Judgment Creditors Can Grab Undisbursed Loan Funds Sitting at the Bank!

August 16, 2018 Publications

By:  Craig Penrose

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Often times, after a Plaintiff obtains a coveted money judgment from the court, a second fight begins. Many judgment debtors simply refuse to voluntarily make good on the judgment, forcing a creditor to engage in costly post-judgment statutory proceedings with the goal of forcing a court-ordered turnover of the debtor’s property. That fight arguably just got a little bit easier.

In the recent Illinois case of National Life Real Estate Holdings, LLC v. Scarlato, 2017 IL App (1st) 161943, the First District Appellate Court held that a judgment creditor could grab undisbursed loan funds sitting at the bank that would ultimately flow to a judgment debtor’s related business, even when the debtor himself, although a signatory on the loan, could not directly spend the money.

The case stems from an approximately $3.5 million judgment entered in November 2012 against Scarlato and the resulting supplementary proceeding in which National Life attempted to collect the judgment amount by serving International Bank of Chicago (a bank that conducted business with Scarlato) with a third-party citation to discover assets. A citation to discover assets is a statutory proceeding that allows a judgment creditor to discover what assets the judgment debtor has, or what assets a third-party holds for a judgment debtor. The citation allows the judgment creditor to seek a court mandated turnover of those discovered assets. Significantly, if the recipient of a citation does not hold or retain the funds of the debtor after receipt of the citation, it can be liable on the judgment up to the amount transferred.

On April 12, 2013, National Life issued a third-party citation to discover assets to International Bank of Chicago, and a day later the citation was served on the bank. The citation prohibited any transfer of funds belonging to the judgment debtor. On August 1, 2013, nearly four months after International Bank of Chicago was served with National Life’s third-party citation to discover assets, Scarlato, and several other related companies that were not subject to the judgment, applied for a $3.5 million loan from International Bank of Chicago. The loan agreement listed Scarlato and these companies as the borrowers. Scarlato executed and signed the loan agreement three times and in three ways: individually, on behalf of himself, and in his capacity as the managing member of his companies. Scarlato also executed and signed the note in conjunction with the agreement on August 1, 2013, again signing three times and in the same three ways.

On August 1, 2013, the borrowers requested a $3.5 million “advance” under the loan agreement and instructed International Bank of Chicago to disburse and pay all of the loan proceeds to Greater Illinois Title, the construction escrow agent. Scarlato executed the disbursement request and authorization three times and in three ways: individually, on behalf of himself, and in his capacity as the managing member of the other companies. From August 2013 to March 2014, International Bank of Chicago disbursed a total of $3.5 million pursuant to the agreement.

On July 8, 2014, National Life filed a motion for entry of judgment against International Bank of Chicago for allegedly violating the citation to discover assets that it was served on April 13, 2013. National Life argued that International Bank of Chicago violated the prohibitive provision of the citation when it transferred $3.5 million in assets belonging to Scarlato after receipt of the citation. International Bank of Chicago filed its response claiming that none of the funds from the loans were assets “belonging to the judgment debtor or to which he or she may be entitled or which may thereafter be acquired by or become due to him or her,” as required by the applicable statute, 735 ILCS 2-1402.

On April 15, 2015, the circuit court entered a memorandum decision. The court concluded that although Scarlato was party to the loan agreement and note, “[t]he record does not show that the assets were assets of Scarlato individually.” The court ultimately determined that the loan disbursement checks were not for Scarlato individually but were delivered to his companies.  Thus, the loan disbursements were not “assets” of Scarlato. National Life appealed.

In a case of apparent first impression, the Appellate Court reversed the lower court’s ruling. The Appellate Court began its analysis by noting that under the statute, the citation only restrained the bank from transferring property of the debtor.  This meant that the key legal issue was whether the loan funds were considered property of the debtor, Scarlato. The Court held that although Scarlato did not receive the funds directly, he exercised sufficient control over the disbursement of the funds such that the Court determined the funds were functionally his property.

In analyzing this issue the Appellate Court noted that there were no Illinois cases directly on point. However, the Court found several out of state and federal cases persuasive. The Court analyzed the federal criminal case of United States v. Kristofic, 847 F.2d 1295, (7th Cir. 1988).  In Kristofic, the defendant was convicted of converting $50,000, which was in the form of proceeds of a loan from the Small Business Administration. The issue before the court was whether a person who misapplies the proceeds of a federal government loan may be charged with conversion of United States property. Id. The court ultimately reversed the defendant’s conviction, finding that the elements of conversion were not present where the federal government did not retain a property interest in the loan proceeds once the loan agreement was entered into. Id. at 1299.

Specifically, the court in Kristofic recognized that “[a]s a matter of basic principles, loan proceeds do not remain the property of the lender,” and further acknowledged that “[u]ndertaking an obligation to repay and agreeing to conditions contained in loan documents do not make a debtor a trustee for her creditor; the creditor does not, by virtue of these conditions, remain in any degree the owner of the proceeds.” Id. at 1296–97.

The Court also examined several Washington state criminal cases. In State v. Gillespie, 41 Wash. App. 640, 705 P.2d 808, 811 (1985), and State v. Berman, 50 Wash. App. 125, 747 P.2d 492, 495 (1987), the courts held that title loan proceeds made upon a promissory note pass to the borrower upon the signing of the note, and thus the defendants did not “embezzle” the money from any financial institution. The Court also noted that in the civil bankruptcy case of In re Southwestern Glass Co., 332 F.3d 513, 518 (8th Cir. 2003), the bankruptcy court determined that funds disbursed from a line of credit constitute property of the debtor and were, therefore, subject to a garnishment claim.

With the above cases as support, the Illinois Appellate Court held that National Life could reach loan proceeds flowing from a lender to Scarlato’s associated business entity even though Scarlato himself lacked access to the proceeds. The Court stated that it believed the language “belonging to the judgment debtor or to which he or she may be entitled or which may thereafter be acquired by or become due to him or her” is open-ended and can reasonably be interpreted to apply to a loan’s proceeds, even when the funds were not disbursed to the judgment debtor. The Court noted the following operative facts: (i) Scarlato signed the documents individually such that he was individually liable for repayment; (ii) the funds were placed in the related companies’ bank account to which Scarlato had control; and (iii) Scarlato had sole authority to request advances under the loan agreement. The Court concluded that this level of control over the funds was sufficient to earmark the funds as the property of Scarlato.

The Court further suggested that permitting judgment debtors to enter into loan agreements with third-parties that restrict the debtor’s access to the loan proceeds – yet still allow a judgment debtor to control the disbursement of said loan – was against public policy in that it might allow the judgment debtor to improperly ignore the judgment and continue operating.

The dissent, authored by Judge Mikva, highlighted that the loan was earmarked for a specific purpose and for specific payees.  Judge Mikva determined that such earmarks were indicative of a lack of control over the loan proceeds.  Judge Mikva applied the general collection law maxim that a creditor cannot obtain the funds if the debtor himself cannot obtain the funds.

National Life Real Estate Holdings, LLC v. Scarlato reaffirms the general notion that undisbursed approved loans are really the property of the debtor, and not the bank. More importantly, this case serves as a caution to recipients of citations to discover assets.  The scope of what is “under a debtor’s control” may be broader and the reach of a judgment creditor further than you might have thought.

© Laurie & Brennan, LLP 2018