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Unwinding Fraudulent Transfers and the Diligent Creditor Rule
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Unwinding Fraudulent Transfers and the Diligent Creditor Rule

January 4, 2016 Banking & Financial Services Industry Legal Blog

Reading Time: 5 minutes

Quite often a creditor discovers that one of its debtors has avoided satisfying a liability by fraudulently transferring assets to another individual or entity.  This is a frustrating discovery, but the creditor is not without remedies.  Under Florida Statutes fraudulent transfers can be attacked and unwound through two methods.  The popular method is filing a lawsuit to include a statutory cause of action to invalidate the fraudulent transfer under Chapter 726, Florida Statutes.  A lesser used approach is through a post-judgment procedure known as proceedings supplementary under Section 56.29, Florida Statutes.  This blog post discusses these two differing approaches for unwinding fraudulent transfers, when proceedings supplementary is the preferable approach, and a related doctrine of Florida common law known as the Diligent Creditor Rule.

It is first important to understand what constitutes a fraudulent transfer.  It is (1) where a debtor transfers an asset with actual intent to hinder, delay, or defraud any creditor of the debtor, and/or (2) when a debtor does not receive a reasonably equivalent value in exchange for a transferred asset where a creditor has a valid claim against that debtor.  Fla. Stat. § 726.105.  Additionally, a creditor must understand the priority of its claim against its debtor according to Florida law.  The general rule is that between two or more creditors, the creditor priority is established by the timing of recordation of each respective judgment in the county records or with the Florida Secretary of State.  This is known as “first-in-time, first-in-right.”  For example, if two creditors record judgments against a debtor in 2014, and another creditor records its judgment in 2015, the creditor with the 2015 judgment is third in line in making a claim against the debtor’s assets.

Chapter 726, Florida Statutes, allows a creditor to sue a debtor under a fraudulent transfer cause of action and obtain the judicial remedy of unwinding that fraudulent transfer.  Alternatively, proceedings supplementary is a post-judgment tool for assisting a creditor who has already obtained a money judgment against its debtor.  Proceedings supplementary is a continuation of the original lawsuit by utilizing a procedural mechanism that provides the judgment creditor with a means for investigating the assets of a judgment debtor.  In re Hill, 332 B.R. 835 (Bankr. M.D. Fla. 2005).  Both real and personal property may be the subject of the proceedings, including property located outside Florida.  See Florida Guaranteed Securities v. McAllister, 47 F.2d 762 (S.D. Fla. 1931).  The proceedings are begun by the judgment creditor filing a motion and affidavit regarding the unsatisfied judgment and purpose of the proceeding, such as evidence that a fraudulent transfer has taken place. A hearing is then set before the judge to examine the debtor or any third parties in possession of the debtor’s property.

While both approaches allow for a fraudulent transfer to be unwound, there could be vast differences in the ultimate outcome for the creditor depending upon the approach used and the debtor’s asset in question.  In certain instances, it is preferable for a creditor to first obtain a money judgment against its debtor and then attempt to unwind any known fraudulent transfers via proceedings supplementary as the general rules of creditor priority may be avoided through this approach.  This is because of a doctrine of law known as the Diligent Creditor Rule.

The Diligent Creditor Rule applies to proceedings supplementary hearings for unwinding fraudulent transfers and applying those assets to the satisfaction of the judgment debt.  “The diligent creditor who discovers and brings into equity the assets of a debtor is ordinarily entitled priority over all other creditors, including the full claim for costs and expenses of the suit.”  Salina Mfg. Co. v. Diner’s Club, Inc., 382 So.2d 1309, 1311 (Fla. 3d DCA 1980).  Said another way, “A judgment creditor which, through supplemental proceedings, is responsible for subjecting property of a common debtor to execution has priority in the satisfaction of its judgment from that levy, even over another judgment creditor which had first delivered its writ of execution to the sheriff.”  Id.

To illustrate, if a debtor has three judgments against him, any new judgment-creditor would be fourth in line when it comes to using the debtor’s assets to satisfy the judgment.  But if that fourth judgment-creditor obtains a money judgment against the debtor and then uses proceedings supplementary to unwind a fraudulent transfer, that fourth judgment-creditor now trumps the prior three judgment-creditors concerning that unwound asset and can use it to satisfy its judgment regardless of there being three priority creditors.

Conversely, when fraudulently transferred property is unwound pursuant to a separate cause of action under Chapter 726, Florida Statutes, the property reverts back to the debtor.  In re Romano, 51 B.R. 813, 814 (Bankr. M.D. Fla. 1985).  After that property is unwound back to the debtor, it then becomes subject to the debtor’s existing judgment creditors based on judgment priority.  Id.  The Diligent Creditor Rule does not apply.  In the example used above, if the fourth creditor files a lawsuit to unwind the fraudulently transferred property under Chapter 726, Florida Statutes, the property, after unwound, must be used to satisfy the prior three judgment-creditors.  See Fla. Stat. §§ 726.102(2)(a) & (15).  If the property’s value is not enough to satisfy those three prior judgments then the fourth creditor just wasted its time and money in filing a separate lawsuit to unwind that asset.

One caveat is the Diligent Creditor Rule only applies to judgment execution on personal property, not real property.  So it can apply to a judgment creditor seeking to satisfy its judgment against a debtor’s vehicles, machinery equipment, jewelry, etc., but not against a debtor’s real property.  In conclusion, if your debtor has transferred personal property assets fraudulently and has prior recorded judgments, you may be better off not bringing a statutory cause of action under Chapter 726, Florida Statutes, to unwind that fraudulent transfer, but rather first getting a money judgment against that debtor and then unwinding the fraudulent transfer via proceedings supplementary so that the Diligent Creditor Rule may apply.

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