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“Negative Value” Dooms Indiana Fraudulent Transfer And Direct Continuation Claims

Not infrequently, a borrower’s loan collateral will fail to fully satisfy a secured debt, particularly after the add-ons of default interest, attorney’s fees and other costs of collection.  In such cases, lenders must choose whether to pursue a recovery of the remaining, unsecured debt from either the borrower or a corporate or individual guarantor.  Sometimes, a pre-loan and post-judgment comparison of financial statements causes lenders to question whether there may have been fraudulent transfers of assets that could be avoided and become a source of recovery.  Guttierrez v. Kennedy, 2010 U.S.Dist. LEXIS 73053 (S.D. Ind. 2010) (.pdf) helps guide a judgment creditor’s decision of whether to incur the time and expense of pursuing suspected fraudulently-transferred assets. 

Fact sensitive.  No two fraudulent transfer/veil piercing cases are alike, and I’ve concluded that a detailed summary of facts in cases like Guttierrez adds little to the overall message.  For more about the assets and relationships at issue, I recommend that you read the opinion. 

Negative value.  The key asset in Guttierrez involved a contract previously held by the judgment debtor that was transferred (assigned) to a related corporate entity.  Indiana’s Uniform Fraudulent Transfer Act (“UFTA”) at Ind. Code § § 32-18-2-1 through 21 permits creditors to obtain avoidance of a fraudulent transfer to the extent needed to satisfy a claim.  Guttierrez specifically touched upon the amount of the potential recovery.  “The creditor may recover the lesser of the amount necessary to satisfy its claim or the value of the transferred asset.”  Valuation is determined at the time of the transfer but can be adjusted “as the equities may require.”  To the extent the asset may generate income from use, the liability of the transferee will be “limited in any event to the net income after the deduction of the expense incurred in earning the income.”  After an examination of the facts in Guttierrez, the Court concluded that the judgment creditor could not recover under the UFTA because the subject contract had negative value after the deduction of the expenses incurred in earning the income. 

Direct continuation.  The judgment creditor in Guttierrez also argued that the corporate assignee of the contract was a “direct continuation” of the judgment debtor and, as such, should be liable for the judgment.  I discussed this type of veil piercing claim on July 28, 2007.  Generally, in Indiana “when a corporation is clearly a direct continuation of the ownership and operations of another corporation, it will be liable to the other corporation’s creditors.”  The corporate entities in Guttierrez operated from the same location and performed the same jobs.  On the other hand, the targeted entity was not created immediately after the threat of judgment against the judgment debtor and indeed preexisted the judgment by twelve years.  Additionally, even though one of the principals of the judgment debtor had a stake in the targeted entity, two of the other principals did not.  Moreover, the judgment creditor did not offer evidence of the important factors of undercapitalization, comingling of personal and corporate assets, or corporate payment of personal obligations.  But the nail in the coffin was the “negative value” of the asset at issue:  “Plaintiffs were not harmed by the transfer because the [contract] turned out to be a losing proposition.”   

No harm, no foul.  From the perspective of judgment creditors, one lesson of Guttierrez is to ensure that the asset being chased is worth chasing.  Guttierrez centered upon the capture of an income-producing asset (a contract) that, on its face, appeared to have significant worth.  But the Court concluded that, after deducting operating/overhead costs, the contract had negative value.  The judgment creditor’s efforts to seize the contract were for naught.  While it may be understandable that a value determination cannot be made before a claim is filed, prompt post-filing discovery and investigation should be undertaken in order to assess what an income-producing asset may be worth.  In Guttierrez, the subject transfers and corporate entities were suspect, but in the end those circumstances didn’t matter because the targeted asset turned out to be a liability. 

Indiana-Based Home Builder, Estridge Group, To Face Foreclosure Action(s)?

Estridge Group has fallen victim to the real estate-centered recession.  Here are links to recent stories in the Indianapolis Business Journal and The Indianapolis Star:

As Estridge shuts sales operations, homeowners ask, 'What now?'

Estridge: We need cash to survive

My experience in representing the largest secured creditor in the Hansen & Horn situation suggests to me that one or more foreclosure cases may be right around the corner.  But, I could be wrong.  I don’t have any first-hand knowledge of the nature and extent of Estridge’s loans or collateral.

From a commercial foreclosure/creditor’s rights perspective, I thought this quote by Mr. Estridge was particularly interesting:

'I continued making interest payments on all the land we owned at a level of $400,000 a month for three or four years,'Estridge said. 'That depleted all of our capital. I should have just given the land back to the bank. As I look back, there’s the tactical versus the moral and the ethical.'

Again, I'm not familiar with the case, but in basic terms the quote implies the possibility that Mr. Estridge may have been presented with the choice between a deed-in-lieu of foreclosure and a loan extension/modification.  Experience has taught me that some borrowers simply don’t want to give up (or settle) when perhaps they should…. 

Title Agents May Be Liable For Negligent Misrepresentation In Indiana

Mortgagees and their Indiana counsel rely heavily on title commitments.  In Indiana, if a loan commitment fails to identify a prior lien, and if that oversight leads to losses, there are potential consequences to the issuer of the commitment - commonly known as the title agent, abstractor or searcher - not just to the issuer of the insurance policy.  The Indiana Supreme Court in U.S. Bank v. Integrity Land Title, 210 Ind. LEXIS 396 (Ind. 2010) (.pdf) broke new ground in this regard. 

Missed it.  U.S. Bank held what it believed to be a senior mortgage on its borrower’s real estate.  Before making its loan, U.S. Bank ordered a title commitment from Integrity, which also closed the transaction.  The commitment did not disclose a prior judgment lien held by another lender, LPP, against the seller/owner.  LPP later prevailed in its foreclosure action and sold the subject property at a sheriff’s sale that netted no proceeds to U.S. Bank.  In other words, LPP’s lien rendered U.S. Bank’s loan unsecured.  (Notably, Southern National Title Insurance underwrote a loan policy with U.S. Bank as the insured, but Southern later dissolved.  A conventional title insurance claim thus was unavailable.) 

Breach of contract.  Privity of contract refers to a connection between contracting parties.  In U.S. Bank, the Court concluded that there was no privity between Integrity and U.S. Bank and, as such, U.S. Bank had no breach of contract claim against Integrity.    

Tort liability.  The critical question became whether Integrity owed a duty in tort (a civil wrong, other than a breach of contract, that gives rise to an action for damages).  The answer to that question turned upon the Court’s analysis of Indiana’s economic loss rule that, if applicable, would shield Integrity from liability.  The Court found that the economic loss rule did not apply.  (To learn more about the rule, read U.S. Bank, as well Indianapolis-Marion County Public Library v. Charlier Clark & Linard (.pdf), in which the Court addresses the rule and its exceptions in depth.   

Negligent misrepresentation.  U.S. Bank sought to hold Integrity, a title commitment issuer with which U.S. Bank had no contractual privity, liable for negligence in failing to uncover a defect in title during the search.  The Court posed the legal question as “whether the issuance of a title commitment gives rise in Indiana to a tort cause of action for negligent misrepresentation against a commitment insurer, separate and apart from the contractual obligations of the title policy.”  The theory is that, once the commitment issuer assumes the responsibility of performing a title search and disclosing defects, that company should be liable to all foreseeable third parties injured by the issuer’s failure to exercise reasonable care in supplying information.  The Court held that Integrity had a duty to communicate the state of title accurately when issuing the commitment.  Here’s the rationale:

Integrity should have known that Texcorp (U.S. Bank’s predecessor in interest), in closing the loan to buyer, would act in justifiable reliance on the statement in the preliminary commitment that title was free and clear of any encumbrances.  …  Armed with direct knowledge of Texcorp’s interests and requirement of accurate title information to guide its lending practices, Integrity prepared the title commitment that indicated that it had performed a title search on the subject property and had found no prior judgment liens.

Not a foreclosureU.S. Bank did not involve a foreclosure commitment (leading to an owner’s policy) but rather a loan commitment (leading to a lender’s policy).  The U.S. Bank negligent misrepresentation claim comes into play in a loan default/foreclosure case only when the lender discovers that its mortgage is primed by a prior lien that should’ve been identified pre-closing.  In that instance, foreclosure may not be a viable option (depending upon the amount of the prior lien and the equity in the property).  A title claim under the loan policy and/or a negligence claim against the title agent may be the only avenue for recovering losses.  (For scenarios when a foreclosure commitment misses a lien, please see my October 14, 2009 post for background and my Strict Foreclosure category of posts regarding the remedy.)

In scenarios involving defective loan commitments, U.S. Bank seemingly permits the lender to sue two parties – the carrier and the agent.  Maybe this would be redundant, but maybe not.  It  depends on the circumstances of the particular case.  I welcome e-mails or comments on experiences or thoughts concerning whether, under circumstances like those in U.S. Bank, lenders should assert claims against both its title company (under an insurance policy) and its title agent (based on the commitment). 

Set-Off Versus Garnishment: Rights To And Priorities In Deposit Accounts

Fifth Third Bank v. Peoples National Bank, 210 Ind. App. LEXIS 952 (Ind. Ct. App. 2010) (.pdf) outlines a plethora of legal principles related to judgment enforcement generally and garnishment proceedings specifically.  The opinion analyzes a priority dispute between one lender, which had a judgment lien in a checking account, and a second lender, which had a security interest in the same account.

The parties and the account.  An accounting firm, OMS, opened a checking account with Fifth Third.  Fifth Third also loaned OMS approximately $1.5MM, secured in part by the same account.  Years later, Peoples obtained a judgment against OMS in the amount of $64,000.  About the same time, OMS defaulted on the Fifth Third loan.  Fifth Third did not initially freeze the OMS checking account.  Meanwhile, Peoples initiated proceedings supplemental against OMS and named Fifth Third as a garnishee defendant.  Although Fifth Third did not at first disclose to Peoples that OMS had the account, it subsequently identified the account and froze it.  In a separate suit, Fifth Third soon thereafter got its own judgment against OMS.

Competing interests.  The Court in Fifth Third noted that, under Indiana law, a judgment creditor (here, Peoples) acquires an equitable lien “on funds owed by a third party [here, Fifth Third] to the judgment debtor [here, OMS] from the time the third party receives service of process in proceedings supplemental.”  The third party (here, Fifth Third) may be “liable for paying out funds in a manner inconsistent with the judgment creditor’s lien.”  On the other hand, Indiana recognizes a right of depositary bank (here, Fifth Third) to set-off any amounts owed to it with funds from its “indebted depositors’ [here, OMS’s] account after receipt of notice of garnishment proceedings.”  The pivotal rule proved to be:  a garnishing creditor (here, Peoples) “has no greater rights in the judgment debtor’s [here, OMS’s] assets than the judgment debtor does.” 

General rule of priority.  In Fifth Third, the “first in time is first in right” rule applied.  Fifth Third, a secured creditor with a perfected prior security interest in the deposit account, had rights that were superior to Peoples, a subsequent judgment (unsecured) creditor.  At the time of the loan default, OMS owed Fifth Third in excess of $470,000, which was the account balance at the time in question.  Once OMS defaulted, Indiana law entitled Fifth Third to exercise the remedy of self-help in order to apply the balance of the deposit account to the indebtedness owed under the security agreement.

Compelled to set-off?  Peoples asserted various equitable arguments against Fifth Third’s position.  Peoples contended that, by not immediately exercising the right to set-off, Fifth Third lost its superior priority status and should have been foreclosed from attempting to belatedly enforce its right to the account.  Under the UCC, a secured party holding a perfected security interest in a deposit account “may set-off or apply the balance of the deposit account to the loan obligation secured by the deposit account.”  Again, Peoples, the garnishing creditor, had no greater rights in OMS’s assets than did OMS.  OMS owed Fifth Third in excess of $1MM.  The OMS deposit account contained only $470,000.  As such, OMS’s rights in the deposit account “were extremely subject to” Fifth Third’s security interest.  According to Fifth Third, a failure to exercise set-off will not result in a subordination of those rights to the rights of a garnishing creditor.

Compelled to freeze?  Peoples also claimed that Fifth Third lost its superior priority status when Fifth Third continued to honor checks drawn on the deposit account after the OMS loan default.  Fifth Third’s security interest was automatically perfected by its “control” over the account.  Ind. Code § 26-1-9.1-104 provides that the requisite “control” over the account exists even if the debtor retains the right to direct the disposition of the funds in the account.  Fifth Third’s decision to allow OMS to reach the funds was not inconsistent with the required “control” for purposes of automatic perfection.  Banks have “the latitude to allow their indebted depositors to have reasonable access to funds, which may enable them to continue to operate and generate revenue that may be applied to their existing indebtedness.”  Under circumstances like those in Fifth Third, the failure to freeze an account that is subject to set-off will not permit a garnishing creditor to assume senior status.


Indiana Supreme Court Draws The Equitable Subrogation Line At Priority

This follows up on my June 21, 2007 and August 24, 2009 posts on Indiana’s doctrine of equitable subrogation, specifically the opinions arising out of the Gibson v. Neu case.  The Indiana Supreme Court wrote the final chapter in Neu v. Gibson, 2010 Ind. LEXIS 376 (Ind. 2010) (.pdf), which is Indiana’s definitive statement regarding the scope of the doctrine. 

Circumstances.  Nowak owned a residence with a mortgage loan from lender Irwin.  He subsequently granted a second mortgage to Gibson.  Nowak later sold the residence to Neu, who utilized a mortgage loan from Wells Fargo to pay off the Irwin mortgage.  Neu and Wells Fargo (and their title insurance company) overlooked Gibson’s junior mortgage, which survived the sale.  In the first Gibson v. Neu opinion (the subject of my June 21, 2007 post), the Court of Appeals granted priority to Neu and Wells Fargo over Gibson.  Because that decision remained undisturbed by the Indiana Supreme Court, Indiana law appears to be settled that the amount of the equitable lien is at least the amount of money that was used to pay off the prior mortgage.  The Supreme Court’s opinion dealt with the additional rights and remedies, if any, to which the subrogees (Neu and Wells Fargo) may have been entitled.

Foreclosure.  Gibson had not exercised his foreclosure rights, evidently due to “the presently depressed real estate market.”  It seems that Gibson was biding his time for the value of the home to turn around.  On the other hand, Neu sought a sheriff’s sale, presumably to quiet title to his real estate.  This likely would have extinguished Gibson’s lien and netted no proceeds to him, resulting in a substantial financial loss.  The Court of Appeals previously determined that Neu and Wells Fargo were permitted to request a sheriff’s sale to enforce their equitable lien.  Indeed the Irwin mortgage included that right.  But Nowak’s obligation under the Irwin mortgage ended when Neu and Wells Fargo satisfied that debt.  Since the Irwin mortgage was discharged, “no party can possibly foreclose under the terms of the Irwin mortgage any longer.”  The Court therefore drew “the equitable subrogation line at priority [because] these circumstances [do] not unfairly prejudice [Neu yet they] preserve Gibson’s rights as an inferior lienholder.” 

Interest.  Both the Court of Appeals and the Supreme Court denied Neu’s and Wells Fargo’s claim to include mortgage interest in the amount of the equitable lien based upon the Irwin mortgage.  The Court of Appeals concluded that some interest could be recovered at the statutory post-judgment rate of 8% from the date of the payoff of the prior mortgage, but the Supreme Court would not even go that far.  “The trial court’s earlier ruling giving [Neu] priority ahead of [Gibson] seems like a substantial step of equity that largely rescued [Neu] from the calamity that might have otherwise befallen [him] (namely, ending up in line behind Gibson).” 

Attorney’s fees.  Similarly, the Supreme Court held that “the equities weigh against [Neu] recovering fees . . ..”  Again, the Irwin mortgage was not in default, so that mortgage could not form the basis for including attorney’s fees and costs in the equitable lien under the circumstances of the Neu case. 

Prevailing theme – fairness.  “The key to subrogation is an equitable result,” the Court said.  Equitable subrogation:

Substitutes one who fully performs the obligation of another, secured by a mortgage, for the owner of the obligation and the mortgage to the extent necessary to prevent unjust enrichment.  This avoids an inequitable application of the general principle that priority in time gives a lien priority in right.  In considering whether to order subrogation and thus bypass the general principle of priority, courts base their decisions on the equities, particularly the avoidance of windfalls and the absence of any prejudice to the interests of junior lienholders.

The line of Neu v. Gibson decisions provides substantial clarity to the equitable subrogation doctrine and specifically the nature and extent of the equitable lien.  The lien exists primarily to establish priority, but the scope of the lien is limited.  What is fair will carry the day.