Plaintiff Shows Actual and Constructive Fraud in Fraudulent Transfer Suit – IL Court

The plaintiff mortgage lender in Summitbridge Credit Investments II, LLC v. Ahn, 2017 IL App (1st) 162480-U sued the husband and wife borrower defendants for breach of a mortgage loan on two commercial properties in Chicago

Two days after the plaintiff obtained a $360K-plus default judgment, the defendants deeded a third commercial property they owned to their adult children.

The plaintiff caught wind of the post-judgment transfer during citation proceedings and in 2015 filed a fraudulent transfer suit to undo the property transfer.  The trial court granted summary judgment for the lender and voided the defendants’ transfer of property. The defendants appealed.

Affirming, the First District recited and applied the governing standards for actual fraud (“fraud in fact”) and constructive fraud (“fraud in law”) under Illinois’s fraudulent transfer act, 740 ILCS 160/1 et seq. (the “Act”)

The Act allows claims for two species of fraud under the Act – actual fraud and constructive fraud, premised on Act Sections 5(a)(1) and 5(a)(2) and 6(a), respectively.  (Also, see http://paulporvaznik.com/uniform-fraudulent-transfer-act-actual-fraud-constructive-fraud-transfers-insufficient-value-il-law-basics/5646)

Actual Fraud and ‘Badges’ of Fraud

Actual fraud that impels a court to unwind a transfer of property requires clear and convincing evidence that a debtor made a transfer with actual intent to hinder, delay or defraud creditors.

Eleven badges or indicators of fraud are set forth in Section 5(b) of the Act.  The factor the Summitbridge Court particularly homed in on was whether there was an exchange of reasonably equivalent value.  That is, whether the defendants’ children gave anything in exchange for the transferred commercial property.

In analyzing this factor, courts consider four sub-factors including (1) whether the value of what was transferred is equal to the value of what was received, (2) the fair market value of what was transferred and what was received, (3) whether it was an arm’s length transaction, and (4) good faith of the transferee/recipient.  Reasonably equivalent value is measured at the time of transfer.

In opposing the plaintiff’s summary judgment motion, the defendants made only conclusory assertions they lacked fraudulent intent.  Moreover, they failed to come forward with any evidence showing they received consideration for the transfer.

In summary, because there were so many badges of actual fraud present, and the debtors offered no proof of consideration flowing to them in exchange for quitclaiming the property, the appeals court affirmed the trial court’s actual fraud finding.

Constructive Fraud

Unlike actual fraud, constructive fraud (i.e., fraud in law) does not require proof of an intent to defraud.  A transfer made for less than reasonably equivalent value of the thing transferred that leaves a debtor unable to meet its obligations are presumed fraudulent.  A fraudulent transfer plaintiff alleging constructive fraud must prove it by a preponderance of evidence – a lesser burden that the clear and convincing one governing an actual fraud or fraud in fact claim.

Constructive fraud under Act Section 5(a)(2) is shown where a debtor did not receive a reasonably equivalent value for the transfer and the debtor (a) was engaged or was about to engage in a business or transactions for which the debtor’s remaining assets were unreasonably small in relation to the business or transaction, or (b) intended to incur, or believed or reasonably should have believed he would incur, debts beyond his ability to pay as they came due.

Section 6(a) constructive fraud applies specifically to claims arising before a transfer where a debtor doesn’t receive reasonably equivalent value and was insolvent at the time of or resulting from a transfer.

The First District agreed with the lower court that the plaintiff sufficiently proved defendants’ constructive fraud.  It noted that the plaintiff’s money judgment pre-dated the transfer of the property to defendant’s children and there was no record evidence of the debtors receiving anything in exchange for the transfer.

Take-aways:

Summitbridge provides a useful summary of fraud in fact and fraud in law fraudulent transfer factors in the context of a dispositive motion.

Once again, summary judgment is the ultimate put-up-or-shut-up litigation moment: a party opposing summary judgment must do more than make conclusory assertions in an affidavit.  Instead, he/she must produce specific evidence that reveals a genuine factual dispute.

The defendants’ affidavit testimony that they lacked fraudulent intent and transferred property to their family members for value rang hollow in the face of a lack of tangible evidence in the record to support those statements.

 

 

 

Fraudulent Transfer Action Can Be Brought In Post-Judgment Proceedings – No Separate Lawsuit Required – IL Court

Despite its vintage (over two decades), Kennedy v. Four Boys Labor Service, 664 N.E.2d 1088 (2nd Dist.  1996), is still relevant and instructional for its detailed discussion of Illinois’ fraudulent transfer statute and what post-judgment claims do and don’t fall within a supplementary proceeding to collect a judgment in Illinois.

The plaintiff won a $70K breach of contract judgment against his former employer and issued citations to discover assets to collect the judgment.

While plaintiff’s lawsuit was pending, the employer transferred its assets to another entity that had some of the same shareholders as the employer.  The “new” entity did business under the same name (Four Boys Labor Service) as the predecessor.

Plaintiff obtained an $82K judgment against the corporate officer who engineered the employer’s asset sale and the officer appealed.

Held: Judgment for plaintiff affirmed

Rules/reasons:

The Court applied several principles in rejecting the corporate officer’s main argument that a fraudulent transfer suit had to be filed in a separate action and couldn’t be brought within the context of the post-judgment proceeding.  Chief among them:

– Supplementary proceedings can only be initiated after a judgment has entered;

– The purpose of supplementary proceedings is to assist a creditor in discovering assets of the judgment debtor to apply to the judgment;

– Once a creditor discovers assets belonging to a judgment debtor in the hands of a third party, the court can order that third party to deliver up those assets to    satisfy the judgment;

– A court can authorize a creditor to maintain an action against any person or corporation that owes money to the judgment debtor, for recovery of the debt (See 735 ILCS 5/2-1402(c)(6);

– A corporate director who dissolves a company without providing proper notice to known creditors can be held personally liable for corporate debts (805 ILCS 5/8.65, 12.75);

– An action to impose personal liability on a corporate director who fails to give notice of dissolution must be filed as a separate lawsuit and cannot be brought in a post-judgment/supplementary proceeding;

– Where a third party transfers assets of a corporate debtor for consideration and with full knowledge of a creditor’s claim, the creditor may treat the proceeds from the sale of the assets as debtor’s property and recover them under Code Section 2-1402;

– A transfer of assets from one entity to another generally does not make the transferee liable for the transferor’s debts;

– But where the transferee company is a “mere continuation” of the selling entity, the transferee can be held responsible for the seller’s debt.  The key inquiry in determining successor liability under the mere continuation framework is whether there is continuity of shareholder or directors from the first entity to the second one;

– An action brought under the Uniform Fraudulent Transfer Act (FTA), 740 ILCS 160/1, is considered one that directly concerns the assets of the judgment debtor and imposes liability on the recipient/transferee based on the value of the transferred assets;

– A transfer is not voidable against one who takes in good faith and provides reasonably equivalent value.  740 ILCS 160/9;

– A court has discretion to sanction a party that disobeys a court order including by entering a money judgment against the offending party;

(664 N.E.2d at 1091-1093)

Applying these rules, the Court found that plaintiff could properly pursue its FTA claim within the supplementary proceeding and didn’t have to file a separate lawsuit.  This is because an FTA claim does not affix personal liability for a corporate debt (like in a corporate veil piercing or alter ego setting) but instead tries to avoid or undo a transfer and claw back the assets actually transferred.

FTA Section 160/5 sets forth eleven (11) factors that can point to a debtor’s actual intent to hinder, delay or defraud a creditor.   Some of the factors or “badges” of fraud that applied here included the transfer was made to corporate insiders, the failure to inform the plaintiff creditor of the transfer of the defendant’s assets, the transfer occurred after plaintiff filed suit, the transfer rendered defendant insolvent, and all of the defendant’s assets were transferred.  Taken together, this was enough evidence to support the trial court’s summary judgment for the plaintiff on his FTA count.

Take-away: Kennedy’s value lies in its stark lesson that commercial litigators should leave no financial stones unturned when trying to collect judgments.  Kennedy also clarifies that fraudulent transfer actions – where the creditor is trying to undo a transfer to a third party and not hold an individual liable for a corporate debt can be brought within the confines of a supplementary proceeding.

 

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.