State Debtor-Creditor Laws - Module 2 of 5

Module 2 State Debtor-Creditor Laws

Although there are several federal debtor-creditor statutes, which we will discuss in the next module, the majority of law in this area is litigated on the state and local level. In this module, we will cover some of the most important aspects of state debtor-creditor law.

Equitable Liens

A lien is a creditor’s security interest in the property of a debtor for the satisfaction of a debt or duty that arises under the law.[1] State laws allow the creation of several different kinds of liens on property. Liens can be voluntary or involuntary. Voluntary liens are by the agreement of the parties, are usually in writing, and act as security interests in property, such as real estate mortgages. Involuntary liens are placed upon property without the consent of the property owner. These can be equitable liens or government liens or other liens such as judgment liens. 

This module will cover some of the kinds of liens that occur in daily business and personal transactions, including equitable liens.  

A lien creates a security interest, which means that the lienholder (creditor) may be able to bring a legal action to enforce the lien against the property secured by the lien. This action is usually called a “foreclosure” or “repossession.” In the case of a written agreement, the possibility of foreclosure may be part of the contract.

Equitable liens can create debtor-creditor relationships by operation of law even if the parties never agreed to the relationship. An equitable lien is placed on property to prevent unjust enrichment of one party. Equitable liens are created when there is “no adequate remedy at law”[2] for a breach of contract or other harm, which usually means a money judgment is impractical or impossible.  

Equitable liens have been established by centuries of common law decisions. They can be created by courts as a result of certain kinds of litigation. They can be used in the same way as a foreclosure action or any lien or other money judgment. They can exist without the need for the debtor to have possession of the property.[3]

The lien can be created and enforced under one of two theories in equity: equitable estoppel or unjust enrichment.[4] Each have different pleading requirements. The burden of proof is on the plaintiff seeking to establish the lien.[5]  

Equitable estoppel is a defensive doctrine and equitable solution connected to fraud.[6] Equitable estoppel is an action that a judge can take to terminate, or “estop,” an agreement or other action that was based in fraud. Litigation seeking equitable estoppel requires proof of fraud. For example, where a contractor promises a subcontractor that there will be funds available to cover a subcontractor’s work, and the promise turns out to be false, the subcontractor may seek a lien in the construction materials or property as an equitable remedy, even if such lien is not provided by their agreement.[7]

Unjust enrichment[8] requires proof that the defendant received something of value from the plaintiff and the plaintiff was not fairly compensated for the value provided. Going back to the construction example, imagine that the subcontractor, by agreement, was only to get paid after having completed the installation of all the plumbing in a new construction. Assume the subcontractor goes out of business and is forced to abandon the project with 80% of the work completed. The contractor gets to hire a new subcontractor to complete the work. Although the first subcontractor is not entitled to any payment under the agreement, it would be fundamentally unfair to allow the contractor to enjoy the windfall of the free work by the subcontractor without providing any compensation. This would be a classic scenario where unjust enrichment may be applied by the court.[9]

States often impose statutes of limitations on equitable lien actions.[10] A successful action can have the property in question sold and the proceeds distributed to the plaintiff, or have the property returned. 

Equitable principles dictate that if a property sale is agreed on, the law creates an enforceable right to the property even if the contract itself is defective in some way.[11] A common example is when a mortgage document is somehow defective. Maybe the interest rate is wrong or there is a typo in the legal description of the property or a party in interest, such as a spouse, is not listed. An equitable lien may be imposed by a court so that the parties are held to the agreement that they intended, rather than by the faulty language.

Other Types of Liens

There are many other kinds of liens that arise out of contracts or other actions of parties, even absent an agreement.  

Mechanics' liens create liens on property in favor of workers who were hired to repair or otherwise work on them. In most cases, these mechanics' liens are in writing as part of the work agreement and enforceable as such in a contract action. [12]  However, handymen sometimes perform jobs without a formal contract or without a contract that has mechanics lien language. These workers are granted mechanics liens in equity.

Mechanics' liens are also sometimes called construction liens, laborer’s liens, artisan’s liens, materialmen’s liens, garage keeper’s liens or supplier’s liens. As the name implies, mechanics liens apply to automobile mechanics, construction workers and anyone who provides a physical service in the building or repair of real or personal property.  

Mechanics liens are often given preference over other liens on the same property.  This means that they are paid before other liens when the property is sold or foreclosed on. In practical terms, that means that when the property is sold, the holder of the mechanics lien has a check cut to him before anyone else gets paid. Note, though, that some state statutes require the filing of a mechanics lien with the county for it to be effective.[13]

Governments, state and federal, are the largest lienholders in the country.[14] If a debt to the government is secured, the government has the same rights as any other secured creditor. If unsecured, as in the case of taxes, the government has the same rights as any other general creditor. However, state and federal statutes grant governments certain preferences in the collection of their debts.

For example, the Internal Revenue Code provides for the creation and enforcement of a lien against the property of a party that owes taxes under certain circumstances[15] In addition, debts owed to the federal government by insolvent debtors are statutorily entitled to a limited priority over other liens.[16] Where the IRS assesses a tax bill, demands payment of the taxes owed and the taxpayer does not pay,  the IRS can place a lien on all property, real estate, wages or any other assets of the debtor and seize and sell them.[17] States also have similar powers to create tax liens.

A judgment lien is placed upon the property of a litigant who has lost a court case and has had the judgment entered into the record. We will discuss judgment liens in later modules.

A constructive trust is not a lien or an actual trust but is a court-created equity solution.[18] It puts a defendant who unlawfully holds the property of another in the position of a trustee for that property. A constructive trust can be imposed when a defendant breaches its fiduciary duty, interferes with ownership of property or realizes unjust enrichment. The device enables courts to transfer the property to the appropriate party.

Fraudulent Conveyances

Laws against fraudulent transfers date from 1570 and are a part of the common and statutory law in every state. A “fraudulent transfer” or “fraudulent conveyance” is “a conveyance of property made for the purpose of rendering the property unavailable for satisfaction of a debt or otherwise hindering or defeating the rights of creditors.”[19] In debtor-creditor law, a fraudulent conveyance is a transfer of ownership rights in property that is made in return for inadequate consideration by one who is either:

1) insolvent or who is rendered insolvent, undercapitalized or unable to pay his debts as a result of the conveyance; or

2) that is made with the intent of hindering, delaying, or defrauding creditors.

Fraudulent conveyances are voidable, which means that the parties who are negatively affected by the fraud can void the contract.[20] In most states, fraudulent conveyances can give rise to civil actions and in some states, there are criminal penalties. Some notable uses of fraudulent transfer actions have been actions against Ponzi scheme operators like Bernie Madoff, to recover property given away before the scheme’s collapse, for the benefit of the victims of the scheme.[21]

While people don’t generally admit to transferring property with the intent to defraud creditors, the common law over the years developed ways to determine if a transfer is fraudulent. These are the “badges of fraud”—circumstantial actions on the part of the donor that indicate that the transfer may have been fraudulent.[22] Common badges of fraud include voluntary intra-family transfers, transfers made for less than full consideration and transfers made shortly before litigation is brought. Payment of one creditor that renders the person unable to pay other creditors is not considered fraudulent, but may be set aside as a “preference,” depending on the circumstances.

Where actual fraudulent intent cannot be proven, transfers made with badges of fraud may be set aside as “constructive” fraudulent conveyances.[23]  

Because of the uncertainty that varieties of fraudulent transfer law could create, the National Conference of Commissioners on Uniform State Laws has written three proposed state codes to deal with them: the Uniform Fraudulent Conveyances Act in 1919; the Uniform Fraudulent Transfer Act in 1984; and the more recent Uniform Voidable Transactions Act in 2014.[24] While these uniform acts are not mandatory and are not laws in and of themselves, most states have adopted some form of these laws[25].  

Regardless of which version has been adopted by an individual state, all these statutes have some things in common. They give courts the power to render any fraudulent transfer voidable as a result of a lawsuit against the transferor. They can amend, usurp, modify or run parallel with common law.

For example, all state statutes have codified the concept of “badges of fraud” in some way. These badges may include “insider” transfers, transfers with retained of control of the property, secret transfers, transfers during pending litigation and concealed assets.

Insolvency is both a condition that can be used to infer that a transfer is fraudulent and is a condition that may trigger certain statutory assumptions that transfers are fraudulent. An insolvent debtor is one who owes more money than can be paid by liquidating all the debtor’s property.  

Insolvent debtors also have certain rights under state statutes that can be used to save ownership of property. For instance, some states allow debtors the rights to keep various personal and real property from attachment. Other states allow “homestead” exemptions, which allow debtors to keep primary residences.

A transfer that deliberately creates insolvency so that the debtor can take advantage of state exemption laws can be considered fraudulent. One example would be a large gift to a relative that reduces the assets of the debtor to an insolvent level.

The remedy for a fraudulent transfer under these state statutes is typically cancellation of the transfer and the reintegration of the property into the debtor’s estate, from which it can be sold or transferred to a creditor. Note that only present creditors have remedies under these statutes, while potential or future creditors do not. Still, if the actions that give rise to a debt (such as a car accident) have already occurred, the potential plaintiff is considered a current creditor, even if the lawsuit has not yet been filed.

Leases

State laws regarding leases, including leases of apartments, automobiles, smartphones, etc., include aspects that fit into debtor-creditor relations. A lease is a contract by which one conveys real or personal property to another for a specific, limited time and for a specified rent[26] or other compensation. A lease can create a debtor-creditor relationship wherein the debtor is called the lessee and the creditor is called the lessor or the lease holder. Leases are covered by state law, though some federal laws like bankruptcy or tax lien law have rules for leases. Leases of personal property are covered by Article 2A of the Uniform Commercial Code.

Leases are comparable in many ways to secured transactions. In fact, determining whether an agreement is a lease or a security agreement may sometimes be difficult.[27] The primary difference between a lease and a secured transaction is that in a lease the creditor (lessor) retains ownership and title of the property and gives possession to the lessee, whereas in a secured transaction, such as a real estate mortgage, the debtor receives ownership, not just possession. Moreover, if the payments can be made at once, clearing the lien, it is likely a secured transaction. If the amount cannot be prepaid and must eventually be returned to the creditor, it is likely a lease.[28]  

For instance, in many leases for goods, like automobiles or office equipment, the total amount financed is expressed as a lump sum, and the monthly rate is expressed as a percentage of that total amount (the total amount divided by the number of months in the lease). If the customer can prepay the amount and keep the item, it’s a secured transaction. If the payments must remain monthly and the item goes back to the dealer eventually, it’s probably a lease.

State residential landlord-tenant laws also include elements of debtor-creditor relations, including financial protections for both parties. For example, if lease payments are not made, one possible remedy for a landlord is eviction of the tenant. After the eviction, the tenant may still owe the landlord money under the lease. This debt can be enforced under law, but many states require the debt action to be litigated separately from and after the eviction.[29]

A constructive eviction takes place when the tenant leaves the property because of something the landlord did.[30] For instance, all leases come with an implied right of “quiet enjoyment.” If the landlord harasses the tenant by, for example, regularly entering the residence unannounced, the tenant can leave and potentially not owe the landlord any more money. A court may need to look at the whole picture to determine the fairest remedy in each case.

The tenant commits abandonment by leaving the property without a legal reason. In that case, the debt amount owed is the total remaining lease payments plus any other damages allowed by law.

In our next module, we will look at federal laws and regulations that affect debtors and creditors.