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INDIANA FOLLOWS THE LIEN THEORY OF MORTGAGES

An interesting dispute in the United States Bankruptcy Court for the Northern District of Indiana resulted in a March 27, 2007 opinion by Judge Harry C. Dees, Jr. about a borrower’s attempt to transfer ordinance citations, fines and other property-related liabilities to a lender.  The issue was whether a mortgagor’s/borrower’s unilateral execution and recordation of a quit-claim deed effectively transferred the real estate to the mortgagee/lender.  Although the case involved residential property, the rules and holding are equally applicable to commercial real estate and business borrowers.  The lesson of Phillips v. City of South Bend, 2007 Bankr. LEXIS 1503 (N.D. Ind. 2007) is:  a borrower simply can’t unload its real estate-based problems onto a secured lender without some kind of agreement or consent.  (PhillipsOpinion.pdf).   

The facts.  The City of South Bend pursued a residential property owner for nuisance violations related to property, which was in disrepair and had documented unsanitary conditions in the yard.  Potential fines and penalties were around $5,000.  Citifinancial held a mortgage on the property.  The borrower/mortgagor, in an apparent effort to avoid municipal liability, executed and recorded a quit-claim deed purporting to abandon the property and transfer title to Citifinancial.  Citifinancial, however, never “acknowledged transfer of the property” or took “responsibility for maintaining the property.”  Id. at 3.  Citifinancial “did not accept the transfer” (although it is not entirely clear how Citifinancial manifested that non-acceptance).  The borrower did not enter into any kind of written agreement with Citifinancial, and Citifinancial “took no action at all” with regard to the property.  Id. at 14.  There was no written consent by Citifinancial or any activity demonstrating consent, such as the physical possession of the property.  Evidently, Citifinancial simply ignored the quit-claim deed.

Indiana mortgages, generally.  Indiana follows the “lien theory” of mortgages.  This means that a mortgage creates a lien on property but not title to it.  Mortgagees do not have an ownership interest in the real estate.  Id. at 15.  Title to property cannot be transferred to the mortgagee unless there is a foreclosure and sale (or a deed-in-lieu of foreclosure).  Indiana defines “foreclosure” as a legal proceeding that terminates a mortgagor’s interest in property.  Id.  “The right to possession, use and enjoyment of the mortgaged property, as well as title, remains in the mortgagor, unless otherwise specifically provided, and the mortgage is a mere security for the debt.  Id.  So, secured lenders holding Indiana mortgages merely have liens as security for their loans.

Transfer is a two-way street.  In Phillips, the borrower executed and recorded a quit-claim deed in order to surrender the property, but no foreclosure took place.  The Court held that the borrower could not compel the mortgage holder to accept the surrendered, quit-claimed property and that the borrower continued to be the owner of the property, with all the rights and obligations.  The City properly enforced its property maintenance codes against the borrower, not the lender, as owner of the property.  Id. at 15.  The unilateral execution of a quit-claim deed in an effort to surrender the property to mortgage holder, while clever, ultimately accomplished nothing from the standpoint of avoiding liability. 

Impact on commercial cases.  Phillips impacts the handling of commercial foreclosure cases as well.  A corporate borrower in possession of commercial real estate collateral could decide, in an effort to avoid certain liabilities related to the ownership of the land (such as public nuisance fines, utility charges or maybe even real estate taxes), to dump these problems back on a commercial lender simply by quit-claiming the property and surrendering possession.  A secured lender may, for a variety of reasons, not want the property, particularly by quit-claim deed, until the property is run through a foreclosure.  In that case, according to Phillips, the secured lender should take every possible action to show that it has not acknowledged or accepted transfer of the property or otherwise consented to ownership.  Don’t sign any paperwork indicating you are the owner.  Avoid physical presence on the premises.  Make sure there are no communications with the mortgagor/borrower other than with statements that unequivocally demonstrate you do not want title to the property at that time (unless through a deed-in-lieu of foreclosure with a supporting agreement).  That way, if and when you want to liquidate the collateral or become the owner of the property, you can do it on your own terms and avoid the potential liability found in Phillips.


IRISH V. WOODS: Which Surety Was Left Holding the $500,000 Bag?

A secured lender’s primary source of recovery when a project goes bad usually is the loan collateral.  Secondary sources could be the assets of a guarantor, a surety or an accommodation party, labels that often are used interchangeably to describe a person who signed a loan document but who did not directly benefit from the loan.  (See, March 23, 2007 post, Liability of Guarantors or Accommodation Parties when the Original Obligation Is Materially Altered).  The April 24, 2007 decision by the Indiana Court of Appeals in John T. Irish v. F. Lawrence Woods, 2007 Ind. App. LEXIS 786 (IrishOpinion.pdf) addresses some general rules applicable to these secondary sources and also provides a good suretyship vocabulary lesson. 

Backdrop.  Plaintiff Irish and defendant Woods formed LLC.  Lender Old National Bank loaned LLC about $500,000.  Both LLC and Irish were named borrowers on the note, but Irish did not directly benefit from the loan.  Only LLC did.  Woods guaranteed the note and, interestingly, also signed a separate guaranty of Irish’s debt under the note.  LLC defaulted but evidently was judgment proof.  Irish settled with Old National for the total amount due by purchasing the note.  Irish then sued Woods for the debt, claiming Woods was liable as the guarantor of the note.  Irish also asserted a contribution claim against Woods based on the guaranty of Irish’s obligation under the note. 

7 things to know about Indiana suretyship law. 

1. A borrower is a “principal obligor” – here, the LLC.  Id. at 6.

2. When a party places a signature on a note solely for the benefit of another party, and without receiving any direct benefit, he or she is an “accommodation party” – here, Irish.  Id

3. An accommodation party is considered a “surety.”  When the term surety refers to a person, it is a person who is liable for the payment of a debt, or performance of a duty, of another person.  Id.  (The words “guaranty” and “guarantor” are synonyms for “suretyship” and “surety.”  Id. at 7, n.4.)   

4. The liability of an accommodation party only is relevant in the event of a default by the accommodated party.  Ind. Code § 26-1-3.1-419(e).  In such event, the accommodation party’s suretyship status allows him to seek reimbursement from the accommodated party.  As a party with recourse against another party, the accommodation party’s suretyship status is equivalent to that of a “secondary obligor.”  Id.

5. A “cosuretyship” occurs when two secondary obligors agree that, as between themselves, each should perform part of its secondary obligation or bear part of the cost of performance.  The test of cosuretyship is a common liability for the same debt or burden.  Id. at 8-9.

6. A “subsuretyship” occurs if two secondary obligors agree that, as between themselves, one (the ‘principal surety’ – here, Irish) rather than the other (the ‘subsurety’ – here, Woods) should perform or bear the cost of performance.  Id. at 9.

7. Whether a particular party is a cosurety with, or a subsurety to, another party affects rights of contribution.  The right of contribution operates to make those who assume a common burden bear it in equal proportions.  In a cosuretyship, one cosurety is entitled to contribution from the other cosureties so that all cosureties bear the burden in equal, or otherwise agreed to, proportions.  With regard to subsuretyships, if the principal surety performs on the obligation, it is not entitled to contribution from a subsurety.  But, if the subsurety performs on the principal obligation, the subsurety is entitled to reimbursement from the principal surety.  Id.

The upshot.  The lender, Old National, was well-served by having Irish co-sign the note.  Even though the direct beneficiary of the loan (the LLC) defaulted, Old National evidently still recovered the debt from Irish, an accommodation party.  There was no need for Old National to pursue the guarantor, Woods.  Because Irish anted up, Woods got off scot-free.

Irish, as principal surety, “purchased” the note for the amount of his liability and then sought to enforce the guaranty of Woods, the subsurety.  But a principal surety cannot “purchase” his own debt and unilaterally create liability for a subsurety, who would not otherwise be liable.  Id. at 13.  The Court also determined that Woods, as guarantor of the note, only was secondarily liable.  Irish, as principal surety, was primarily liable for the cost of performance on the note.  In other words, in what may have been a close call for the Court, the judges ruled that the note’s co-signor (Irish) was on the hook but that the note’s guarantor (Woods) was not.


SLIGHTLY OFF TOPIC: Dispelling A Residential Foreclosure Myth

The Indianapolis Star published a letter to the editor yesterday with the headline:  "Lenders don't want you to lose your house."  Here's a link.  My partner Tom Dinwiddie co-wrote the letter on behalf of the Indiana Mortgage Bankers Association.  Some of the points he makes apply with equal vigor to commercial foreclosures, although as I understand it the pro-consumer legislation currently being considered in Indiana would not impact business borrowers. 


INDIANA’S UNIFORM FRAUDULENT TRANSFER ACT: 2 Recent Cases

If you’re a lender involved in commercial foreclosure actions, you should be at least minimally familiar with the elements of a fraudulent conveyance.  This is because a fraudulent conveyance claim may result in the collection of funds that your borrower once had but improperly transferred away.  I cannot tackle the entire body of law here.  But two recent decisions from the United States District Court for the Southern District of Indiana highlight a few principles applicable to this subject.  The cases are Symons International v. Continental Casualty Company, et al., 2007 U.S. Dist. LEXIS 27356 (S.D. Ind.), decided March 31, 2007 (SymonsOpinion.pdf), and Richter v. Corporate Finance Associates, 2007 U.S. Dist. LEXIS 29155 (S.D. Ind.), decided April 19, 2007 (RichterOpinion.pdf ).  Indiana’s Uniform Fraudulent Transfer Act (“IUFTA”) can be found at Ind. Code § 32-18-2, and a link to the Act is on the left side of my blog’s homepage. 

Richter/voiding a transfer. Richter reminds us of the very basic elements that must be alleged for a colorable claim to void a fraudulent conveyance.  The decision dealt with a  Trial Rule 12(B)(6) motion to dismiss for failure to state a claim, and the court outlined the fundamental elements of a fraudulent conveyance claim: 

1. An allegation of jurisdiction;
2. A statement of the date and the conditions under which the defendant executed a promissory note to the plaintiff;
3. A statement that the defendant owes the plaintiff the amount;
4. A description of the events surrounding the defendant’s conveyance of all of his property to the transfer recipient (a third party) for the purpose of defrauding and for delaying the collection of payment by the plaintiff; and
5. The plaintiff’s demand of the court.

Failure to allege any of these elements will result in the dismissal of the claim. 

Fraudulent transfer defined.  The IUFTA defines a fraudulent transfer in I.C. § 32-18-2-14 and 15.  Section 14 involves a situation where “the debtor made the transfer with actual intent to hinder, delay or defraud any creditor of the debtor or if the debtor did not receive reasonably equivalent value in exchange for the transfer.”  Symons at 47.  Importantly “lack of consideration, standing alone, is insufficient to support a charge of fraud – fraudulent intent must be proven as well.”  Id. at 48.  Section 15 deals with situations where “the debtor did not receive reasonably equivalent value in exchange for the transfer, and the debtor was insolvent at the time or became insolvent as a result of the transfer.”  Id. at 47. 

Symons/transferee liability.  This case, decided in the context of a Trial Rule 56 motion for summary judgment, involved multiple issues, many of which are irrelevant to secured lenders.  But one very relevant question in Symons had not been answered before by an Indiana court, namely whether an officer or director of a “first transferee” who was found to have personally participated in the fraud can be held personally liable under the IUFTA.  The defendants’ contention was that they did not qualify as “transferees” of the assets.  See, I.C. § 32-18-2-18(b).  Judge Young noted that the IUFTA does not define the term “transferee” but that it should generally be defined as one to whom a transfer of property is made.  Symons at 44.  Judge Young held that there were facts upon which a reasonable jury could conclude that the individuals in question personally participated in the fraudulent transaction and thus could be liable under the IUFTA.  Id. at 46.

Learn more.  For those who want to become more familiar with the IUFTA and the remedies afforded by it, the Richter and Symons opinions offer good illustrations of the law in action.  I encourage you to read the .pdf’s.  This limited post may help to familiarize you with the issue, but it’s impossible to cram everything into one article.  You can be sure that this subject will continue to be covered on my blog, however.


MORE FROM SYMONS: Piercing the Corporate Veil

The March 31, 2007 opinion in Symons International v. Continental Casualty Company, et al., 2007 U.S. Dist. LEXIS 27356 (S.D. Ind.) discusses Indiana’s common law theory of piercing the corporate veil.  (SymonsOpinion.pdf).  The legal principle, not unlike the principles in Indiana’s Uniform Fraudulent Transfer Act, which also is analyzed in the case, provides a method for collecting a debt from someone other than the actual, named borrower.  If applicable, the piercing doctrine provides a nice remedy for Indiana creditors victimized by shady debtors hiding behind the corporate shield.

Piercing the corporate veil.  It’s frustrating when a lender knows that there are assets to cover the debt but that the assets are protected from collection because they are in the hands of the individual owners of a corporate entity or by entities separate from the borrowing entity.  The theory of “piercing the corporate veil,” in rare circumstances, will permit lenders/creditors to chase the assets of the individuals or entities who actually have the money.   

Persons/Owners.  “Indiana courts are reluctant to disregard a corporate entity and extend the liabilities of one corporation and its affiliates, shareholders and/or officers; however, they may do so to prevent fraud or injustice to a third party.”  Symons at 56.  The issue is “highly fact sensitive.”  Id.  With regard to targeting individuals, here are eight factors Indiana courts look to, but the factors are not exhaustive or ranked:

1. Undercapitalization;
2. Absence of corporate records;
3. Fraudulent representation by a corporation’s shareholders or directors;
4. Use of the corporation to promote fraud, injustice or illegal activities;
5. Payment by the corporation of individual obligations;
6. Commingling of assets and affairs;
7. Failure to observe required corporate formalities; and
8. Other shareholder acts or conduct ignoring, controlling or manipulating the corporate forum.

Other entities.  In addition to these eight factors, Indiana courts look to at least four other factors when a plaintiff seeks to pierce the corporate veil in order to hold a corporation (or LLC, etc.) liable for another corporation’s debt:

1. Similar corporate names;
2. Common principal corporate officers, directors and employees;
3. Similar business purposes; and
4. The same offices, telephone number and business cards.

Id. at 57.  Again, this is not an exhaustive or ranked list.  On pages 57-62 of Judge Young’s opinion, he addresses many of the factors in detail and provides an excellent analysis of the remedy should you want a better understanding of what it takes to pierce the corporate veil.  He held there to be questions of fact and denied the defendants’ motion for summary judgment.  Symons is a favorable opinion for Indiana creditors.


IBJ: Experts Claiming That Banks Are Losing Patience With Marginal Borrowers

The Indianapolis Business Journal's on-line edition has an interesting article today asserting that a bank's tendency to negotiate traditional workouts is changing.  The piece quotes Indianapolis experts in the area, including Dave Hamernik, who I've seen speak and whose firm is located in my firm's office building.  A CPA and turnaround specialist, Mr. Hamernik knows his stuff.  (Click here for his firm's website.)  If what Mr. Hamernik and Mr. Beck say is true, this trend doesn't bode well for underperforming business borrowers. 


“NUCLEAR WEAPON OF THE LAW” UNAVAILABLE TO CREDITOR IN RECENT CASE

Getting a judgment is one thing; collecting it is another.  Creditors often are concerned about the ability to recover money from debtors that may have sufficient assets at the outset of a dispute but may squander those assets over the course of litigation.  As previously mentioned in this blog, there are a few remedies under Indiana law that address this very legitimate concern.  In a decision by Judge David F. Hamilton on March 20, 2007, another remedy, albeit one with virtually zero applicability to most commercial collection cases, is discussed - prejudgment injunctive relief.  The lesson J&J Wehner, Inc. v. H&L Plating & Grinding, Inc., 2007 U.S. Dist. LEXIS 24366 (S.D. Ind.) [WehnerOpinion.pdf] teaches us is that, unlike prejudgment attachment and garnishment, injunctive relief usually is not the answer.

Case background.  The dispute surrounded the sale of a chrome plating and grinding business.  As a part of the sale, the purchasers gave the sellers an installment promissory note in the sum of $866,000.  Not long after taking over the business, the purchasers learned that the site might have been contaminated with high levels of chromium and hexavalent chromium and that the sellers likely had actual knowledge of the contamination at the time of the sale.  Several employees told the purchasers that the sellers had disposed of chromium waste on the premises.  Remediation estimates were between $1.5 million and $2.25 million.  Due to the hefty environmental liability exposure, the purchasers stopped making payments on the note, which they claimed they were fraudulently induced to sign.  The note contained a warranty that the sellers were not in violation of any environmental laws affecting the properties or the business.  One issue in the case was whether the purchasers’ default could be excused due to the sellers’ fraud. 

Prejudgment relief requested.  Given the potential delays associated with litigating the claims, the sellers sought a preliminary injunction under Ind. Code § 34-26-1-5, ordering the purchasers, at the outset of the case, to pay all amounts due and owing under the note either directly to the sellers or into an escrow account with the court.  Wehner at 9.  The sellers’ objective was to secure satisfaction of the judgment they ultimately hoped to receive.  (Wishful thinking, perhaps, given the evidence of the environmental misconduct . . ..) 

Relief denied.  One of the elements to be established for preliminary injunctive relief is that the remedy at law must be inadequate - the injury cannot be rectified by the recovery of money.  As a general rule, a party that suffers “mere economic injury” is not entitled to injunctive relief because an award of damages is sufficient to make the party whole.  Id. at 10.  There are, however, “unusual” cases in which the collection of damages may be “impossible, uncertain or unusually difficult” so that a preliminary injunction should be available.  Id.  In this particular case, at issue was the demand for a pre-trial payment to a creditor on a disputed debt or, in the alternative, an impoundment of money to the court.  Such extraordinary relief can arise out of a procedural tool that the United States Supreme Court in Grupo Mexicano de Desarrollo, S.A. v. Alliance Bond Fund, Inc., 527 U.S. 308, 329 (1999) described as “the nuclear weapon of the law.”  Id. at 11.  The problem in Wehner was that, if the sellers prevailed on their underlying claim, the damages from the purchasers’ default would be entirely monetary and easy to quantify.  Although there was a legitimate concern that the purchasers might not be ready to pay the full damages when due, “that is often the case in civil litigation.”  Id. at 12.  Judge Hamilton held that the sellers “have not shown that their case is so compelling as to justify use of ‘the nuclear weapon of the law,’ a pre-judgment injunction ordering payment of a general creditor or freezing assets to protect a general creditor.”  Id

Fraudulent inducement.  Judge Hamilton also addressed, in part, whether the alleged fraud by the sellers could excuse nonperformance under the note.  The note was, in fact, an unconditional promise to pay according to its terms.  I.C. § 26-1-3.1-106(a).  But, in this case, the note was not in the hands of a holder in due course.  If it were, the purchasers’ fraudulent inducement defense would have no merit.  I.C. § 26-1-3.1-305(a)(1)(C) .  Because the purchasers were not holders in due course (defined in Indiana’s UCC at 26-1-3.1-302), common law defenses such as fraud in the inducement were available to them.  I.C. § 26-1-3.1-306.  Judge Hamilton denied the sellers’ motion for summary judgment on the defense and concluded that the fraudulent inducement issue must be tried.

In sum.  For commercial lending institutions concerned about the dissipation of the assets of their borrowers during a foreclosure proceeding, remedies such as pre-judgment attachment and/or garnishment may be viable.  Barring highly unique circumstances, however, an injunction is not.  A motion for a prejudgment order to pay money almost always will fail.  Lenders will be better served by prosecuting the underlying action as quickly as possible.  Once a judgment is obtained, courts are much more accommodating in terms of collection efforts.