Sutherland himself pointed out)
the rule is helpful in determining the existence of the
ambiguity, but not in solving the puzzle when both read-
ings are plausible. See, e.g., Nobelman v. American Sav.
Bank, 508 U.S. 324, 330 (1993); In re: Kruse’s Estate, 250
N.W.2d 432, 433-34 (Iowa 1977). Unless one always fol-
lowed a rigid formalistic approach, the rule would not cast
light on which of the two interpretations should prevail.
Instead, courts (including those in Iowa) turn to other
canons of interpretation. Under Iowa law, those other
canons should be used to resolve an ambiguity before parol
evidence may be introduced. See Kibbee v. State Farm &
Cas. Co., 525 N.W.2d 866, 868 (Iowa 1994). The rules in
Iowa are the familiar ones used in contract interpretation
in United States courts: the contract must be construed as
a whole; the court requires a fair and reasonable construc-
tion; avoid illegality; the interpretation must account for
surrounding circumstances; and the parties’ own practical
construction is relevant. Iowa also applies the rule requir-
ing the court to construe terms against the drafter of the
instrument (still known to those fond of Latin phrases as
the rule of contra proferentem); it favors specific terms over
general terms; and it favors handwriting to typing and
typing to printing.
Construing the contract before us as a whole leaves as
many doubts as we had at the outset: nothing within
No. 01-2250 7
it bears on the intended scope of the phrase “including
but not limited to agricultural chemicals, fertilizers, and
fertilizer materials sold to Debtor by Van Diest Supply
Company.” Van Diest could have acquired a security in-
terest in everything that Hennings owned in inventory
(as it had done, for instance, with the 1981 security agree-
ment), or it could have limited its interest to the goods
it supplied to Hennings. Without resort to other interpre-
tive principles or to outside evidence, such as evidence
of custom in the trade, it is impossible for a court to de-
cide which reading the parties intended to adopt.
We do agree with the Bank’s claim, however, that it
would be bizarre as a commercial matter to claim a lien
in everything, and then to describe in detail only a small-
er part of that whole. This is not to say that there is no
use for descriptive clauses of inclusion, so as to make
clear the kind of entities that ought to be included. See, e.g.,
National Cash Register Co. v. Firestone & Co., Inc., 191
N.E.2d 471 (Mass. 1963). But if all goods of any kind are
to be included, why mention only a few? A court required
to give “reasonable and effective meaning to all terms,”
AmerUs Bank v. Pinnacle Bank, 51 F. Supp. 2d 994, 999
(S.D. Iowa 1999), must shy away from finding that a
significant phrase (like the lengthy description of chem-
icals and fertilizers we have here) is nothing but sur-
plusage.
Iowa law permits courts to consider the parties’ conduct,
such as the prior security agreements that Van Diest
entered into with Hennings, as one way of resolving
the ambiguity. Those earlier agreements at times pro-
vided for a blanket security with collateral in all inven-
tory. This, too, is not terribly helpful here. On the one
hand, the prior use of a general claim for all inventory
demonstrates the availability in the trade of such a
term and the willingness of Hennings, on occasion at least,
to enter into such broad lien grants. On the other hand,
8 No. 01-2250
it tends to show that the parties knew how to achieve
such a result if they wanted to. There must be a reason
why the historically used “all inventory,” was modified
in this case.
More useful is the parties’ own practical construction
of this particular agreement—a source that Iowa courts
agree may be consulted without opening the door en-
tirely to parol evidence. See Ackerman v. Lauver, 242
N.W.2d 342, 347 (Iowa 1976). After the Security Agree-
ment was executed, Van Diest sent to other lenders no-
tices of its interest thereunder. In all the notices, it
claimed a “purchase money security interest” only in the
inventory it sold to Hennings. In a July 1993 letter to the
Bank, for instance, Van Diest described its security inter-
est as being in “[a]ll of Debtor’s property (including with-
out limitation all inventory of agricultural chemicals
and additives thereto) purchased or otherwise acquired
from the Secured Party. . . .” In the parenthetical, Van
Diest then construed its own interest as being limited to
the goods it sold to Hennings—not to the whole of
Hennings’s inventory, as it now claims.
It is true that this canon of construction treads remark-
ably close to the ground covered by extrinsic evidence.
Furthermore, the course of dealing between principal
parties A and B is not likely to shed light on the way
that third party C should have understood an agreement.
Where a third party disputes a reading of a contract, it
is not in a good position to use course of dealing or other
extrinsic evidence to support its position. It was not a
part of the negotiations and does not have the access
that we otherwise presume of both parties to outside
materials relating to the contract.
The Bank also argues that contractual terms must
be interpreted in a “commercially reasonable” fashion,
even though the Bank has not supported this specific
No. 01-2250 9
proposition with references to Iowa law. Nevertheless,
the somewhat broader requirement of a generally fair
and reasonable construction is amply recognized in Iowa.
See Dental Prosthetic Servs., Inc. v. Hurst, 463 N.W.2d 36,
38-39 (Iowa 1990). Of two plausible interpretations, we
should assume the parties meant one that was fair
and reasonable. The problem once again is that there is
nothing inherently commercially unreasonable about
either of the two possible readings. Under the circum-
stances, it would have been quite reasonable for Van
Diest to get as much security from Hennings as it could,
as the latter managed to ratchet up millions of dollars
in debt before it went bust (it owes the Bank some
$1,412,233.10; Van Diest had, at the time of the petition,
some $2,890,288.75 in unpaid invoices; countless other
creditors have lined up). On the other hand, it might
have been unreasonable for Hennings to commit all of
its potential collateral to Van Diest, if so doing might
have made it more difficult for the company to obtain
credit from others.
C. Contra Proferentem
As between the two parties to a contract, there is an-
other doctrine that often resolves ambiguities: it is the
rule requiring that ambiguous language must be con-
strued against its drafter. Not only should the drafter
be penalized by bearing the costs ex post of having cut
corners ex ante, the penalty of interpretation against
the drafter also aims to avoid overbearing behavior be-
tween contracting parties where the drafter, often the
one in the better bargaining position, tries to pull a fast
one over the party who can merely accept or reject the
contract as a whole. Although this doctrine of contra
proferentem is perhaps on the wane in some jurisdictions,
it is alive and well in Iowa, e.g., DeJong, 168 F.3d at
10 No. 01-2250
1121 (applying Iowa law), Continental Ins. Co. v. Bones, 596
N.W.2d 552, 558 (Iowa 1999), and in many interpretive
contexts, see DeGeare v. Alpha Portland Indus., Inc.,
837 F.2d 812, 816 (8th Cir. 1988) (recognizing contra
proferentem rule as a matter of federal common law).
Unlike many jurisdictions that relegate the contra
proferentem rule to the status of “tie-breaker,” see, e.g.,
Baker v. America’s Mortgage Servicing, Inc., 58 F.3d 321,
327 (7th Cir. 1995) (Illinois law), Iowa takes a strong
view of the rule, holding that ambiguous language is to
be “strictly construed against the drafter.” Iowa Fuel &
Mineral Co., Inc. v. Iowa State Bd. of Regents, 471 N.W.2d
859, 863 (Iowa 1991); see also Village Supply Co. v. Iowa
Fund, Inc., 312 N.W.2d 551, 555 (Iowa 1981); Fashion
Fabrics of Iowa, Inc. v. Retail Investors Corp., 266 N.W.2d
22, 27 (Iowa 1978). Cf. RESTATEMENT (SECOND) OF CON-
TRACTS § 206 (1981) (“In choosing among the reasonable
meanings . . . that meaning is generally preferred which
operates against the party who supplies the words.”).
Here, the drafting party was Van Diest. It was Van Diest
that was trying to obtain a security interest in certain
property of Hennings, in order to protect its advances to
the latter. At least if this were a case against Hennings,
the use of the contra proferentem rule would provide a
way out of the ambiguity in the key contractual lan-
guage: construing it against Van Diest, the security
interest extends only to the products Van Diest sold to
Hennings, not to “all inventory.” It is not such a case,
however, and so we turn to the final consideration that
persuades us that the Bank must prevail.
D. Third-Party Interests
The most compelling reason to construe the language of
this agreement against Van Diest is the fact that it was
No. 01-2250 11
Van Diest that drafted the security agreement, and that
the language of that agreement plays an important part
for third-party creditors. Those creditors have no way of
knowing what transpired between the parties; there is
no parol evidence to which they may turn; and they have
no way to resolve ambiguities internal to a contract. Here,
we are not facing a garden-variety breach of contract ac-
tion between the two contracting parties, both of whom
were present during the negotiations. Instead, this case
involves the effect of a contract between two parties
(Hennings and Van Diest) on a third party (the Bank). The
Bank, as we have already mentioned, is a stranger to
the agreement, albeit one whose rights are affected by it.
As the Bank could not have invested resources ex ante
to avoid problems arising from ambiguous language,
while Van Diest could have, it should be Van Diest who
pays the price ex post.
A security agreement is a special kind of contract for
which an important audience is third parties who need
to know how much collateral has become encumbered.
A potential creditor’s decision whether to provide credit
to Hennings (or anyone else), is contingent on the cred-
itor’s understanding of the extent of pre-existing security
interests. An unclear statement of that extent should
be avoided at all costs: if the creditor reads it reasonably,
but too narrowly, when extending credit, it will be out
of luck when the debtor defaults. If the potential creditor
on the other hand takes a more conservative position and,
fearful of the ambiguity, decides not to extend credit,
the party seeking that credit is penalized in its access
to capital by the shoddy work of its prior creditor—
another result to be avoided.
By perfecting its security interest, Van Diest purported
to give prospective creditors of Hennings notice of Van
Diest’s existing interest in Hennings’s goods. A prospec-
tive creditor should have been able to look at Van
12 No. 01-2250
Diest’s filing and determine on that basis whether to ex-
tend credit to Hennings. Here, the Bank presumably did
so, especially when it received Van Diest’s letter in July
1993 telling it that the Van Diest security interest cov-
ered only goods bought from Van Diest. Whether this
statement alone would have justified reliance on the
Bank’s part is debatable; but coupled with the language
in the perfected Security Agreement that was susceptible
to this interpretation, reliance was certainly reasonable.
The Supreme Court has also noted the special position
that third parties occupy, given their limited ways of
learning about the existence or the precise extent of a
security interest. In United States v. McDermott, 507 U.S.
447 (1993), the Court expressed concern over the possibility
that an after-acquired security interest clause might pre-
vent the Government from asserting its interests. Like
the Bank, the Government could not have protected itself
by contracting with the parties or by analyzing the terms
of the clause. The underlying rationale for the decision
is equally applicable here: for the notice requirement to
be a valid instrument of protection for potential creditors,
that notice must be clearly expressed, and it must be such
as is needed to inform the behavior of the potential creditor.
“When two private lenders both exact from the same debtor
security agreements with after-acquired-property clauses,
the second lender knows, by reason of the earlier recording,
that that category of property will be subject to an-
other claim, and if the remaining security is inadequate
he may avoid the difficulty by declining to extend credit.”
Id. at 454. When the earlier recording is ambiguous, the
“second lender” does not know what collateral will be
at its disposal.
In a broad sense, the problem of later creditors is sim-
ilar to the problem of any third-party beneficiary. In the
context of pension or welfare funds, which might be third-
No. 01-2250 13
party beneficiaries to agreements between unions and
multi-employer bargaining units, this court has held
that the language of the collective bargaining agreement
must stand on its own; it cannot be altered by oral agree-
ments. See Central States, Southeast and Southwest
Areas Pension Fund v. Gerber Truck Serv., Inc., 870 F.2d
1148, 1154 (7th Cir. 1989) (en banc). Similarly, security
agreements should be construed if at all possible with-
out resort to external evidence, and they should be con-
strued in a way that recognizes the important role they
play for third-party creditors. Doing so here leads to the
same result we have already reached: Van Diest’s security
interest extends only to the inventory it furnished. The
limiting clause modifies the term “all inventory,” and it
is not surplusage.
III
For these reasons, we REVERSE the judgment of the
district court and REMAND the case to the bankruptcy court
for the entry of judgment in favor of the Bank.
A true Copy:
Teste:
________________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-97-C-006—9-17-02