Wednesday, October 3, 2012

Friendly Foreclosure



Daniels v. Elks Club of Hartford, 2012 VT 55.

Oh boy!  Sometimes there comes a case that is complicated.  And sometimes there comes a case that divides the SCOV.  And sometimes there comes a case that takes up a completely new area of law where the SCOV has to reason its way to an answer that is not immediately evident.  And then there are cases like today’s that read like a seven layer salad composed of all these issues and then some. 


Let’s start with our cast of characters:

  • Plaintiff—a member of the Elks Club of Hartford, Vermont.  In his spare time, he purchases mortgages.

  • The Elks Club of Hartford, Vermont.  You might remember the Club from SCOV cases, such as Today We Discriminate, Tomorrow We Pay or Operation Expert Witness: CPA.  Basically, the Club would not admit women, and this got them into a mess of trouble.  The Club was a corporation in the 1980s then an unincorporated association for 18 years (during the lawsuit).  The Club recently found religion and re-incorporated. 

  • The Discrimination Creditors—the aforementioned repudiated women and the Vermont Human Rights Commission all of whom sued the Club at the end of the 1990s and won a substantial judgment from the Club for its misogynistic membership rules.  Following their victory, they become a lien holder in the Club’s property, second only to the Bank.

  • Attorney Creditor—the Club’s attorney throughout the underlying public accommodation suits.  Proving that the attorney is often the party that bears the weight of defeat, Attorney’s bills went unpaid.  Following the Club’s loss, Attorney sued for his fees and became another judgment creditor.  His liens are third in line behind the Discrimination Creditors, and the Bank.

  • The Bank—the primary lien holder in the Club’s property.  Like most banks, Bank wants money and will work with anyone who will help them make this dream come true.

Now that we know the players, let’s break down the action:

In the late 1990s, the Club, a non-profit social organization was approached by various women seeking the benefits and obligations of membership.  They were refused, and they, along with the Vt. Human Rights Commission sued to change things.  Years of protracted litigation followed along with two trips to the SCOV.  In the end, the Club lost and was on the wrong end of a judgment order for $456,001 ($1 in compensatory damages; $5,000 in punitives; $5,000 in statutory damages; and $446,000 in attorney’s fees).  When the next pancake breakfast came up short, the Club let the payment go unpaid.  The Creditors filed a lien and secured their judgment with the Club’s large property holding.  . 

When the Club’s former attorney collected a judgment on his unpaid legal fees, he jumped in line behind. 

First lesson for security interests: time is everything.  Before either set of creditors became creditors, the Club had taken out substantial loans from the Bank.  Like all financial institutions, the Bank insisted on a mortgage to secure the Club’s note.  Club granted Bank a mortgage.  So when the later creditors filed their liens, they did so subject to the Bank’s primary lien. 

Here is how this works.  The first mortgage/lien on a property has priority.  That means it can foreclose on the property, and unless they buy out the earlier mortgage, the later liens are effectively cancelled.  Of course, if the property is sold at a foreclosure sale, any amount over the first mortgage/lien goes to the second and third mortgage/liens.  But the reality is that property rarely sells that high since no one has a particular stake in bidding too high above the foreclosure amount.

Nobody likes to be the second security on a property, but it makes sense if the first priority lien/mortgage is small relative to the fair market value of the property.  It also makes sense if you have no other options.   It is safe to say that banks usually hold primary liens and judgment creditors, tradespeople, and family often hold the second, third, and fourth position.  In fact, most banks will consider the property to be in default if another security attaches to the property without its permission.

In today’s case, the Club, in the wake of its legal setbacks, began missing its mortgage payments, which made the Bank nervous.  Enter Plaintiff from stage right.  Plaintiff, Club, and Bank came to the following deal.  Bank assigned the mortgage to Plaintiff.  Plaintiff gave Bank a note for $493,000.  He also offered up some cash collateral and gave the Bank a collateral assignment of the mortgage.

Five months later, Plaintiff began a non-judicial foreclosure against the property and notified all of the subordinate creditors.  Creditors filed an action in Washington County (site of the public accommodation lawsuit) to block the foreclosure.  The Washington trial court denied the action, but everyone realized that the foreclosure would have to go through the judicial process.  One month later, Plaintiff filed a foreclosure action with the trial court in Windsor County. 

Now that the stage is set, let the story begin.

Chapter I: Can You Foreclose from Yourself?

As you can imagine, the idea that Plaintiff, a member of the Club, would own the first priority mortgage over the property was a galling prospect for the other creditors.  The fact that he was now foreclosing and severing their hard won interest in the property was more than they could take. 

In challenging this foreclosure, the Creditors raise several issues.  None of them prove effective. 

First, the Creditors argue that the Plaintiff cannot foreclose on the property because he assigned his legal rights to the Bank.  The trial court rejected this because it found that the Plaintiff had only intended to transfer a security interest in the mortgage and not the mortgage itself.

The SCOV agrees, but it goes one step further and examines the concept of what a collateral assignment in a mortgage means.  Citing to the Vermont Title Standards (a set of documents worthy of their own discussion) the SCOV notes that a collateral assignment is essentially a mortgage of a mortgage.  The key is that while Plaintiff retained title to the mortgage, he gave a legal interest in and the right to foreclose on the mortgage to the Bank. 

Creditors tried to argue that because Plaintiff had made such an assignment, he no longer had the right to foreclose.  The SCOV rejects this position by concluding that the party who pledges an interest in a mortgage retains the right to foreclose—so long as the assignee, who holds the legal interest is made a party to the proceedings.  The long and short of it is that both Plaintiff and Bank have the power to foreclose.  Just because Bank did not, does not mean that Plaintiff cannot, and because Bank was a party to the proceedings and supporting Plaintiff, the SCOV sees no problem with the foreclosure established by Plaintiff.

Creditors’ next argument concerns merger.  Because Plaintiff was also a member of the Club and had an interest in the Club property when he took title to the mortgage, it merged with his interest in the property and effectively cancelled the mortgage. 

The SCOV rejects this position two ways.  First, it finds that the identity of the interests is not equal.  Plaintiff is a member of the Club, and as such, he is not the actual owner of the property.  Notwithstanding his membership interest in the Club, the identities remained distinct and did not lead to merger.  Second, the SCOV concludes that the parties did not intend for a merger to occur.  While merger may occur in some cases where title and mortgage ownership are held by one person, it does not necessarily follow as a matter of law.  This is a tricky point as the SCOV does not go so far as to rule that the intent of the parties can trump a merger, but it does indicate where merger is clearly unintentional and works a certain unfairness on the parties, the courts should consider intent.

Creditor’s third and last argument on this issue is an appeal to the SCOV’s power of equity.  The Creditors argue that Plaintiff, Bank, and Club colluded to defraud Creditors by assigning the mortgage to Plaintiff and then initiating foreclosure proceedings to cut off the interest of the junior creditors. 

The SCOV notes that regardless of the parties’ intentions, the Creditors have not been affected by the situation.  When Creditors filed their liens, they knew they were the junior creditors and would take subject to the Bank’s mortgage.  Despite selling the mortgage to Plaintiff, nothing has changed.  Creditors are still in the second and third position, and Plaintiff is acting in the same manner that the Bank could have acted at the time Creditors filed their liens—no more, no less.

Chapter II: A Mixed Advance

The SCOV’s second area of review takes up the argument that money advanced by the Bank in 2006 should not take priority over the Creditor’s liens.  In advancing this argument, the Creditors were trying to reduce the amount due in the foreclosure—thereby increasing the odds that a sale of the property would result in money to them.

As a bit of background, the Bank initially gave the Club a $700,000 loan in 1989, which was secured by the mortgage now held by Plaintiff.  In 2006, Bank loaned an additional $25,000 to the Club on the same mortgage.  Creditor’s arguments in this field seek to block this second amount from taking priority. 

The SCOV begins with the general test for priorities among future advances.  This is known as the optional/obligatory advance doctrine.  If a future advance is obligatory, then it maintains its priority over succeeding liens.  Think of loans made in installments or certain lines of credit where the Bank is obligated to extend a loan or credit to the borrower.  If, however, the future advance is optional, and the bank has notice of succeeding creditors, then the advance loses its priority and sits behind the secondary liens. 

The trial court denied this argument because Creditors had not affirmatively notified the Bank of their liens prior to 2006.  In making this conclusion, the trial court used the test for notice set up in a series of 19th Century cases, and while there is nothing wrong with citing 19th Century case law, as the Unnamed Partner is quick to point out, but there is a when a more modern statute controls.

It is this statute, 27 V.S.A. § 410(b)(3)(B) upon which the SCOV focuses their review.  In looking at this statute and its history, the SCOV concludes that the legislature changed the common law on the question of notice to no longer require a junior lienholder to notify the primary lien holder of her existence or formally object to prevent an optional future advance from taking priority.  While such formal objections are still sufficient, the SCOV notes that the statute allows actual notice too. 

So if the Bank was aware of Creditors’ liens, then the 2006 advance goes to the back of the line.  If not, then Plaintiff can include it because Creditors did not file formal objections.  The SCOV finds that the trial court did not allow discovery on this issue, and remands for further discovery and findings. 

Chapter III: The Creditors Strike Back

To this point, the SCOV has been dealing with the somewhat esoteric field of secured transactions.  Scintillating stuff, but at the same time nothing completely new or expansive.  In fact, if today’s case had ended at paragraph 38, it likely would have been big news in banking circles and SCOV Law blogs but little else.  It almost certainly would not have spawned a vigorous dissent. 

But such is the beauty of the judiciary.  The courts do not go looking for issues.  Cases come to them, and the issues that they raise cannot always be avoided.  If properly raised, a straightforward case can become window dressing for a thorny, court-dividing controversy that eats up more page space than the original issue that sparked the action in the first place.

Such is the case here with the final issue of whether Plaintiff is liable to Creditors for the judgments they achieved against the Club and whether Plaintiff’s foreclosure amount should be offset by the Creditors’ judgments.

Let’s back up for a moment to discuss corporations.  Corporations exist for two, arguably three, main purposes.  First, they are vehicles for raising capital.  Second, they are shields against individual liability.  Third, they are recipients for a number of tax incentives—particularly if they are an LLC, which allows for pass-through taxation. 

The liability issue, in particular, has proven to be one of the great innovations in modern society.  You can, for example, buy stock in General Electric or go to work for General Electric and enjoy the profits, salary, and dividends of the corporation, but when General Electric is found to have violated a workers’ compensation law, polluted a particular stream, or defaults on a debt, you are not liable and your family’s financial assets are not at risk.

While some might cite this as an example of a lack of accountability, this is a short sighted view.  The corporate liability mechanism protects investors and employees and allows business to flourish.  If every investor had to worry about liability with each stock purchase, the markets would shut down, businesses would crash, and we would become a nation of legal actions trying to sort out liability.  That is not to say that there should not be individual accountability behind corporate actions, in fact today’s case gets to the heart of that issue, but it is merely to note that our entire economy, indeed the world’s economy is built on the idea that everyone can, without fear of liability, invest or work for a corporation where capital is expanded into profits and labor is rewarded with adequate wages. 

Because corporations alter the liability, tax, and investment fields, there are a few rules to how they are formed, listed, and registered.  First and foremost, a corporation must through articles of incorporation register with the Vermont Secretary of State.  This registration must be kept current with annual filings, or the Secretary will suspend the corporation’s status. 

Big secret: registering and filing annual reports is a form-driven mechanical process that is no more onerous than clicking a fee boxes on a pdf file and paying the $75 or $35 fee.  Moreover the cure for failing this process is to file and pay the back-due fees.  Once that ministerial transaction is complete, reinstatement occurs and back dates to the last annual filing. 

The other important rule is disclosure.  Every corporation must admit to being one.  They must put Inc., LLC, Ltd., PLLC, or the appropriate corporate designation after their name, on their invoices, their forms, and all relevant documentation.  Its agents must identify themselves as such, and they must give you the information to know that you are dealing with a corporate entity, not an individual.  This is so you do not get fooled into dealing with Joe Smith, individual, and then find out that Joe was really just an agent for MegaCorp, LLC, which has no assets.  Failure to properly disclose corporate identity is a big reason why courts will set aside the shield of liability for individuals within a corporation.

The problem in this case is that the Club was a fully incorporated entity until 1989 when it stopped filing its annual report with the Secretary of State’s office, a practice the Club continued for the next 18 years during which all of the critical events of the underlying lawsuits occurred.   In fact, during the litigation, the Club referred to itself as an unincorporated entity.  Only in 2008 did the Club pay all of its back fees and reinstate its corporate identity with the state.

The issue for the SCOV is complicated.  On one hand, the Club’s sole sin is a failure to file regular corporate records.  The SCOV has time and again affirmed that reinstatement wipes the slate clean and that no drop in corporate identity attaches when such overdue filings were made.  On the other hand, the evidence is clear that all of the parties (Club included) considered the Club to be a non-corporate entity during the time that the Club incurred liability and judgment liens.  As the majority points out, the Club at one point even argued against a hefty judgment because its members might be individually liable due to the Club’s status. 

Reacting to this situation divides the SCOV, but there is, perhaps, more disagreement on how to go forward than the ultimate results.  As we will see, the dissent vigorously rejects the majority’s reasoning but offers another channel to possibly come to the same conclusion. 

Let’s start with the majority opinion.  It begins with a discussion of liability for members of an unincorporated association.  The majority notes that there really is no such beast, but that this moniker refers to the default result of a corporation that, while organized, does not fall under the law of corporations. 

Reaching back to the early 20th Century, the majority (much to the dissent’s derision) applies the reasoning from three cases dealing with debt liability for unincorporated associations.  The majority concludes that individual members at the time a debt or obligation is incurred are liable for the association’s debt.  This liability is not primary but a secondary contractual liability.  Essentially, the individual members of an association act as the entity’s guarantors.  Membership has its obligations as well as privileges. 

Under this theory, Plaintiff and the other members of the Club at the time that the judgment occurred are individually liable for the Club’s judgment debts.  The majority spends ten more paragraphs outlining the dissent’s objection to holding individual members liable for the Club’s actions when there is no proof that the members participated, agreed with, or were necessarily aware of the Club’s position.  The majority’s response is basically the law does not allow for the exempting of individual liability because of level of participation and that even if it did, the equities here would not warrant such a step. 

This leads to the majority’s final burst of decision-making—addressing the question of whether the reinstatement of the corporation nullifies the individual liability.

Make no mistake, the SCOV is breaking new ground here, and the extensive reasoning it engages in to justify and narrow its decision is the process that you expect from the SCOV when it heads out into new precedent. 

First, the majority notes that the statute allowing reinstatement permits the corporate registration to relate back to the point of termination, but it does not address the issues of personal liability.  For that the majority looks to other jurisdictions.  The majority, in a point hotly disputed by the dissent, concludes that a significant number of jurisdictions allow personal liability to attach during periods of suspended incorporation for the acts of individual directors, members, or employees involved in the governance of the corporation.   The majority, though— via a footnote— admits that this position is not uniform and that reasonable minds as well as jurisdictions have disagreed.

So instead of adopting a bright-line rule, the majority forges a new direction.  The majority announces that whether the shield of retroactive corporate liability will be determined by a test of whether the creditor believed that it was dealing with a corporation or an unincorporated entity.  In other words, the majority adopts the corporate identity disclosure test. 

You can see how this will work out in the present case.  Because the Club represented itself as a non-corporation throughout the pendency of the litigation, post-judgment actions, and even the pre-litigation issues, it is a no-brainer.  Corporate protection from individual liability is unavailable to Plaintiff and his club chums. 

Mind you, the majority also looks closely at the actual nature of the claims and notes that they stem from Club-wide activity before assigning liability on fairly broad basis.  For example, the bulk of Creditors’ liens stem from the Discriminatory Creditors’ attorney’s fees.  These came from the Club’s vigorous, multi-year fight with the VHRC and the women applicants.  While the Club was entitled to defend itself, its members must bear liability because they voted to do this.  (Raise your hand if you want to be the attorney who has to explain this to the membership.)   

This leads to the majority’s examination of which of the members should be held liable.  Rather than try to tie liability to a particular act, vote, or decision, the majority adopts the rule that any member who knew or should have known that the organization lacked corporate status and shielding for individual liability should be held liable for these organization-wide decisions. 

This brings us to the final question and the summation of the majority’s opinion: Are the Creditors entitled to a counterclaim against Plaintiff?  The answer to that question is muddled.  Basically, the SCOV rules that the record is incomplete and that the Creditors were unable to properly amend their counter-claim to allege the facts that would support a claim against Plaintiff.  In light of that the majority orders a remand to the trial court.  But the remand is specific.  The foreclosure goes through with a period of redemption and order for a public sale.  What is left is for the trial court to make findings as to the amounts attributable to each party in what order and to determine the validity of the counterclaims.  All of which are more likely to be settled after a public sale than before.  At that point, one suspects it will be a fight between the Bank and the Creditors not unlikely the childhood game of Hungry-Hungry Hippos with the foreclosure proceeds replacing the iconic white marbles.

Chapter IV: With a Concurrence on Top

Specially assigned to the case, Judge Cohen pens a brief concurrence.  He argues that the majority can and should have gone a step further to rule that the liability of individual members should be subject to review of contribution among the membership.  The concurrence readily admits that it stands alone on this issue since none of the parties briefed the issue and the rest of the SCOV was unwilling to take up the issue.  Nevertheless, the concurrence is compelled by the potential inequity of having inactive members with large assets paying the judgment while more culpable members that are more judgment-proof escape liability. 

The concurrence’s issue is a larger question about liability.  When you have a group of defendants, the rule in Vermont is that they are jointly and severally liable for the judgment.  So if a pharmaceutical company sells a drug with a confusing label, it may be held liable for the entire judgment even if the bulk of the responsibility falls upon a doctor or nurse who misapplied it.  As you might imagine, this doctrine is vigorously defended by plaintiffs’ attorneys and the source of much teeth gnashing by the defense bar. 

Nevertheless, the majority is unwilling to go down the road of tort reform in this case, and the Concurrence stands as a brief beacon to future litigants who seek to raise the issue.

Chapter V: Piercing Dissents

Chief Justice Reiber—joined by Justice Burgess—dissents from the majority on the issues of individual liability.  The dissent objects to the majority’s new rule to determine individual liability during the suspension of incorporation. 

The dissent begins with the statute covering reinstatement of incorporation.  As the majority also notes, this statute creates a retroactive effect.  Unlike the majority, the dissent cites to various opinions from other jurisdictions that have interpreted similar statutes to cover the issue of individual liability.  In those cases, as the dissent would have here, the reinstatement is completely effective in restoring the shield against individual liability.

The dissent notes that what the majority is really describing in their new rule is fraud, where an agent or members represent themselves as something other than what they are.  The dissent notes that the remedies against fraud are unaffected by restoring corporate liabilities limits.  Even if the elements of fraud are not met, there is the equitable doctrine of piercing the corporate veil, which allows a court to set aside a corporate structure and find individuals liable if the rules of incorporation are not followed to the detriment of a creditor or outside party. 

In this the dissent indicates that Creditors’ claims might have had a chance, but under a very different vehicle.  While the resulting analysis might differ from the majority’s proposal, the dissent indicates that it would track more closely to the issues that both sides of the SCOV hold as important but would allocate liability to the individuals most likely to be involved in the improper actions.  The dissent’s view has the advantage of utilizing existing doctrines (fraud, piercing the corporate veil) instead of creating new and untested standards.

The dissent further criticizes the majority’s test as a confusing “multivariate, ‘expectations’ dependent, ‘contextual’ approach” that will only create problems for future courts and litigants trying to apply this fact-sensitive test to different factual settings. 

Finally, the dissent argues that even if corporate liability protection was not extended, the non-profit nature of the Club should make its member immune from personal liability.  Against the majority’s early 20th Century cases, the dissent marshals a diverse array of cases that have held individual members of unincorporated non-profit associations immune from personal liability. 

The dissent’s point is that the Club, like many non-profits, is peopled by individuals out to make a difference rather than a profit and the courts should recognize this fundamental difference when reviewing liability. 

But with one vote short of a majority, the dissent remains the minority position.  As with recent, similar split, the deciding vote is a specially assigned trial court judge.  It remains to be seen whether the full SCOV will continue down the majority’s path or shift to give the dissent’s fully articulated vision some legs. 

If nothing else, we should look forward to the next trip the Elks make to the high court.  At this point, they have outlasted three of the five justices who reviewed their original case.  If they last for another nine years, who is to say that another slate of justices won’t see things differently.

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