More On Piercing The Corporate Veil In Indiana, And The UFTA

This follows-up my May 15, 2007 posts (one and two) about Indiana law applicable to creditors that want to pierce the corporate veil and that wish to recover under Indiana’s Uniform Fraudulent Transfer Act.  On July 20, 2007, the Indiana Court of Appeals issued an opinion upholding the trial court’s piercing of the corporate veil, normally a difficult thing to do, as well as affirming liability based on the UFTA.  See, Four Seasons Manufacturing, Inc. v. 1001 Coliseum, LLC, 2007 Ind. App. LEXIS 1589 (Ind. Ct. App. 2007) (FourSeasonsOpinion.pdf ).

Indiana’s general principles on “piercing”.  Four Seasons, on page 12, sets out these guidelines:

1.  Indiana courts are reluctant to disregard the corporate identity and do so only to protect third parties from fraud or injustice when transacting business with a corporate entity.
2.  The process of piercing a corporate veil is equitable in nature, and courts necessarily engage in “a highly fact-sensitive inquiry.”
3.  Parties seeking to pierce the corporate veil bear the burden of establishing that the corporation was so ignored, controlled or manipulated that it was merely the instrumentality of another and that the misuse of the corporate form would constitute a fraud or promote injustice.

Factors to be considered.  To get to individual owners, the following evidence may be considered (see, pp. 12 and 13):

1.  Undercapitalization;
2.  Absence of corporate records;
3.  Fraudulent representation by corporation 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; or
8.  Other shareholder acts or conduct ignoring, controlling or manipulating the corporate forum.

To get to other entities, in addition to the eight factors above, Indiana courts consider these:

1.  Similar corporate names were used;
2.  The corporations shared common principal corporate officers, directors, and employees;
3.  The business purposes of the corporations were similar; and
4.  The corporations were located in the same offices and used the same telephone numbers and business cards.

Importantly, each of the above factors does not need to be proven in order to pierce a corporate veil.  The list is non-exhaustive.  There does not necessarily need to be evidence of every  factor.  Id. at 16.  In Four Seasons, the Court of Appeals held that the plaintiff commercial lessor (creditor) presented adequate evidence that the defendant entity basically orchestrated a fraudulent purchase agreement between two related entities (both of which were owned by the defendant) in order to shield those entities from liability associated with a lease default.   

Uniform Fraudulent Transfer Act.  Actions pursuant to the UFTA and proceedings to pierce the corporate veil sometimes go hand in hand.  Four Seasons is one of those cases.  Indeed the plaintiff was able to recover its damages from the corporate owner of the defaulting entity/lessee under the piercing theory and, alternatively, the fraudulent transfer theory.  One specific question in Four Seasons was whether the defendant was a “debtor” under the UFTA, Ind. Code § 32-18-2.  A “debtor” is “a person who is liable on a claim.”  I.C. § 32-18-2-6.  The Court of Appeals held that the defendant entity was a debtor because it coordinated the fraudulent transfer at issue.  Also important was the fact that the defendant was the 100% owner of both the defaulting lessee and the entity that “purchased” the lessee at the time of the default. 

The remedies provision of the UFTA, I.C. § 32-18-2-7, focuses on the amount of the fraudulent transfer – no more, no less.  In Four Seasons, the UFTA damages consisted of the value of assets the defendant entity fraudulently transferred between one entity to the other entity in order to avoid a judgment based on the lease breach.  Id. at 22-24.  That amount consisted of the value of the assets that the breaching entity (the corporate lessee) possessed upon default – the same amount of money fraudulently transferred out of that entity to the second, related entity. 

The Four Seasons case offers secured lenders guidance when faced with decisions concerning whether to pursue the assets of individuals or entities other than those of the actual borrower’s.  Piercing the corporate veil and UFTA actions can be expensive and time-consuming cases, not to mention difficult ones to win.  This and other recent Indiana cases demonstrate, however, that it can be done under certain circumstances. 

Frozen Pay Drives Out Bankruptcy Judges

An article from BusinessWeek.com dated July 20 may be of some interest to secured lenders that periodically find themselves in bankruptcy court protecting their interests in collateral or advocating for other loan rights.  Click here for the story.

COULD INDIANA'S PROPERTY TAX CRISIS LEAD TO COMMERCIAL FORECLOSURES?

If you don't live in Indiana, you may not be aware of the major, continuously-developing story about the recent changes to Indiana's property tax scheme, which changes have resulted in substantial increases for some residential real estate owners.  For background, click on the The Indianapolis Star, which has covered the issue for a couple weeks.  Today, in an effort to provide some relief, Indiana's governor Mitch Daniels ordered a new assessment in Marion County (Indianapolis), in part to deal with commercial properties that were ignored in the recent reassessment.  Here's that story.

So far, residential property owners have been hit the hardest, but significant tax increases for Indiana commercial property owners appear to be on the horizon, barring a fundamental change in the system.  This begs the question of whether we may see an upsurge in under-performing or non-performing commercial mortgage loans.  An article from the Indianapolis Business Journal suggests this possibility.  In a piece about multifamily properties - Apartment Owners Hammered by Tax Hikes - a local apartment broker thinks that, in some cases, complex owners "will default on their mortgage," in addition to deferring maintenance or improvements.  It stands to reason, for instance, that a 70 percent increase in real estate taxes could trigger some businesses to default on their mortgages.  I will continue to keep an eye on this issue and how commercial lenders may or may not be impacted.  I suspect that, ultimately, we'll see a political solution to the dramatic tax increases before we'll see a significant rise in commercial foreclosures, however.      

LIEN PRIORITY FOLLOW-UP: The Operative Statutes

Following-up my July 3 post concerning a potential priority dispute between a construction lender and a contractor, I thought it might be beneficial to set out the key statutes in full.  Here are the provisions, both of which are in Indiana's mechanic's lien statute.   

IC 32-28-3-2
"Extent of lien; leased or mortgaged land"
    Sec 2. (a) The entire land upon which the building, erection, or other improvement is situated, including the part of the land not occupied by the building, erection, or improvement, is subject to a lien to the extent of the right, title, and interest of the owner for whose immediate use of benefit the labor was done or material furnished.
    (b) If:
        (1) the owner has only a leasehold interest; or
        (2) the land is encumbered by mortgage;
the lien, so far as concerns the buildings erected by the lienholder, is not impaired by forfeiture of the lease for rent or foreclosure of mortgage. The buildings may be sold to satisfy the lien and may be removed not later than ninety (90) days after the sale by the purchaser.

IC 32-28-3-5
"Recording notice; priority of lien"
    Sec. 5. (a) As used in this section, "lender" refers to:
        (1) an individual;
        (2) a supervised financial organization (as defined in IC 24-4.5-1-301);
        (3) an insurance company or a pension fund; or
        (4) any other entity that has the authority to make loans.
    (b) The recorder shall record the statement and notice of intention to hold a lien when presented under section 3 of this chapter in the miscellaneous record book. The recorder shall charge a fee for recording the statement and notice in accordance with IC 36-2-7-10. When the statement and notice of intention to hold a lien is recorded, the lien is created. The recorded lien relates back to the date the mechanic or other person began to perform the labor or furnish the materials or machinery. Except as provided in subsections (c) and (d), a lien created under this chapter has priority over a lien created after it.
    (c) The lien of a mechanic or materialman does not have priority over the lien of another mechanic or materialman.
    (d) The mortgage of a lender has priority over all liens created under this chapter that are recorded after the date the mortgage was recorded, to the extent of the funds actually owed to the lender for the specific project to which the lien rights relate. This subsection does not apply to a lien that relates to a construction contract for the development, construction, alteration, or repair of the following:
        (1) A Class 2 structure (as defined in IC 22-12-1-5).
        (2) An improvement on the same real estate auxiliary to a Class 2 structure (as defined in IC 22-12-1-5).
        (3) Property that is:
            (A) owned, operated, managed, or controlled by:
                (i) a public utility (as defined in IC 8-1-2-1);
                (ii) a municipally owned utility (as defined in IC 8-1-2-1);
                (iii) a joint agency (as defined in IC 8-1-2.2-2);
                (iv) a rural electric membership corporation formed under IC 8-1-13-4;
                (v) a rural telephone cooperative corporation formed under IC 8-1-17; or
                (vi) a not-for-profit utility (as defined in IC 8-1-2-125);
            regulated under IC 8; and
            (B) intended to be used and useful for the production, transmission, delivery, or furnishing of heat, light, water, telecommunications services, or power to the public.

(Remember that, as to mortgages, Indiana is a "first to file" state.  I.C. 32-21-4-1(b) provides that a "mortgage ... takes priority according to the time of its filing" in the recorder's office.)

My partner Tom Hanahan, who often represents lenders on the front end of construction deals, informs me that title companies in Indiana usually will not insure absolute priority over mechanic's liens, where construction has commenced before recording of the mortgage, without securing indemnity from the principals of the borrower.  In speaking with Tom, I gather that the title lawyers have noted the potentially-inconsistent language in Ind. Code 32-28-3-5 and 32-28-3-2, about which I discussed in my prior post.  I highlighted the areas of potential conflict.  Judge for yourself. 

CONSTRUCTION MORTGAGE VS. MECHANIC’S LIEN: Win, Lose or Draw?

Recently, I met with a commercial lender who mentioned a problem with one of his projects.  Construction had started, but the developer hadn’t closed the construction loan.  Thus the lender’s mortgage hadn’t been recorded, but likely would be soon.  He wondered how the delay might affect the priority of his bank’s mortgage lien.  Secured lenders involved in real estate development in Indiana probably should be aware of some of the rules governing these situations.      

1910: A Draw.  The Indiana Supreme Court’s 1910 decision in Ward v. Yarnelle, 91 N.E.7 (Ind. 1910) is the landmark opinion on this subject.  At the time, Indiana’s mechanic’s lien statute “failed to address the lien priority between a [construction mortgage] and the mechanic’s liens of those who [completed] the construction.”  In Re Venture, 139 B.R. 890, 895 (N.D. Ind. 1990).  The Court therefore announced the equitable “doctrine of parity” in which a “real estate mortgage executed while a building was in the process of construction was entitled to equal priority with the claims of [contractors that] worked after [recordation] of the mortgage and with full knowledge of its purpose and effect.”  Beneficial Finance v. Wegmiller Bender, 402 N.E.2d 41, 47 (Ind. Ct. App. 1980) (no parity because contractor completed its work before lender recorded its mortgage); Brenneman Mechanical v. First Nat. Bank, 495 N.E.2d 233, 242 (Ind. Ct. App. 1986) (parity because contractors had knowledge of loan, which helped pay them). 

Whether the contractor had knowledge of the construction mortgage was critical to the Ward analysis.  In such instances, the Court felt that lenders and contractors were in a kind of “common enterprise.”  Ward, 91 N.E. at 15.  Under Ward, if funds derived from the mortgage were used in the construction project and if the contractors had knowledge of the loan when they performed their work, then the mortgage and the mechanic’s lien had equal priority.  Conversely, if the loan was not for purposes of construction or if the contractors worked without knowledge of the purpose of the loan, then the mortgage had priority over mechanic’s liens for work performed after recordation of the mortgage.  Venture, 139 B.R. at 896

1999: Statutory Amendments.  Ind Code §32-28-3-5 is the pivotal statute.  Subsection (b) provides that a mechanic’s lien is “created” when the lien notice is recorded.  But the recorded lien relates back to the date the work began, which could pre-date a mortgage.  In 1999, Indiana’s legislature added the language now in subsection (d) that says construction mortgages have priority over mechanic’s liens if the mortgage is recorded before the notice of mechanic’s lien is recorded (not created).  My reading is that subsection (d) disposes of Ward’s doctrine of parity, at least as to commercial and industrial projects.  (Note that section 5(d)(1)-(3) has carve-outs for certain residential and utility projects.)  Accordingly, Indiana courts should focus on relative filing dates, and not on work dates or contractor knowledge.   

Post-1999: One Case.  The meaning of section 5(d) has not been tested on appeal, however, and I.C. §32-28-3-2(b)(2) priority, which favors contractors, may to some extent conflict with section 5(d) priority, which favors lenders.  Section 2(b) might permit contractors to argue that, despite section 5(d), they have priority as to their specific improvement.  Provident Bank v. Tri-County Southside, 804 N.E.2d 161, reh’g granted, 806 N.E.2d 802 (Ind. Ct. App. 2004) gives some insight into the potential statutory inconsistency.  Provident Bank dealt with a contractor’s improvement (installation of a driveway) at a residence long after a purchase money mortgage had been recorded.  Believe it or not, the majority opinion held that the contractor’s statutory remedy was to remove and sell the driveway.  Anyway, the dissenting opinion toyed with Ward and the new I.C. §32-28-3-5.  “In 1999, our legislature amended I.C. §32-28-3-5 and specifically addressed the situation before our supreme court in Ward and again discussed by the bankruptcy court in Venture.”  Id. at 168.  As an aside, the dissent concluded that I.C. §32-28-3-5(d) applies “where funds from the loan secured by the mortgage are for the project which gave rise to the mechanic’s lien.  In such an instance, the mortgage lien has priority over the mechanic’s liens recorded after the mortgage.”  Id. at 169

2007: Lender Wins.  At least as to a standard commercial project, therefore, the Ward doctrine of parity seems to be a thing of the past.  The lender, in the scenario presented to me, shouldn’t be forced to share equally with any contractors that started construction before the developer closed the deal.  Instead, the lender should hold a superior lien, assuming the lender records his mortgage before a contractor records a notice of mechanic’s lien.  In other words, if the project goes south, the lender should get paid first.  Having done all the research and reasonably assured myself of the answer to the question, therefore, I believe my lender contact can relax.  Minimal delays with the closing should not adversely affect his bank’s mortgage lien.  But, he should make sure he records the mortgage sooner rather than later, and certainly before any of the contractors record a notice of mechanic’s lien.