third-party – Paul Porvaznik – Business Litigator

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 (1^st) 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 (7^th 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.

Joint Owner of Checking Account Must Prove Exclusive Right to Funds by Elevated Burden of Proof – IL Appeals Court

Gataric v. Colak, 2016 IL App (1st) 151281 presents a collection tug of war between a judgment creditor and a third party concerning funds in a joint bank account. The salient issue is what level of proof the third party must meet in order to rebut the presumption that the bank account funds belong not to the third party, but to the judgment debtor.

The plaintiff judgment creditor served a third-party citation on the judgment debtor’s bank who then froze the account. The respondent, a joint account holder, intervened and asserted she was the account’s sole owner and the debtor was only added for “convenience” purposes.

The trial court sided with the plaintiff, and found the respondent failed to prove by clear and convincing evidence that she was entitled to all funds in the account and did not intend to gift the joint account funds to the debtor at the time the account was opened. The court granted the creditor’s turnover motion and defendant appealed.

Held: Affirmed.

Reasons:

The defendant argued that she was only required to prove her rights to the joint account by a preponderance of evidence – a less exacting burden than the clear and convincing evidence standard applied by the trial court. To meet the preponderance standard, the claimant must prove that her allegations “more likely than not” occurred. The common mathematical description of the preponderance standard is that there is a 51% chance that plaintiff’s version of events happened as opposed to defendant’s.

The third party in Gatarik argued that she alone set up the joint account as a convenience account. She claimed to add the judgment debtor as a joint account holder simply to facilitate the repayment of a short-term loan.

Under Illinois law, joint bank account holders are presumed to have equal access to account funds and a creditor of only one holder can attach the account. The burden shifts to the non-debtor account owner to establish what part of the account belongs to him/her.

When a garnishee (i.e. a bank or bank account holder) answers that a judgment debtor holds money in a joint bank account, this establishes a prima facie case that the money in the account belongs to the judgment debtor. The burden then shifts to the garnishee to prove what part of the funds belong exclusively to him/her.

When deciding who owns joint bank account funds, the court examines: (1) who exercised control of the funds, (2) who made contributions to the account and from what source and in what amount, (3) who paid taxes on the account’s earnings, and (4) the purpose for which the account was established. (¶¶ 19-20)

Here, the trial court found, after hearing live testimony, that the citation respondent didn’t establish by clear and convincing evidence that she was the sole owner of the account funds and that the account was a mere convenience account.

Since the respondent couldn’t show that the trial court misapplied the law or the facts, her appeal failed. As a result, the trial court’s turnover order related to the account funds was upheld.

Afterwords:

In situations where two or more people are claiming rights in frozen bank account funds, it is incumbent on the non-debtor to establish by clear and convincing evidence his/her dominant right to the funds.

The clear and convincing evidentiary burden falls midway between preponderance of evidence (the most relaxed burden) and beyond a reasonable doubt (the most severe) on the proof spectrum.

Third Party Enforcement of A Non-Compete and Trade Secret Pre-emption – IL Law

(photo credit: www.glogster.com)

In Cronimet Holdings v. Keywell Metals, LLC, 2014 WL 580414 (N.D.Ill. 2014), the Northern District of Illinois considers whether a non-compete contract is enforceable by a stranger to that contract as well as trade secret pre-emption of other claims.

Facts and Procedural History

Plaintiff, who previously signed a non-disclosure agreement with a defunct metal company (the “Target Company”) it was considering buying, filed a declaratory action against a competitor (“Competitor”) requesting a ruling that the non-disclosure agreement and separate non-competes signed by the Target Company’s employees were not enforceable by the competitor who bought the Target Company’s assets. The NDA and non-competes spanned 24 months.

The plaintiff moved to dismiss eight of the ten counterclaims filed by the Competitor. It argued the Competitor lacked standing to enforce the non-competes and that its trade secrets counterclaim (based on the Illinois Trade Secrets Act, 765 ILCS 1065/1 (“ITSA”)) pre-empted several of the tort counterclaims.

In gutting most (8 out of 10) of the counterclaims, the court applied the operative rules governing when non-competes can be enforced by third parties:

– Illinois would likely permit the assignment of a non-compete to a third party;

– Enforcing a non-compete presupposes a legitimate business interest to be protected;

– A legitimate business interest is a fact-based inquiry that focuses on whether there is (i) a “near-permanence” in a customer relationship, (ii) the company’s interest in a stable work force , (iii) whether a former employee acquired confidential information and (iv) whether a given non-compete has valid time and space restrictions;

– A successor corporation can enforce confidentiality agreements signed by a predecessor (acquired) corporation where the acquired corporation merges into the acquiring one;

– A successor in interest is one who follows an original owner in control of property and who retains the same rights as the original owner;

– The ITSA pre-empts (displaces) conflicting or redundant tort claims that are based on a defendant’s misappropriation of trade secrets;

– Claims for unjust enrichment, quasi-contract relief or unfair competition are displaced by the ITSA where the claims essentially allege a trade secrets violation;

– The ITSA supplants claims that involve information that doesn’t rise to the level of a trade secret (e.g. not known to others and kept under ‘lock-and-key’);

(**4-5).

The court found that since a bankruptcy court (in the Target Company’s bankruptcy) previously ruled that the Competitor didn’t purchase the non-competes, and wasn’t the Target Company’s successor, the Competitor lacked standing to enforce the non-competes.

The Court also held that once the Target Company stopped doing business, its non-competes automatically lapsed since it no longer had any secret data or customers to protect.

The Court also agreed that the Company’s ITSA claim pre-empted its claims that asserted plaintiff was wrongfully using the Target Company’s secret data. The court even applied ITSA pre-emption to non-trade secret information. It held that so long as the information sought to be protected in a claim was allegedly secret, any non-ITSA claims based on that information were pre-empted.

Afterwords:

(1) A non-compete can likely be assigned to a third party;

(2) Where the party assigning a non-compete goes out of business, the assignor no longer has a legitimate business interest to protect; making it hard for the assignee to enforce the non-compete;

(3) ITSA, the Illinois trade secrets statute, will displace (pre-empt) causes of action or equitable remedies (unjust enrichment, unfair competition, etc.) that are based on a defendant’s improper use of confidential information – even where that information doesn’t rise to the level of a trade secret.

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