Judgment Creditor and Debtor’s Lawyers Duke It Out Over Equity in Home – ND IL

A law firm’s failure to look closer at its client’s suspiciously timed transfer of residential property to a land trust recently backfired in a pitched priority battle between competing creditors.
Earlier this month (June 2018), the Northern District of Illinois reversed an earlier priority ruling for the law firm (see Radiance v. Accurate Steel, 2018 WL 1394036) for not exhausting its inquiry notice obligations. (The Court’s order is found at ECF No. 82; Case No. 13 C 7481.)

The case centers around a dispute over real estate between the plaintiff – a judgment creditor of the debtor (who defaulted on some promissory notes) – and the aforementioned law firm, who defended the debtor in post-judgment enforcement proceedings.

The Relevant Chronology

August 2013 – Defendant debtor transferred the Property to an irrevocable trust;

March 2014 – Plaintiff’s predecessor recorded its money judgment against defendant;

June 2014 – The law firm agrees to represent defendant if she mortgaged her residence property (the Property) as an advanced payment retainer (retainer funds that immediately become property of the attorney)(see https://www.iardc.org/DowlingFAQs.html).

June 2015 – The law firm records a mortgage against the Property;

March 2018 – The court voids the 2013 transfer of the Property into a land trust as a fraudulent transfer.

The effect of this last order was the Property reverted back to the debtor and was no longer protected by the trust from the debtor’s creditors. The Court later ruled that the law firm lacked actual or constructive notice that the creditor’s prior judgment lien could wipe out the later mortgage. As a result, the Court found the law firm met the criteria for a bona fide purchaser – someone who gives value for something without notice of a competing claimant’s right to the same property.

Reversing itself on plaintiff’s motion to reconsider, the Court first noted that recording a judgment gives the creditor a lien on all real estate owned in a given county by a debtor. 735 ILCS 5/12-101. Illinois follows the venerable “first-in-time, first-in-right” rule which confers priority status on the party who first records its lien.  An exception to the first-in-time priority rule is where a competing claimant is a bona fide purchaser (BFP). A BFP is someone who provides value for something without notice of a prior lien on it.

Here, the law firm unquestionably provided value – legal services – and lacked notice of the bank’s judgment lien since at the time the firm recorded its mortgage, the title to the real estate was held in trust. Where a creditor records a judgment against property held in a land trust, the judgment is not a lien on the real estate. Instead, it only liens the debtor’s beneficial interest in the trust. (See here  and here.) These factors led the Court originally to find that the Firm met the BFP test under the law.

Granting the creditor plaintiff’s motion to reconsider, the Court found the law firm was apprised of enough facts to put it on inquiry notice that the mortgage was vulnerable to being trumped by the plaintiff’s judgment lien. A species of constructive notice, a party is on inquiry notice “when facts or circumstances are present that create doubt, raise suspicions, or engender uncertainty about the true state of title to real estate, the transferee can’t turn a blind eye….but is required to investigate further.” In re Thorpe, 546 B.R. 172, 185 (Bankr. C.D. Ill. 2016)(citing Illinois state court case authorities). A property mortgagee has a responsibility not only to check for prior liens and encumbrances in the chain-of-title, but also to consider “circumstances reasonably engendering suspicions as to title.” Id.

In its reconsideration order, the Court cited the Creditor recording its judgment lien 15 months before the law firm recorded its mortgage, the copious evidence of the debtor’s financial problems and transfer of the Property just as debtor’s creditors were closing in as likely badges of a fraud. The Court found the debtor’s Property transfer after she defaulted on numerous business loans she guaranteed should have put the law firm on notice that the Property was fair game for creditors like plaintiff. In short, the Court found that the law firm was apprised of facts – namely, debtor’s financial problems, aggressive creditors, and valueless transfer of the Property into a land trust – that obligated the law firm to dig deeper into the circumstances surrounding the transfer.

Afterwords:

Radiance and the various briefing that culminated in the Court’s reconsideration order provide an interesting discussion of creditor priority rules, law firm retainer agreements, trust law fundamentals and fraudulent transfer basics, all in a complex fact pattern.

The case reaffirms the proposition that where property is held in trust, a prior judgment lien against a beneficiary will not trump the later recorded judgment against the trust property.

However, where real estate is arguably fraudulently transferred – either intentionally or constructively (no value is received, transferor incurs debts beyond her ability to pay, e.g.) – a creditor of that transferee, like the Law Firm here, should at least think twice before transacting business with a debtor and  further into whether a given property transfer is legitimate.

 

 

Mechanics Lien Trumps Prior Mortgage in ‘Lien Strip’ Bankruptcy Dispute Involving Residential Property

Priority disputes happen a lot in mechanics’ lien litigation.  Typically, a mortgage lender claims that its first-filed mortgage trumps a later-filed mechanics lien.  The “trumps” part is activated if and when the property is sold and there aren’t enough proceeds to pay both the lender and contractor.  If the lender’s mortgage has priority, it gets first dibs on the sale proceeds, leaving the contractor with little or nothing.

Section 16 of the Mechanics’ Lien Act (770 ILCS 60/16) governs the lien priority issue.  This section provides that (i) prior lien claimants have lien priority up to the value of the land at the time of making of the construction contract; and (ii) mechanics’ lien claimants have a paramount lien to the value of all improvements made to the property after the construction contract is signed.

In re Thigpen, 2014 WL 1246116 examines the mortgage lender-versus-contractor priority question through the lens of a bankruptcy adversary case where the debtors attempt to strip away a mechanics’ lien recorded against their homeresidence.

The debtors filed for Chapter 13 bankruptcy protection and later filed an adversary proceeding to extinguish the lien a contractor recorded against the home. 

The debtors claimed that since there was a prior mortgage on the home and the home’s value had dropped to a sum less than the lien amount, the lien should be removed.

In bankruptcy parlance, this is called “lien stripping” and applies where a mechanics lien lacks collateral; usually because of plummeting property values. 

The contractor argued that its lien took priority to the value of the improvements/enhancements and moved for summary judgment.

Held: Contractor’s summary judgment motion granted.

Q: Why?

A: Applying Section 16 of the Act, the Court held that where proceeds of a property sale are insufficient to pay competing lienholders, a mechanics’ lien claimant takes priority over a lender up to the value the contractor added to the property.

The Court wrote: “the Illinois Supreme Court has expressly recognized that Section 16 of the Act confers first priority, not something less, on mechanic’s lien holders, and that they trump pre-existing mortgages to the extent of the value of the improvements.”  (*2).

While the court found that the contractor’s lien trumped the prior mortgage, the Court did not decide the specific monetary amount of the improvements relative to the home’s value. 

The holding is still significant because now the contractor has a secured claim (as opposed to an unsecured one) against the debtors’ estate which must be paid over the life of the Chapter 13 plan. 

If the debtors default, the contractor can liquidate the collateral –  by forcing a sale of the home – and get paid via the proceeds.  An unsecured creditor, by contrast, has no assets securing its claim.  It must hope that the debtors have unattached assets (e.g. paycheck, bank accounts, accounts receivable) with which to pay the debt.  (Good luck with that!)

Take-away: A big win for the contractor.  Instead of having an unsecured claim (with no collateral tied to the claim), its mechanics’ lien claim is secured.  This means the contractor’s lien attaches to the debtors’ house. 

If the debtor defaults under the plan, the contractor can foreclose its lien and force a sale of the home and take priority to the sale proceeds up to the amount of the improvements (here, about $200,000).  

The case’s unanswered question is how does the contractor prove the dollar amount of his improvements?  The contractor will likely have to produce expert witness testimony or documents to establish the dollar value of the contractor’s time, labor and materials  furnished to the debtors’ home.