Lender Lambasted for Loaning Funds to Judgment Debtor’s Related Business – IL Court

The issue on appeal in National Life Real Estate Holdings, LLC v. Scarlato, 2017 IL App (1st) 161943 was whether a judgment creditor could reach loan proceeds flowing from a lender to a judgment debtor’s associated business entity where the debtor himself lacked access to the proceeds.

Answering “yes,” the Court considered some of Illinois post-judgment law’s philosophical foundations and the scope and mechanics of third-party judgment enforcement practice.

The plaintiff obtained a 2012 money judgment of over $3.4M against the debtor and two LLC’s managed by the debtor.   During supplementary proceedings, the plaintiff learned that International Bank of Chicago (“IBC”) loaned $3.5M to two other LLC’s associated with the debtor after plaintiff served a third-party citation on IBC.  The purpose of the loan was to pay for construction improvements on debtor’s industrial property.  And while the debtor wasn’t a payee of the loan, he did sign the relevant loan documents and loan disbursement request.

Plaintiff moved for judgment against IBC in the unpaid judgment amount for violating the third-party citation.  The trial court denied the motion and sided with IBC; it held that since the loan funds were paid to entities other than the debtor, the loan moneys did not belong to the debtor under Code Section 2-1402(f)(1) – the section that prevents a third party from disposing of debtor property in its possession until further order of court.  735 ILCS 5/2-1402(f)(1).

The Plaintiff appealed.  It argued that the debtor sufficiently controlled IBC’s construction loan and the proceeds were effectively, debtor’s property and subject to Plaintiff’s third-party citation.

Reversing, the First District rejected IBC’s two key arguments: first, that the loan proceeds did not belong to the debtor and so were beyond the reach of the third-party citation and second, IBC had set-off rights to the loan proceeds (assuming the funds did belong to debtor) and could set-off the $3.5M loan against debtor’ outstanding, other loan debt.

On the question of whether the post-citation loan was debtor’s property, the Court wrote:

  • Once a citation is served, it becomes a lien for the judgment or balance due on the judgment. Section 2-1402(m);
  • A judgment creditor can have judgment entered against a third party who violates the citation restraining provision by dissipating debtor property or disposing of any moneys belonging to the debtor Section 2-1402(f)(1);
  • Section 2-1402’s purpose is to enable a judgment debtor or third party from frustrating a creditor before that creditor has a chance to reach assets in the debtor’s or third party’s possession. Courts apply supplemental proceedings rules broadly to prevent artful debtors from drafting loan documents in such a way that they elude a citation’s grasp.
  • The only relevant inquiries in supplementary proceedings are (1) whether the judgment debtor is in possession of assets that should be applied to satisfy the judgment, or (2) whether a third party is holding assets of the judgment debtor that should be applied to satisfy the judgment.
  • Section 2-1402 is construed liberally and is the product of a legislative intent to broadly define “property” and whether property “belong[s] to a judgment debtor or to which he or she may be entitled” is an “open-ended” inquiry. (¶¶ 35-36)

The ‘Badges’ of Debtors Control Over the Post-Citation Loan and Case Precedent

In finding the debtor exercised enough control over the IBC loan to subject it to the third-party citation, the Court focused on: (i) the debtor signed the main loan documents including the note, an assignment, the disbursement request and authorization, (ii) the loan funds passed through the bank accounts of two LLC’s of which debtor was a managing member, and (iii) the debtor had sole authority to request advances from IBC.

While conceding the loan funds did end up going to pay for completed construction work and not to the debtor, the Court still believed IBC tried to “game” plaintiff’s citation by making a multi-million dollar loan to businesses allied with the debtor even though the loans never funneled directly to the debtor.

Noting a dearth of Illinois state court case law on the subject, the Court cited with approval the Seventh Circuit’s holding in U.S. v. Kristofic, 847 F.2d 1295 (7th Cir. 1988), a criminal embezzlement case.  There, the appeals court squarely held that loan proceeds do not remain the lender’s property and that a borrower is not a lender’s trustee vis a vis the funds.  Applying the same logic here, the First District found that the loan proceeds were not IBC’s property but were instead, the debtor’s.  Because of this, the loan was subject to the plaintiff’s citation lien.

The Court bolstered its holding with policy arguments.  It opined that if judgment debtors could enter into loan agreements with third parties (like IBC) that restrict a debtor’s access to the loan yet still give a debtor power to direct the loan’s disbursement, it would allow industrious debtors to avoid a judgment. (¶ 39)

The Court also rejected IBC’s set-off argument – that set-off language in other loan documents allowed it to apply the challenged $3.5 loan amount against other loan indebtedness.  Noting that IBC didn’t try to set-off debtor’s other loan obligations with the loan under attack until after it was served with the citation and after the plaintiff filed its motion for judgment, the Court found that IBC forfeited its set-off rights.

In dissent, Judge Mikva wrote that since IBC’s loan was earmarked for a specific purpose and to specific payees, the debtor didn’t have enough control over the loan for it to belong to the debtor within the meaning of Section 2-1402.

The dissent also applied Illinois’s collection law axiom that a judgment creditor has no greater rights in an asset than does the judgment debtor.  Since the debtor here could not access the IBC loan proceeds (again, they were earmarked for specific purpose and payable to business entities – not the debtor individually), the plaintiff creditor couldn’t either.  And since the debtor lacked legal access rights to the loan proceeds, they were not property belonging to him under Section 2-1402 and IBC’s loan distribution did not violate the citation. (¶¶ 55-56)

Afterwords

A big victory for creditor’s counsel.   The Court broadly construes “property under a debtor’s control” in the context of a third-party citation under Section 2-1402 and harshly scrutinized a lender’s artful attempts to dodge a citation.

The case reaffirms that loan proceeds don’t remain the lender’s property and that a borrower doesn’t hold loan proceeds in trust for the lender.

The case also makes clear that where loan proceeds are paid to someone other than the debtor, the Court may still find the debtor has enough dominion over funds to subject them to the citation restraining provisions if there are enough earmarks of debtor control over the funds

Finally, in the context of lender set-off rights, Scarlato cautions a lender to timely assert its set-off rights against a defaulting borrower or else it runs the risk of forfeiting its set-off rights against a competing judgment creditor.

 

Florida Series II: RE Broker Can Assert Ownership Interest in Retained Deposits in Priority Dispute with Condo Developer’s Lenders

Plaza Tower v. 300 South Duval Associates, LLC considers whether a real estate broker or a lender has “first dibs” on earnest money deposits held by a property developer.  After nearly 80% of planned condominium units failed to close (no doubt a casualty of the 2008 crash), the developer was left holding $2.4M of nonrefundable earnest money deposits.  The exclusive listing agreement (“Listing Agreement”) between the developer and the broker plaintiff provided the broker was entitled to 1/3 of retained deposits in the event the units failed to close.

After the developer transferred the deposits to the lender, the broker sued the lender (but not the developer for some reason) asserting claims for conversion and unjust enrichment.

The trial court granted the lenders’ summary judgment motion.  It found that the lenders had a prior security interest in the retained deposits and the broker was at most, a general unsecured creditor of the developer.  The broker appealed.

The issue on appeal was whether the broker could assert an ownership interest in the retained deposits such that it could state a conversion claim against the lenders.

The Court’s key holding was that the developer’s retained deposits comprised an identifiable fund that could underlie a conversion claim.  Two contract sections combined to inform the Court’s ruling.

One contract section provided that the broker’s commission would be “equal to one-third of the amount of the retained deposits.”  The Court viewed this as too non-specific since it didn’t earmark a particular fund.

But another contract section did identify a particular fund; it stated that commission advances to the broker would be offset against commissions paid from the retained deposits.  As a result, the retained deposits were particular enough to sustain a conversion action.  Summary judgment for the developer reversed.

Afterwords: Where a contract provides that a nonbreaching party has rights in a specific, identifiable fund, that party can assert ownership rights to the fund.  Absent a particular fund and resulting ownership rights in them, a plaintiff’s conversion claim for theft or dissipation of the fund will fail.

 

Discovery Rule Can’t Save Trustee’s Fraud Suit – No ‘Continuing’ Violation Where Insurance Rep Misstates Premium Amount – IL Court

Gensberg v. Guardian, 2017 IL App (1st) 153443-U, examines the discovery rule in the context of common law and consumer fraud as well as when the “continuing wrong” doctrine can extend a statute of limitations.

Plaintiffs bought life insurance from agent in 1991 based in part on the agent’s representation that premiums would “vanish” in 2003 (for a description of vanishing premiums scenario, see here).  When the premium bills didn’t stop in 2003, plaintiff complained and the agent informed it that premiums would cease in 2006.

Plaintiff complained again in 2006 when it continued receiving premium bills.  This time, the agent informed plaintiff the premium end date would be 2013. It was also in this 2006 conversation that the agent, for the first time, informed plaintiff that whether premiums would vanish is dependent on the policy dividend interest rate remaining constant.

When the premiums still hadn’t stopped by 2013, plaintiff had seen (or heard enough) and sued the next year.  In its common law and consumer fraud counts, plaintiff alleged it was defrauded by the insurance agent and lured into paying premiums for multiple years as a result of the agent’s misstatements.

The Court dismissed the plaintiffs’ suit on the grounds that plaintiff’s fraud claims were time barred under the five-year and three-year statutes of limitation for common law and statutory fraud.

Held: Dismissal Affirmed.

Rules/reasons:

The statute of limitations for common law fraud and consumer fraud is five years and three years, respectively. 735 ILCS 5/13-205, 805 ILCS 505/10a(e). Here, plaintiff sued in 2014.  So normally, its fraud claims had to have accrued in 2009 (common law fraud) and 2011 (consumer fraud) at the earliest for the claims to be timely.  But the plaintiff claimed it didn’t learn it was injured until 2013 under the discovery rule.

The discovery rule, which can forestall the start of the limitations period, posits that the statute doesn’t begin to run until a party knows or reasonably should know (1) of an injury and that (2) the injury was wrongfully caused. ‘Wrongfully caused’ under the discovery rule means there is enough facts for a reasonable person would be put on inquiry notice that he/she may have a cause of action. The party relying on the discovery rule to file suit after a statute of limitations runs has the burden of proving the date of discovery. (¶ 23)

The plaintiff alleged that it wasn’t until 2013 that it first learned that defendant misrepresented the vanishing date for the insurance premiums.
The Court rejected this argument based on the allegations of the plaintiff’s complaint. It held that the plaintiff knew or should have known it was injured no later than 2006 when the agent failed to adhere to his second promised deadline (the first was in 2003 – the original premium end date) for premiums to cease.

Plaintiff stated it complained to the insurance agent in 2003 and again in 2006 that it shouldn’t be continuing to get billed.  The court found that the agent’s failure to comply with multiple promised deadlines for premiums to stop should have put plaintiff on notice that he was injured in 2003 at the earliest and 2006 at the latest. Since plaintiff didn’t sue until 2014 – eight years later – both fraud claims were filed too late.

Grasping at a proverbial straw, the plaintiff argued its suit was saved by the “continuing violation” rule.  This rule can revive a time-barred claim where a tort involves repeated harmful behavior.  In such a case, the statute of limitations doesn’t run until (1) the date of the last injury or (2) when the harmful acts stop. But, where there is a single overt act which happens to spawn repetitive damages, the limitations period is measured from the date of the overt act. (¶ 26).

The court in this case found there was but a single harmful event – the agent’s failure to disclose, until 2006, that whether premiums would ultimately vanish was contingent on dividend interest rates remaining static. As a result, plaintiff knew or should have known it was harmed in 2006 and could not take advantage of the continuing violation rule to lengthen its time to sue.

Take-aways:

1/ Fraud claims are subject to a five-year (common law fraud) and three-year (consumer fraud) limitations period;

2/ The discovery rule can extend the time to sue but will not apply where a reasonable person is put on inquiry notice that he may have suffered an actionable wrong;

3/  “Continuing wrong” doctrine doesn’t govern where there is a single harmful event that has ongoing ramifications. The plaintiff’s time to sue will be measured from the date of the tortious occurrence and not from when damages happen to end.