Not every loan proceeds as planned. When borrowers default, understanding available legal options can mean the difference between recovery and writing off substantial losses.
Strategic Foreclosure Planning: A Foundation for Successful Recovery
Upon default, the initial instinct may be to rush to foreclose. However, taking time to evaluate certain factors at the outset can prevent complications and maximize recovery potential.
Factors to evaluate include:
Thorough Collateral Assessment
The distinction between real property, personal property, or a mix of the two fundamentally affects the foreclosure approach. Real property requires filing a foreclosure proceeding in the county where the property is located, and involves in rem relief only (affecting only the property itself).
On the other hand, when pursuing personal property, there may be more flexibility in venue selection and the ability to pursue in personam relief (affecting the individual in possession) through a judgment. Also consider whether the situation involves easily movable assets, such as vehicles that can be quickly repossessed (or concealed by a debtor), or specialized equipment that requires more complex recovery procedures.
In some cases, creditors may have access to prejudgment remedies that allow for the immediate seizure of collateral through a court order, thereby preventing debtors from hiding or moving assets during collection proceedings.
The Nature of the Underlying Debt
Commercial debts are often governed by less restrictive laws and have fewer procedural hurdles to navigate than consumer debts, with restrictions varying considerably between categories. Creditors will need to be careful about how they proceed in any given situation, depending on how the debt and borrower are classified.
Collateral Location Considerations
Where collateral is situated can affect recovery strategy due to legal requirements and practical considerations. When personal property is spread across multiple locations, it may require coordinated efforts across different jurisdictions. On the other hand, real property that straddles county lines can require additional efforts to ensure notice requirements are met and a clean title passes at foreclosure.
Lien Perfection
The importance of ensuring security interests are properly perfected cannot be overstated. Nothing derails collection efforts faster than discovering halfway through the process that title problems or inadequate documentation exist.
It is essential to verify that all signatures are authentic, that collateral descriptions between security instruments and UCC filings match, and that all documents were filed and recorded properly. This due diligence becomes even more crucial if borrowers file for bankruptcy, as trustees can jump ahead of improperly secured liens.
The Strategic Advantage of Simultaneous Actions
Another effective collection strategy involves filing a foreclosure proceeding while simultaneously initiating a lawsuit to obtain a money judgment for the anticipated deficiency balance. While this approach requires greater upfront investment, it offers compelling advantages that may justify the additional cost.
The additional pressure placed on the borrower alone can prove decisive. A borrower who may be inclined to ignore a foreclosure action suddenly faces two legal proceedings, each with its own set of legal fees and defensive considerations. This dual pressure can sometimes accelerate a resolution to help avoid ever-increasing legal costs and expenses.
From a practical standpoint, simultaneous actions can also help avoid service problems that may arise later. If a creditor completes a foreclosure and then attempts to serve the borrower with a new deficiency lawsuit months later, the borrower may have become wise to the creditor's collection efforts and try to actively evade service. By addressing both actions simultaneously, this cat-and-mouse game is eliminated.
Simultaneous actions can also help sidestep certain common defenses. For example, North Carolina's "offset defense" allows borrowers to reduce deficiency judgment awards if the property's fair market value equaled the debt on the day of foreclosure, or if the foreclosure sale yielded an amount substantially below true value. However, that defense only applies to post-foreclosure deficiency actions, meaning that it is unavailable in those actions filed prior to a foreclosure sale.
Recovering Fraudulent Transfers and the Importance of Asset Monitoring
Even the most carefully structured loan can become uncollectible if the borrower or guarantor transfers assets beyond the reach of the lender. The lender who understands the law of voidable transactions (sometimes called fraudulent transfers) can have powerful legal tools at their disposal to recover assets that debtors have attempted to hide.
North Carolina's version of the Uniform Voidable Transactions Act ("UVTA") covers three main categories of problematic transfers. While this article mainly covers "transfers" of assets and uses that terminology, the UVTA also covers voidable "obligations" – such as the granting of a mortgage or lien – where the transaction in question had the same kind of fraudulent intent or impact on the creditor.
The first category of transactions under the UVTA involves transfers made with actual fraudulent intent – i.e., the intent to hinder, delay, or defraud creditors. This classic scenario occurs when a debtor, facing default and fearing a money judgment, transfers assets to family members or other third parties to remove them from the reach of creditors.
Proving actual fraud typically requires circumstantial evidence since debtors rarely admit to having fraudulent intent. Courts examine a debtor's intent by looking for "badges of fraud"—fact patterns commonly seen in fraudulent transfer cases. These may include, for example, transfers to close relatives or other insiders, debtors retaining possession or control of the assets supposedly transferred, inadequate consideration received for the assets transferred, threatened litigation against the debtor around the time of transfer, and attempts to conceal the transfer.
The second category of voidable transactions covered by the UVTA is constructively fraudulent transfers, where a debtor may not have intended fraud, but the transfer nonetheless has the same harmful effect on creditors. This category may involve transfers for less than reasonably equivalent value at a time when a debtor was engaged or was about to engage in a business or transaction for which their remaining assets are unreasonably small, or when they intended to incur or believed they would incur debts beyond their ability to pay. Perhaps an even more common variation involves transfers without reasonably equivalent value at a time when the debtor was already insolvent or became insolvent as a result of the transfer.
The third category of voidable transactions addressed by the UVTA involves preferential transfers to insiders, situations where insolvent debtors pay legitimate debts to family members or other closely related parties instead of using those assets to pay unrelated creditors. The UVTA recognizes this as unfairly preferring these insiders if they had reasonable cause to believe the debtor was insolvent at the time of the transfer.
The UVTA contains various remedies for a creditor who has been harmed by a debtor's voidable transaction. Such remedies include, among other things, obtaining a judgment that avoids the transfer to the extent necessary to pay the creditor's claim, an order attaching the asset transferred and enjoining the transferee from disposing of the asset, the appointment of a receiver over the asset, or the ability to enforce a judgment against the debtor against the transferred asset or its proceeds.
Critically, a creditor must bring a voidable transaction claim within the time periods prescribed by the UVTA. For preferential transfers, the deadline to file a claim is only one year from the date of the transfer. For other types of voidable transactions, the deadline is not later than four years after the transfer was made or the obligation was incurred. For claims based on actual fraud, there is a "savings clause" that allows a claim to be brought later than four years as long as it is brought within one year of when the transaction was or could reasonably have been discovered by the creditor.
Finally, the one-year statute of limitations for deficiency actions creates another compelling reason for simultaneous filing. Time moves quickly after foreclosure sales, especially when factoring in REO processes, cleaning and preparing the property for sale, resolving any tenant or title issues, and finally, marketing and selling the property. That one-year deadline can seem to approach faster than expected, but simultaneous filing eliminates this concern entirely.
The case of KB Aircraft Acquisition, LLC vs. Berry, et al. provides North Carolina creditors with a crucial lesson about the limitations of the UVTA's one-year savings clause and the need to effectively monitor a debtor's assets.
In this case, the purchaser of a loan brought a claim to set aside the loan guarantor's transfer of a $4 million vacation home to a related LLC. The loan purchaser had obtained a $10.5 million judgment against the guarantor before discovering that he had transferred the home to the LLC five years earlier. The transfer occurred after the loan was in default, with no consideration paid to the guarantor, creating strong grounds for a fraudulent transfer claim. But the creditor still lost the case because the claim was untimely.
The court held that a careful examination of the guarantor's personal financial statements, which the original lender had periodically collected from the guarantor during the life of the loan, would have revealed the transfer shortly after it was made. The loan purchaser failed to act within the four-year limitations period and was not entitled to receive the benefit of the one-year savings clause because their predecessor-in-interest (the original lender) reasonably could have discovered the transfer years earlier.
This case highlights why lenders who collect personal financial statements and other financial information during the life of the loan should actually review and compare the documents, year over year, to determine whether an obligor is inappropriately transferring assets or incurring inappropriate obligations that may render the lender insecure. If so, the lender should seek legal advice about enforcing its rights under the loan documents and the UVTA. Otherwise, the lender's right to challenge a voidable transaction may be lost.
Piercing the Corporate Veil: Reaching Beyond Business Entity Shields
Oftentimes, borrowers will take advantage of the corporate structure to help shield themselves from personal liability or insulate certain valuable assets. However, when those individuals ignore corporate formalities or commingle assets, piercing the corporate veil may be a viable recovery option. In general, piercing the corporate veil allows creditors to ignore the separate legal identity of a business, to be able to hold the owner personally liable for the business debts.
When considering whether piercing the veil is an available remedy, North Carolina follows the instrumentality rule, which examines three key factors: dominion and control so complete that entities have no separate business mind or will; using the business to commit a fraud, wrong or other injustice; and actual harm caused by such dominion and control. While no single factor guarantees success, courts generally look for fact patterns implicating these factors when considering whether an entity is merely an alter ego of its owner rather than a legitimate separate business.
Warning signs include inadequate capitalization, ignoring corporate formalities like annual reports or required meetings, complete domination and control by a single owner, commingling of personal and corporate funds and assets, fraudulent misrepresentations, and excessive fragmentation of what should be a single enterprise into multiple entities designed to separate the business's assets from its liabilities.
The commingling of personal and corporate funds often provides the clearest and most convincing evidence that veil piercing may be appropriate (although it is not altogether determinative). When business owners use corporate accounts as their own—buying personal vehicles, paying personal expenses, or treating business funds as their own—they destroy the separate identity that justifies the corporate protection.
Veil piercing claims can be expensive to pursue (largely because they typically require a jury trial) and the outcome is usually uncertain. Substantial discovery is required to gather evidence to support the claim, which may include depositions of corporate officers, and the forensic analysis of corporate records that are often disorganized. Success depends heavily on judicial interpretation of whether the evidence is sufficient to meet the burden of proof. A creditor considering a veil piercing claim should carefully consider the associated burdens, costs, and risks, while also understanding that it may be the only available option when dealing with judgment-proof debtors who structured their affairs to improperly shield assets that should have been available to address corporate liabilities.
Building Comprehensive Collection Strategies
Successful collections require more than just good loan documentation—they demand strategic thinking about potential problems before they arise. By understanding collateral positions, timing legal actions strategically, monitoring debtor assets for suspicious transfers, and recognizing when business entities are being misused, creditors can position themselves to maximize recovery even when borrowers default.
Every situation presents unique circumstances, and these collection strategies should always be developed and implemented with guidance from experienced legal counsel who can assess specific facts of the case and help navigate the complexities of creditors' rights law. Investing in a comprehensive and correct legal strategy at the outset often proves far more cost-effective than attempting to remedy problems after they have fully developed.
