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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