Articles Posted in Case Update

Cashmere

Kashwere, LLC vs. Kashwere USAJPN, LLC
Before the U.S. Court of Appeals 7th Circuit
Docket No. 13-3730 Decided November 13

The Facts

Diversity jurisdiction brought this complex commercial case before the 7th Circuit, which applied Illinois law to a series of trademark and business questions. At issue was whether the developer of chenille fabric under the tradename “Kashwere” (Selzer) could prevent a series of transactions via a non-compete agreement (“NCA”) and, conversely, whether the buyer of the Kashwere trademark (Kashwere LLC) could prevent Selzer from using a conduit company and distributors (Kashwere USAJPN) to get around that same NCA.

The Issues

The background in the case makes the opinion lengthy and complex: in fact, the Court goes out of its way to mention the convoluted facts and blames the litigants’ Attorneys for failing to keep it simple. But the issues are actually limited and familiar. In a nutshell, they are:

1) Can Kashwere LLC, as licensee of the Kashwere trademark, prevent Selzer from using USAJPN to market overseas via distributors; and
2) Can Kashwere USAJPN prevent Kashwere from allegedly violating the same NCA by attempting to sell directly into the Japanese market.

Put another way, the issues were:

(A) Does the NCA prevent distributors – not the signatories themselves but their distributors – from selling Kashwere?
(B) If not, do the equitable obligations of good faith and fair dealing implied in Illinois contracts prevent the same?

The Decision

The Appellate Court concluded that the facts indicated Selzer was not playing fair (so licensee Kashwere LLC has a cause of action) but it is dubious whether the NCA would affect the right of distributors of USAJPN to sell the product once they bought it. In other words, the NCA could only bind the signatories, not prevent the distributors from selling the product.

The Upshot

The Opinion basically favors free commerce and reads the NCA – a document the parties hoped would prevent future litigation – narrowly. That narrow reading means that there is only the slightest wiggle room for Selzer, so licensee, Kashwere LLC, ought to obtain relief on remand (although not the draconian relief that it was seeking initially). As for Selzer and his would-be Japanese conduit USAJPN, they do not fair well in this opinion at all.

Your Turn

Want to share your thoughts on this post? Need to discuss your own situation? Call us in confidence at 630-378-2200 or reach us via e-mail at mhedayat[at]mha-law.com.

Detroit SkylineThe Announcement

Recently Steven Rhodes, the Judge tasked with managing the largest municipal Bankruptcy in American history, cleared Detroit to emerge from reorganization and put to bed a series of hard-fought battles between creditors, citizens, employees, and pension recipients. Before approving the move though, Judge Rhodes issued a heart-felt plea to all involved: “move past your anger” and “fix the Motor City. What happened in Detroit must never happen again.” He also observed that “Detroit’s inability to provide adequate municipal services… is inhumane and intolerable, and must be fixed.”

Politicians and civic leaders, including Michigan’s Republican Governor Rick Snyder, hailed Friday’s decision as a milestone and a “fresh start” for the Motor City. Indeed, it was Snyder who originally agreed with State-appointed Emergency Manager Kevyn Orr to take the City into Chapter 9: a last-resort he had promoted during his re-election campaign.

Lightning Fast Recovery

By Bankruptcy standards Detroit’s case finished in a flash thanks to a series of deals between the City and major creditors, especially retirees who agreed to smaller pension checks (after the Judge reminded them that they had no protection under the Michigan Constitution) and bond insurers who relented on their push to sell the City’s art collection despite being owed more than $1 Billion. By contrast it took more than 2 years for Stockton, California to get out of Bankruptcy, while tiny San Bernardino is still operating under Chapter 9 more than 2 years after filing.

An Innovative Plan

Detroit’s Plan of Reorganization involves cutting pensions of non-public-safety retirees by 4.5%, completely discharging $7 Billion of debt, and spending over $1.7 Billion to demolish blighted buildings and improve basic services. In particular, Judge Rhodes praised the way contentious issues in the Plan were resolved: such as the deal to avoid selling artwork from the Detroit Institute of Arts, and to keep pension cuts from getting worse. In fact, while he said the pension deal bordered on “the miraculous,” he acknowledged that the necessary cuts would cause hardship for the many who would now have to get by on less than $20,000 a year.

Ultimately Judge Rhodes had to accept or reject Detroit’s Plan in full rather than cherry-picking sections. He relied on the advice of an expert, who deemed the Plan “feasible” and predicted that its success would depend on the fiscal skills of the Mayor and City Council, as well as a City Hall technology overhall. Maybe the most unusual feature of the Plan was its reliance on $816 Million put up by the State, foundations, philanthropists, and the Institute of Arts, in order to forestall even deeper pension cuts and avert the sale of art – a step the Judge warned “would forfeit Detroit’s future.”

What Went Wrong In The First Place

In retrospect, perhaps this was inevitable. After all, Detroit’s economy was clearly at the center of a “Perfect Financial Storm” consisting of municipal corruption, fiscal mismanagement, the long, slow decline in the auto industry, and widespread urban flight that strangled the population from 1.2 Million to 688,000 by 1980, turning whole neighborhoods into boarded-up wastelands. Adding insult to injury, despite encompassing more square mileage than Manhattan, Boston, and San Francisco combined, Detroit couldn’t even count on sufficent tax revenue to cover pensions, retiree benefits like health insurance, and debt service on funds borrowed to meet its budget burden. Still, the nail in Detroit’s coffin was the horrible debt deal made by former Mayor Kwame Kilpatrick, which locked it into paying high rates on its debt even as interest rates fell during the recession

Light At The End of The Tunnel

Detroit Regional Chamber President and CEO Sandy K. Baruah declared Detroit to be “on the cusp of a new era and primed to reinvent itself in a way many people did not think possible.” True. But what really matters is that the Motor City has a new direction and a long, hard, clean-up job ahead. Sure, Bankruptcy was the catalyst for change, but only the City and its residents – businesses, individuals, religious institutions, and government – can affect real change. Here’s hoping, Detroit. We’re all pulling for you.

Your Turn

Want to share your thoughts on the largest municipal Bankruptcy in U.S. history? Need to discuss your own situation? Call us in confidence at 630-378-2200 or reach us via e-mail at mhedayat[at]mha-law.com.

Franchise Business

Many small business owners find comfort and success capitalizing on a franchise. Franchisors use Non-Compete (“NCA”) and Non-Disclosure (“NDA”) clauses as well as mandatory arbitration provisions to protect themselves. But should such a provision be effective against a non-signing spouse? That was the question before the Appellate Court in the recent 7th Circuit case of Everett vs. Paul Davis Restoration. The short answer? Yes, it is.

The Family Business

Davis Restoration entered into a Franchise Agreement with Matthew Everett, husband of Plaintiff Renee, as the “principal owner” of Franchisee EA Green Bay. Sometime after signing as the sole owner of EA, Matthew transferred 50% of the company to his wife despite not securing permission from the Franchisor beforehand. Eventually, the Franchise Agreement was terminated and the 2-year non-compete provision took effect. Matthew then transferred the remaining 45% of EA to his wife, who continued to operate it under the name “Building Werks” from the same location with the same customers and employees. Moreover, the Franchisor contended, Building Werks continued to capitalize on its good will and reputation.

Reversal of Fortune

The Franchisor reacted to the breach of its NCA by initiating arbitration with Mrs. Everett, who sought a declaratory judgment in District Court to the effect that she should not be bound by the Arbitration Clause because the Franchise Agreement was signed by her husband. The District Court, however, found “abundant evidence” that she had benefited from the Franchise Agreement and therefore could be compelled to arbitrate according its terms. This was the so-called Direct Benefits Doctrine.

Following arbitration, the Franchisor went back to Court to confirm the unanimous finding in its favor. To its great surprise, this time the District Court denied confirmation and declared that its earlier ruling had been in error. Now, the Court felt, the benefit to Renee from the Franchise Agreement had not been “direct” but “indirect” through her ownership interest in EA and relationship to her husband. As a result, she could not be compelled to accept the arbitration award.

The Doctrine of Direct Benefits Estoppel

The Franchisor appealed to the 7th Circuit, which set about deciding whether the obligation to arbitrate in such a document was limited to those who had personally signed it or could include non-signatories benefited by it. Ultimately the Appellate Court reached same basic conclusion drawn by the District Court the first time around: that the non-signing, benefited party could not escape her obligation to arbitrate because she was estopped from doing so by the Doctrine of Direct Benefits.

As the Court observed, a direct benefit is derived the subject agreement itself. An indirect benefit by contrast would be one derived from exploitation of the contractual relationship of the parties. The 7th Circuit found that Mrs. Everett received the same benefits as her husband, including the ability to trade on the name, goodwill, and reputation of the Franchisor. In fact, Mrs. Everett’s ownership in EA had only arisen because EA had been formed to satisfy the requirements of the Franchisor. In every sense, Renee had benefitted from Matthew’s relationship with the Franchisor.

The Upshot

Perhaps the primary message of this case was that those who live by the Franchise Agreement, die by the Franchise Agreement…. So to speak. If a party directly benefits from a deal, they should be made to comply with its less glorious features as well. After all, any other conclusion would end up handing franchisees a giant loophole.

Questions about your own situation? Business owner looking for answers? Call us in confidence at 630-378-2200 or reach out to us by e-mail at mhedayat[at]mha-law.com.

Gift CardIn the recent case of Beeman et. al. v. Borders Liquidating Trust et al. from the Circuit Court for the Southern District of New York decided on October 29, that Court examined what ought to happen when relief that could be granted, for practical reasons is not.

This controversial policy, referred to as “Equitable Mootness” means certain judgments will not be issued – even though they could – because doing so upsets the established order in a Bankruptcy case. It is obviously a touchy subject, but squarely within a court’s discretion.

Here, more than $17 Million had been distributed to creditors of Borders Bookstores in its Chapter 11 reorganization when 3 of its customers whose store gift cards became useless when it went bankrupt sought to be placed in a special “class” of claimants. The Plaintiffs started in the Bankruptcy Court but did not get traction there, so they proceeded in District Court.

In the Bankruptcy case below, the Court determined due to a variety of factors, including timing of the claims and the stage reached in the case, that Equitable Mootness should kick in.  The District Court agreed and clarified that the doctrine applied not only to ongoing reorganizations but to the ones, like this, that ended in liquidation – a s0-called “Liquidating 11.”

In its Opinion the District Court did point out the exceptions to the Equitable Mootness doctrine articulated in the 1993 case of Frito‐Lay v. LTV Steel(In re Chateaugay Corp.). But the Court also made it clear that this situation did not satisfy those conditions.

In the end, the decision in this case was complex, as were the legal principals, but the basic idea could be reduced to this: if you are a creditor in a Bankruptcy , act fast, be timely, and don’t let up. If you can’t do that, stay home and save yourself the Attorneys’ fees.

If you are a Creditor in a Bankruptcy case, call us in confidence at 630-378-2200 or via e-mail at mhedayat[at]mha-law.com.

Money Fight

So you’re doing business as usual and notice that payments from your customer are getting later and later. Turns out that customer is struggling to navigate in the sputtering economy. Waiting for your money is bad enough; but what if you receive a demand to refund what you’ve been paid? And not because of anything you’ve done but because your customer has filed for Bankruptcy?

Sound like a nightmare? Actually, it happens everyday. So what do you do if you’re next? That was the question addressed in the recent New York case of Davis vs. Clark-Lift, in which a reorganizing Chapter 11 Debtor paid vendors later and later as it listed towards Bankruptcy. But even those lucky creditors who got paid could not escape the demand of the Trustee (Davis) to fork over what they had received.

As the Court in Davis explained, to set aside a payment as a “Preferential Transfer” under Section 547(b) of the Bankruptcy Code the moving Creditor or Trustee must established that the Debtor made it:

(1) To an  existing creditor to satisfy an existing debt;
(2) While it was actually, or presumptively, insolvent;
(3) Within 90 days before filing its Bankruptcy case; and
(4) The payee therefore gets more than it otherwise would.

So if you got paid within 90 days before your customer filed Bankruptcy, it’s all over right?

Not exactly. Even if a payment qualifies as a Preferential Transfer the recipient can assert defenses. If successful, the payee retains the money. One of the most frequently-used strategies is the “Ordinary Course of Business” defense found in Section 547(c)(2) of the Code, which provides that a payment made in the ordinary course of business will not be avoided as a preference. The idea behind the defense is to permit a reorganizing Debtor to maintain a semi-normal relationship with some creditors: because rebuilding goodwill is key to a successful reorganization.

In the Davis case the Court’s analysis was primarily focused on what the “ordinary course of business” was; which in turn meant determining the most common and frequently-used payment terms for vendors during the relevant 90-day period. This means looking at all vendors at first; then vendors of a certain type; then payments of a certain type; and finally a comparison between terms bef0re the 90-day period began running and afterwards.

The decision in the Davis case, like many similar cases, was that the vendor had to disgorge what it was paid. What would it get in return? Perhaps a return of its goods so it could resell them and offset its losses? Nope. In return for disgorging the payment the vendor got a claim in the Debtor’s case. Most likely, it wouldn’t see the money. So now the vendor was out both its money and its property. Isn’t the law grand?

If you have seen situations like this or are yourself the subject of such a situation, call us in confidence at 630-378-2200 or reach us at mhedayat[at]mha-law.com.

House of Dollars

In LaSalle Bank N.A. vs. Cypress Creek 1, LP (Edon Construction et al.), 950 N.E.2d 1109 (2011), 242 Ill.2d 231 (Feb. 25, 2011), the Illinois Supreme Court ruled on the thorny problem of how to apportion proceeds from a foreclosure sale between the mortgagee bank and mechanics lien claimants when there weren’t enough proceeds arising from the foreclosure sale to pay both in full. In other words, who gets paid and who gets the shaft according to Sec. 16 of the Illinois Mechanics Lien Act?

Holdings

Here’s what the Court decided:

#1 Sec.16 of the Mechanics Lien Act gives lien claimants priority only as to the value of work in place (materials and labor).

#2 The Illinois S. Ct. case of Clark v. Moore, 64 Ill. 273 (1872) indicates that while the contractor is entitled to the value of unpaid work and materials used to improve the property (which would be in its Mechanics Lien), the value of paid-for work and materials should benefit the mortgage lender (mortgagee), not title holder (mortgagor) or the contractor.

#3 In dividing sale proceeds between the mortgagee and the lien claimant, Illinois Courts have used one of two analyses:

(a) Market Value approach;

(b) The Contract approach.

Courts have also used subordination rules to supplement their analysis.

Conclusion

Under the facts of this case the Court determined that the value of unpaid work in place (the liened sum) should be tendered to the Contractor, except for those improvements paid for with mortgage funds or construction loan funds, which should inure to the Mortgagee. All other sums should go to the Mortgagee as well.

Mechanics Lien or construction law question of your own? See our Construction Primer and feel free to contact us for a confidential consultation.

By Guest Blogger: Paul B. Porvaznik, Esq.

When you file for bankruptcy, you sign sworn schedules that itemize your assets.  If you fail to fully disclose or update your asset summary, you risk a creditor objecting to your discharge on the basis of fraud.  Another peril of nondisclosure concerns claims that arise after the bankruptcy filing; like future lawsuits.   So, what happens if a claim develops after you file your bankruptcy petition but before you are granted a discharge and you don’t inform the bankruptcy court of this claim?  That’s the question examined in Schoup v. Gore, 2014 IL App (4th) 130911 (4 Dist. 2014), a case that will doubtless serve as a cautionary tale for future bankruptcy petitioners.

 In Schoup the debtor filed in 2010 and obtained a discharge in 2012.  Several months into the case the debtor was injured on private property, giving rise to a premises liability claim.  The debtor didn’t tell the bankruptcy court or trustee of the premises suit until after his bankruptcy case was discharged. Indeed, after obtaining his discharge the debtor filed that claim. The property owners moved for summary judgment on the basis of judicial estoppel, arguing that the plaintiff’s failure to disclose the suit as an asset in his bankruptcy barred the post-discharge action entirely.  The trial court agreed and the plaintiff/debtor appealed.

Ruling: Summary judgment affirmed. Why? Because the judicial estoppel doctrine barred the plaintiff’s premises liability suit.  Judicial estoppel prevents a litigant from taking a position in one case and then, in a later case, taking the opposite position (i.e., you can’t claim that you’re an independent contractor in one case and then in a second case, claim that you’re an employee).  Judicial estoppel’s purpose is to protect the integrity of the court system and to prevent a party from making a mockery of court proceedings by conveniently taking whatever position happens to serve that party at a given moment.  (¶ 9).  The five elements of judicial estoppel: (1) two positions are taken by the same party; (2) the positions must be taken in judicial proceedings; (3) the positions must be taken under oath; (4) the party must have successfully maintained the first position and received a benefit from it; and (5) the two positions must be “totally inconsistent.” (¶ 10).  Illinois courts have consistently held that a debtor who fails to disclose an asset – including an unliquidated lawsuit – can’t later realize a benefit from the concealed asset after discharge.  (¶ 14).

The Court agreed with the trial court that all five elements were met.  First, the plaintiff took two positions: he impliedly represented to the bankruptcy court that he had no pending lawsuits and then filed a personal injury suit in state court after discharge.  The two positions were taken in judicial proceedings (Federal bankruptcy court and Illinois state court) and under oath (the plaintiff signed sworn disclosures in the bankruptcy court and filed a sworn complaint in state court).  The plaintiff also obtained a benefit from concealing the premises liability case as he received a discharge without any creditor knowing about the state court claim.  Finally, plaintiff’s positions were “totally inconsistent”: he omitted his personal injury case from his bankruptcy schedules and then filed a state court personal injury suit after he got his discharge. (¶¶ 17-18).

In conclusion, a party that had absolutely nothing to do with the plaintiff’s prior bankruptcy was able to get a case dismissed because the plaintiff didn’t update his asset schedules to account for an inchoate lawsuit.  The case is a great reminder to always check on-line bankruptcy records to see if a plaintiff suing your client has any prior bankruptcies.  More than once I’ve found that a plaintiff recently received a discharge before filing suit and never disclosed the lawsuit as an asset in the bankruptcy case.  In those situations, the plaintiff, not wanting to deal with a judicial estoppel motion (like the one filed by the defendants in this case), is usually motivated to settle for a reduced amount and in one case, even non-suited the case.  Viewed from the debtor’s lens, I counsel clients to fully disclose all assets – even lawsuits that haven’t materialized on the bankruptcy filing date.  Otherwise, they run the risk of having a creditor challenge the discharge or even having a future lawsuit dismissed; like the plaintiff in this case.

My other observation concerns the “sworn statement” judicial estoppel element.  What if the state court complaint wasn’t verified under oath?  Would that still meet the sworn statement criterion?  It’s unclear from the text of the opinion.  If the complaint wasn’t verified, I think I’d argue that the plaintiff didn’t take two sworn contradictory positions.

Paul Porvaznik Photo

About the Author: Paul B. Porvaznik, Esq. is a business litigation attorney practicing in Chicago at the firm of Molzahn, Rocco, Reed & Rouse, LLC, a full-service litigation firm.  He has practiced for 17 years primarily in the areas of general civil litigation, mechanics liens, landlord-tenant law, collections, post-judgment enforcement and general business disputes.

seal_of_the_supreme_court

In June 2013 the US Supreme Court published an opinion arising from a dispute over the estate of Pierce Marshall – better known as the husband of Anna Nichole Smith. That case, Stern vs. Marshall, gave rise to a surprising decision; namely, that Bankruptcy Courts could not rule on the State-law aspects of a dispute even if they were before the Bankruptcy Court as part of the larger dispute. The operative distinction would henceforth come down to whether or not a dispute qualified as a “core proceeding” (i.e. whether it was the kind of question over which the Bankruptcy Court had jurisdiction).

Since the Stern decision was released in 2011, results across the country have often been inconsistent as Bankruptcy Lawyers and Judges attempt to apply this new set of distinctions and decide whether cases should be heard or referred back to the State Courts. In many cases, Bankruptcy Courts defaulted back to State Courts without much discussion.

In an update and clarification to its Stern vs. Marshall Opinion, the Supreme Court recently decided Executive Benefits vs. Ch. 7 Trustee for Bellingham Ins. Agency(Jun. 09). The opinion answered a number of questions that had arisen in the wake of Stern. In particular, the Supreme Court clarified how Bankruptcy Courts should proceed when faced with “core” claims that were now designated as “non-core” under the Stern standard. These claims fall into the so-called “statutory gap” in the Bankruptcy Code.

In its Opinion the Supreme Court observed that 28 U.S.C. §157(c) does in fact permit “Stern” type claims to proceed before the Bankruptcy Court as non-core claims. How? The Supreme Court explained it this way:

With the “core” category no longer available for the Stern claim at issue, we look to section 157(c)(1) to determine whether the claim may be adjudicated as a non-core claim – specifically, whether it is “not a core proceeding” but is “otherwise related to a case under title 11.

In short the Supreme Court determined that, when faced with a Stern claim, the Bankruptcy Court must now decide whether it satisfies the standards of 28 U.S.C. §157(c)(1). If it doesn’t, the Bankruptcy Court could not hear the claim and had to send it back to State Court. If it did however, the the Bankruptcy Court was to “hear the proceeding and submit proposed findings of fact and conclusions of law to the district court for de novo review and entry of judgment.”

Chapter 13 Bankruptcy

[T]here are known knowns… known unknowns … and unknown unknowns… things we do not know we don’t know.—US Secretary of Defense Donald Rumsfeld

When it comes to Bankruptcy, many Debtors don’t know what they don’t know about real estate taxes. Confused? So were the District Courts until the 7th Circuit Court of Appeals addressed the issue in the case of In re LaMont, Opinion 13-1187 (January 7, 2014).

The 7th Circuit began its analysis in LaMont by acknowledging the 2 kinds of real estate taxes with which Debtors must deal:

(a) Sold; and (b) Unsold.

The 2 are treated differently under State law and receive distinct treatment in a Plan of Reorganization as well:

Unsold taxes can be paid through the Plan in the same way that a Debtor would pay arrears to a secured creditor like a mortgage company. The rationale for such treatment is that the taxing body – the County – is presumed to have a secured lien in the subject property for its taxes. Moreover, those axes cannot be sold once a Bankruptcy Petition is filed. Such taxes generally get paid directly to the County Treasurer via the Plan.

Sold taxes are trickier. They can be paid through the Plan like unsolid taxes, but only so long as the “redemption period” has not expired. Even if the redemption period expires during the Plan, sold taxes can still be paid over the rest of the Plan period. And while that is taking place, the Automatic Stay will remain in effect to prevent Tax Buyers from redeeming the sold taxes or forcing a sale of the underlying property (the typical State law remedy).

In LaMont the issue was sold taxes. The LaMont Debtors owed real property in Minooka, Illinois on which the Village had levied a special assessment that they hadn’t paid. The Court noted that in this context a special assessment was deemed a property tax. Thus, the unpaid assessments were disposed of at a tax sale. Shortly afterwards the Debtors filed Chapter 13 and their Plan provided for payment of the assessment directly to the Village. However, the Plan did not identify. nor did notice go out to, the tax buyer. Nonetheless, the Plan was confirmed and the Debtors made payments to the Trustee who distributed them to the creditors including the Village.

But was the tax buyer bound by the terms of the confirmed Plan even though he had not been notified? In answering the questions the Court conducted a thorough analysis of the Illinois property tax system including tax sales and redemption periods – treating the sold special assessments the way they would sold property taxes.

The upshot of the analysis was that for the entirety of the redemption period – usually 2 to 2 ½ years, – a property owner could redeem his or her sold taxes by paying the County Clerk the past due amount, plus penalties and interest. Between 3 and 6 months before the expiration of the redemption period, a tax buyer had to file a Petition for Tax Deed with the Circuit Court, then take the resulting Order to the County Clerk to secure a Tax Deed, which then had to be recorded within a year. If those steps were not followed the tax buyer would lose his interest in the subject property. That is time enough for the property owners to act, but here the time period was tolled because of the Bankruptcy. Still, the Debtors neither identified the proper party to pay nor made adjustments to their Plan of Reorganization.

The LaMont the tax buyer filed his Petition for Tax Deed with the Circuit Court 3 years after the Debtors filed Bankruptcy and the Circuit Court denied it. The tax buyer then filed a Lift Stay Motion in the Bankruptcy Court, which denied the Motion because he was ostensibly being taken care of in the Plan. The tax buyer appealed, arguing that the Stay should not apply since he was not given notice of the case. But the District Court affirmed the Bankruptcy Court.

The tax buyer had also argued that his interest was in the real property, so it was not an interest against the Debtors. In other words he argued that his interest automatically divested the Debtors of their interest in the property after the redemption period expired. In response the 7th Circuit first examined whether or not the tax buyer had a claim, concluding that he did even though there wasn’t a traditional creditor-debtor relationship present. Nonetheless, the Court found that the tax buyer did not have an executory interest in the property itself: he merely had a tax lien on the property.

In reaching its decision the LaMont Court reviewed Illinois case law in concluding that, while there were differences, precedent favored the treatment of sold taxes as a lien. Since the tax buyer’s claim was deemed to be a lien, it could be modified under Section 1322(b)(2) of the Bankruptcy Code and the Debtors could force him to take payments even past the redemption date as long as the Plan was in effect.

In short, sold taxes can be addressed in a Plan of Reorganization but notice should be given to the payee or the Debtors risk paying into their Plan for 5 years only to end up with no credit towards their sold property taxes – and in the end stand to lose their home. Sad but true.

Battle Royale

A Little Light Reading

Are you excited to read about a dispute between competing secured creditors for the priority of their liens in property of the Bankruptcy Estate? Of course not.

Lucky for you issues such as these are generally heard in State court rather than in Federal Bankruptcy courts. Why? Because real property is considered a unique feature of the state and county in which it is located. Local features get local treatment.

But priority disputes can, and do, get played out in Bankruptcy court. For example take the case of In re Jones, 2011 WL 6140686 (Bankr. SD IL 2011) in which Debtors in a Chapter 11 case owned several pieces of property encumbered with mortgages cross-collateralized with other property of the Estate.

1st mortgage on Property #1 was taken by Bank #1, cross-collateralized, and provided that the maximum secured liability under its terms was approximately $214,000.

2nd mortgage on Property #1 was taken by Bank #2.

Both mortgages were timely recorded and Bank #2 did not contest its priority status. But then something happened.

1st mortgage on Property #2 was taken by Bank #1 and cross-collateralized with its mortgage on Property #1.

Since the interest of Bank #2 was not yet recorded when the additional loan from Bank #1 was taken, Bank #2 found itself in a tentative position.

Got all that? Because here is where it gets interesting…

As part of their reorganization, the Debtors sought lave to sell, and the Court agreed to permit the sale of, Property #1.  But by that time the Great Recession was in effect. Property #1 was not worth nearly what it had been when the loan was taken. In fact, it looked as if a sale of the property would not even generate enough to pay off all the lenders.

That’s when the fighting started.

Eventually Property #1 sold for $388,000. At that time Bank #1 was owed $115,000 under the terms of its 1st mortgage, plus more than $300,000 under the loan against Property #2. Bank #2 looked to be owed more than $300,000. But it was Bank #1 that sought all sale proceeds; so when Bank #2 objected, the battle was on!

Come Out Swinging

At the core of In re Jones was the distinction between 2 equally accepted concepts found in Illinois law:

  • Actual Notice; and
  • Record (“Inquiry”) Notice

There was no denying that Bank #1 and Bank #2 had actual notice of  claims on Property #1. Nor could it be denied that Bank #2 did not know of Bank #1’s claim on the 2nd Property until it was too late.

Rather, the question was whether Bank #2 should have known of the cross-collateralization clause and investigated further. In its opinion the Court noted that the cross-collateralization clause was on the first page of the mortgage document so even a cursory review of the title records would have revealed it. The Court also went through an analysis of Illinois case law and the recording statute in reaching its decision.

The opinion in Jones explains record notice: if a mortgage is properly recorded, then actual knowledge is no longer important. The burden of due diligence shifts to subsequent lenders who can, and should, search public records. The Court explains inquiry notice in a similar way. Where a lender has been made aware of facts or circumstances that lead it to believe there could be other liens on a property, that lender has a duty to perform a diligent inquiry.

The Decision and Appeal

Here, the Court found Bank #2 knew about the senior mortgage and cross-collateralization – the language was on the front page of the mortgage document, which was sufficient to put Bank #2 on inquiry notice that its borrower might have additional loans that could trigger the cross-collateralization. Finally, since Property #2 was in the same county as Property #1, the loan could easily have been discovered.

On appeal, the 7th Circuit affirmed the Bankruptcy Court and found for Bank #1.

There are many instances where priority fights occur in bankruptcies. Cross-collateralization is a frequent case, but refinancing can also trigger such clauses. Generally, the lender who refinances will get a formal subrogation agreement to eliminate a potential priority fight, but even if it doesn’t, equitable subordination will allow it to keep its priority intact.  

Questions about your own situation? Contact us for a no-cost consultation.