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)
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.