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Restraining notices.

2. Secured Creditors as Garnishees

When CPLR section 5222(b)'s fourth sentence refers to transferring the debtor's "property," it is using the crude totemistic notion of property, not the sophisticated Hohfeldian usage that philosophy prefers. Property is a thing, such as a lawn mower or a caveman's shillelagh. Property is not the debtor's interest in a thing, as the eggheads insist.

This causes headaches for senior secured creditors with perfected security interests in collateral they have repossessed. This is because the creditor in possession is, basically, a bailee--a person in rightful possession of property of another. (315) A foreclosure sale under Article 9 constitutes the transfer of the debtor's property interest to a buyer. (316) Any such transfer violates the restraining notice served upon the foreclosing secured party. (317) This is so whether the debtor equity is valuable or not. (318)

This is certainly odd. On the one hand, a senior secured party can prevent the sheriff from selling collateral at an execution sale; the sheriff is even guilty of conversion if the sheriff continues an execution sale over the protest of the secured party. (319) Yet an unsecured creditor with no lien at all can stop the senior secured party from foreclosing, simply by serving a restraining notice. (320) To proceed, the secured party needs to procure a court order permitting the alienation of the debtor's property. (321) According to CPLR section 5222(b) (fourth sentence), alienation of the judgment debtor's property interest is forbidden "except upon direction of the sheriff or pursuant to an order of the court." (322)

Could a secured creditor consult a sheriff and obtain immunity from the restraining notice? It is may seem strange that the sheriff has authority to negate the effect of the restraining notice, but, in the context of a garnishee who is a senior secured party, the matter makes sense. If the sheriff perceives that the garnishee has a perfected security interest to which any possible judicial lien is junior, the sheriff can say so and permit the foreclosure sale to proceed. Where the security interest is senior, the secured party's possessory right is better than any possessory right of the sheriff pursuant to judicial process. The sheriff should be competent to vacate the restraining notice if it serves no purpose in preserving the status quo in anticipation of a later execution sale. It may be observed, that, historically, sheriffs were presiding judges. (323) So this part of section 5222(b) restores to the shrievalty some fragment of its medieval glory.

If the sheriff is unwilling to authorize the foreclosure sale, then a secured party must proceed under CPLR section 5240, which invites the court "at any time, on... the motion of any interested person,... [to] make an order denying, limiting, conditioning, regulating, extending or modifying the use of any enforcement procedure." (324)

In CIMC Raffles Offshore (Singapore) Ltd. v. Schahin Holding S.A., (325) the court implied that restraining notices are completely ineffective against senior secured parties, where there is no valuable debtor equity in the collateral. (326) In CIMC, an account debtor (327) paid funds to a collateral agent for senior secured parties. (328) The collateral agent was served with a restraining notice. (329) The collateral agent froze all the collateral accounts and, as a result, the routine payment of senior debt service was halted. (330) The senior lenders moved that the restraining notice be vacated so that the senior payment could go forward. (331) Appropriately, the court gave that relief, but on grounds far too broad for the problem at hand.

The restraining notices were effective in the first instance only against property "which could be assigned or transferred" by the judgment debtor. (332) According to the CIMC court, the debtor could not assign or transfer its interest in the collateral accounts, as these were encumbered by senior security interests. (333)

This misconceives the matter. It is true that a debtor cannot convey its equity interest free and clear of the senior security interests. (334) But it could convey its equity interest in the accounts subject to the security interest. (335) Accordingly the debtor always has property which could be "assigned or transferred" within the meaning of CPLR section 5201(b).

Under old Article 9 this was clear. Old section 9-311 provided: "The debtor's rights in collateral may be voluntarily or involuntarily transferred ... notwithstanding a provision in the security agreement prohibiting any transfer or making the transfer constitute a default." (336) This clear statement of the principle has now been muddied. Under new section 9-401, "whether a debtor's rights in collateral may be voluntarily or involuntarily transferred is governed by law other than this article." (337) So in modern times, one must consult, not the UCC, but New York common law (badly atrophied since the UCC went effective) as to whether debtor equity in bank accounts could be transferred.

There is no reason to think why not. Bank accounts are commercial property and are, in general, alienable. (338) Granted, the transfer is subject to the rights of the senior secured parties. (339) But it cannot generally be said that encumbered bank accounts are property which a debtor cannot assign or transfer, within the meaning of CPLR section 5201(b).

Basically, the CIMC court theorized that if the debtor cannot convey free and clear of perfected security interest, it cannot convey at all. (340) On this view, "debtor equity" is inalienable property not susceptible to any levy. (341) If the court's theory were taken to its limit, restraining notices could not be effective to restrain secured parties, even as to collateral as to which the debtor has a valuable equity. Where a valuable equity exists, the debtor still cannot convey free and clear of the senior perfected security interest. On CIMCs reasoning, that makes the debtor's property inalienable.

As we have seen, the CPLR's theory of property is that property is a thing--such as a lawn mower. It is not a debtor's interest in a thing. Either the restraining notice applies to the lawn mower or it doesn't. Whether the debtor's interest in the lawn mower is valuable (that is, it is held in esteem by hypothetical buyers in the market) has no bearing on the application of restraining notice. It applies to the lawn mower, not to the debtor's interest in the lawn mower. Like it or not, the restraining notice applies to all collateral, or to none at all, in which case a secured party could dispose of valuable debtor equity.

Significantly, the security agreement in CIMC provided that one of the judgment debtors could have a distribution from the encumbered account to cover operating expenses. (342) The restraining notice was deemed effective to prevent the collateral agent from distributing to the judgment debtor. This is inconsistent with the view that the bank account was inalienable by the debtor. If indeed the judgment debtor had no property interest at all in the account, then the withdrawal of expense reimbursements should not have been a transfer of debtor property. In truth, however, the debtor was receiving encumbered dollars in which the debtor had a preexisting valueless equity. This transfer was a violation of the restraining notice. As indeed was any payment of cash collateral to a senior secured party. Such payments extinguish the debtor's technical equity in the encumbered dollars. Any transfer of debtor property (regardless of value) violates the restraining notice.

What the court should have said is that the restraining notice was completely effective against the collateral agent, but that the court had discretion to permit payments to the senior secured parties, (343) where the dollars paid were encumbered dollars which the judgment creditor could not use to satisfy a judgment.

Normatively, should senior secured parties be free and clear of the restraining notice? The matter is not simple. Where there is no debtor equity, the restraining notice has no point, as a subsequent levy by the sheriff will not produce value for the creditor. But where a valuable equity does exist, the restraining notice serves the purpose of slowing down the foreclosure sale until the objecting creditor can establish a junior lien, which the senior secured party must respect. (344) Writing a statute that differentiates in advance between valueless and valuable assets poses a profound challenge. In light of that, perhaps the CPLR is wise to make the senior secured party, in all cases, to seek a vacation of the restraining notice from the courts.

3. Purchasers of Restrained Personal Property

Suppose a garnishee served with a restraining notice is the bailee of debtor property. A debtor can always sell free and clear of the restraining notice because restraining notices do not create liens. (345) Yet, according to CPLR section 5222(b)'s fourth sentence, the garnishee is not to "suffer" a transfer of the thing in which the debtor has a property interest. (346)

Suppose, for example, that on a Monday a bailee holding the debtor's lawn mower has been served with a restraining notice. Suppose the debtor sells her bailor's interest in the mower to X, a purchaser. If the debtor has not been served with a restraining notice, the debtor does not act wrongly in selling the mower to X. X then shows up and demands the mower. Does the garnishee violate the restraining notice by surrendering the mower to X?

CPLR section 5222(b) is ambiguous on this score. We know that the restraining notice was effective on Monday because the debtor then held debtor property--that is, the mower. Accordingly, the garnishee is "forbidden to ... suffer any sale ... [of] such property." (347) The word "suffer" arguably could be read to mean that the garnishee must not recognize X's ownership rights.

This reading ought to be rejected. In interpreting section 5222, it is wise to remember that the goal of the restraining notice is to preserve the status quo as to property that might be used to satisfy a judgment. (348) In this regard, the judgment creditor has no lien on the mower by virtue of serving the restraining notice. This implies that the judgment creditor cannot pursue the mower once X buys it. If the debtor rightfully or even wrongfully conveys the property, the garnishee should not be punished for honoring the rights of the assignee.

Preferred Display, Inc. v. CVS Pharmacy, Inc., (349) is a recent example of a sale of a debtor's interest when a third party had been served with a restraining notice. (350) In CVS, a judgment creditor served a restraining notice on a customer (CVS). (351) CVS had been buying inventory from the judgment debtor on unsecured credit. (352) The judgment creditor served CVS with a restraining notice. (353) Thereafter, CVS bought further inventory from the debtor on credit but regretted the purchase. (354)

Meanwhile, a senior secured party (who had not been served with a restraining notice) declared a default and sold all remaining collateral--inventory and accounts--to a buyer X. (355) As a result of this sale, CVS owed its debt for inventory to X, not to the judgment debtor. (356)

CVS made a deal with X for the return of the unwanted inventory, in exchange for a credit against future purchases of inventory from X. (357) CVS did not pay down its debt, now owed to X. (358) The court reasoned correctly that CVS had "title" to the inventory free and clear of the debtor, and that it did not violate the restraining notice by "selling" this inventory on credit to X. (359) It also went further to sugges t that, had CVS paid X, CVS would not have been in violation of the restraining notice because, as a result of the foreclosure sale, CVS owed the debt to X, not to the judgment debtor. (360) This suggestion assumes correctly that once the debtor's interest in a thing is sold, the restraining notice no longer applies to that thing (in this case, the account receivable).

4. Real Property Analogies

We have seen that a bailee may not surrender bailed goods back to the debtor. (361) The real estate equivalent to bailment is the leasehold tenancy. (362) Each consists of rightful possession of property belonging to another. From what was said in the last few sections, it follows that a holdover tenant or tenant at will of real property is prohibited by section 5222(b) from surrendering the premises back to the judgment debtor. Quitting the premises would be like returning the lawn mower in our previous examples.

In truth, the departure of a holdover tenant actually helps the judgment creditor. A recalcitrant tenant is a positive encumbrance on the value of the real property. A better price will be received if the buyer does not need to pursue an expensive eviction action against the holdover. Yet, if consistency governs between real and personal property, the tenant who, in the absence of the restraining notice, properly ought to get out violates the order by leaving, even though this enhances the prospect of the judgment creditor to maximize recovery on the judgment.

Furthermore, one can argue that the holdover tenant gets to live rent free. It has been held that when a garnishee who owes a debt to a judgment debtor is served with a restraining notice, the garnishee's duty to pay interest is suspended, because interest is a penalty for withholding capital. (363) That is to say, where a garnishee rightfully withholds capital from the judgment debtor, the garnishee may hold the money interest free. Interest is to capital what rent is to real property (the fee simple in real property being capital in dirt form). It therefore follows from this analogy that a holdover owes the debtor no rent during the time the restraining notice is in effect. (364) This is at least the result if logic governs this area of law.

Of course, when logic confronts common sense, common sense is bound to prevail. Common sense, "seeing reason leads, finds safer footing than blind reason stumbling without fear." (365) Indeed, the New York legislature has codified the priority of common sense over the logic of the statute. According to CPLR section 5240: "The court may at any time, on its own initiative or the motion of any interested person, and upon such notice as it may require, make an order denying, limiting, conditioning, regulating, extending or modifying the use of any enforcement procedure." (366) We may therefore expect that a court will not pursue the analogy between leases of real property and bailments of personal property with too much vigor. If so, the tenant must keep his landlord's lawn mower but perhaps he should get off the premises and take the mower with him.

5. Exempt Property

A debtor served with a restraining notice who pays nonexempt cash for groceries to feed his hungry children is, of course, in contempt of court. (367) But what if the cash is proceeds of an exempt income stream, such as a social security benefit? (368) Does the restraining notice affect exempt property?

According to the third sentence of CPLR section 5222(b):
   All property in which the judgment debtor or obligor is
   known or believed to have an interest then in and thereafter
   coming into the possession or custody of [a garnishee]...
   shall be subject to the notice except as set forth in
   subdivisions (h) and (i) of this section. (369)

This sentence does not distinguish between nonexempt and exempt property. Worse, in 2008, the legislature added as exceptions subdivisions (h) and (i), which refer to exempt funds in bank accounts. (370) One could plausibly argue that, since the New York legislature knew how to make exemptions with regard to bank accounts, it must have intended to restrain disposition of any other kind of exempt property.

Nevertheless, courts reason differently from the purpose of the restraining notice, which is to preserve the status quo until the sheriffs busy schedule allows for a levy of the debtor's property. If the sheriff may not levy because the property is exempt, then the restraining notice oversteps its purpose. Therefore, it is uniformly assumed, contrary to the literal words of section 5222, that a debtor or a third party may dispose of exempt property. (371)

That restraining notices do not affect exempt property was presupposed without discussion in Deary v. Guardian Loan Co., (372) which proclaimed the CPLR's restraining notice procedure, as it then existed, unconstitutional for failing to warn debtors that exempt property cannot be restrained. (373) If it were really the case that restraining notices restrain the disposition of exempt property, then the due process right of the debtor to notice and a hearing would be useless, as a claim to exemption would not serve to get rid of the restraint.

Given the fact that the restraining notice does not create a lien (i.e., transfers no property right to the creditor), does a restraining notice actually deprive a debtor of property, as the Deary court presupposed? The answer is yes. The exact wording of the Fourteenth Amendment is "nor shall any State deprive any person of ... property, without due process of law." (374) It may be true that a debtor's property has not been "taken" by a creditor, as no lien was created, but the debtor has been "deprived" of the use of the restrained property. An examination of the due process jurisprudence of the Supreme Court reveals that the ability to use organizes the definition of property in the Fourteenth Amendment--not the ability alienate. (375) For instance, the IRS might obtain a lien on real property or illiquid property. (376) But as this does not interfere with a debtor's ability to use the collateral, the tax lien regime is constitutional. (377) Lien creation as such does not trigger any right to notice or a hearing. (378) Restraint of a liquid asset, such as a bank account, coupled with the creation of a lien, does create a due process issue. (379) This is because the restraint (not the lien) deprives the debtor of her use of the funds. (380) Restraint, not the taking through creation of lien, is the key to due process. Therefore, the Deary court was correct that the restraining notice procedure, though it creates no lien, poses a due process issue. (381)

After 2008, the CPLR carefully regulates the restraint of bank accounts containing exempt funds. (382) We will cover this regulation in due course. (383) For the moment, it may be noted that, in 2008, the legislature certainly assumed that restraining notices do not affect exempt property of the debtor. (384)

The thrust of the reasoning in Deary was that a debtor may have received due process in the course of procedure leading up to the issuance of the money judgment, but the issue of which property is liable to and which property is exempt from the creditor's judicial lien poses a different question: "While notice of and an opportunity to be heard on the merits is directed to the question whether the debt is actually owed, the attempt to enforce the judgment raises the distinct issue whether particular property of the judgment debtor is available to satisfy the judgment." (385) Given that property affected by the restraining notice might be exempt from judgment, due process jurisprudence required a weighing of creditor interests in prompt enforcement and the debtor's right to exempt property from the execution process. (386)

The Deary court ruled that, at a minimum, the debtor has the right to be informed of the availability of a procedure for contesting application of the restraint to exempt property. (387) Debtors, the court predicted, typically do not know that restraints can be challenged pursuant to CPLR sections 5239 and 5240. (388)

The legislature responded to the Deary decision by adding CPLR sections 5222(d) and (e), requiring that debtors be notified of the restraining notice and the possibility of exempting property from judicial process. (389) The exemption notice that the debtor must receive is printed word-for-word in section 5222(e). (390) The notice must set forth a list of possible exemptions that a natural person might claim, such as social security payments and various other exempt income streams. (391) Among other things, the notice must set forth: "If you claim that any of your money that has been taken or held is exempt, you may contact the person sending this notice." (392) There is no requirement, however, that the devil creditor respond if the Hotspur debtor calls. (393)

The obligation to send the restraining notice to the debtor, however, is contingent on the debtor never having received the notice set forth in section 5222(e) "within a year before service of a restraining notice." (394) So if a creditor serves a restraining notice on A, the creditor must serve both the section 5222(e) notice (plus a copy of the restraining notice) to the debtor. (395) When the creditor, within a year, serves a separate restraining notice on B, neither the section 5222(e) notice nor the second restraining notice need be served on the debtor. (396)

The notice of exemption rights must be served upon the debtor no later than four days after the garnishee is served with the restraining notice. (397) What are the consequences of failing to do this? Certainly the restraint can be vacated. (398) But is it void of its own account? This is far from clear. With regard to restraining notices served on banks, the 2008 legislation makes clear that failure to provide banks with the exemption notice (which it must forward to the debtor) makes the restraining notice void. (399) The fact that such a rule does not apply to nonbanks casts doubt on the status of the restraining notice when the section 5222(e) notice has not been timely served.

In Cordius Trust u. Kummerfeld Associates, a creditor served a restraining notice but not the exemption notice. (400) The court nevertheless ruled that the restraining notice was binding, where the judgment debtors were sophisticated tricksters who clearly understood the concept of exempt property. (401) Garnishees therefore take a risk that their clients are sophisticated when they disregard the restraining notice. However, where the creditor fails to send the restraining notice to the debtor and where the creditor permits the restraint to endure after the four days, the creditor is liable to the debtor for any damages caused. (402) Of course, if the debtor is a sophisticated trickster, damages under this provision are likely to be zero.

The notice requirement seems to apply only to debtors who are "natural persons." (403) This certainly makes sense, as the notice described in section 5222(e) deals exclusively with exempt property and how a debtor might get relief if exempt property is restrained. (404) Only natural persons are entitled to exemptions. (405)

The creditor must send the debtor a letter when the first restraining notice issues. (406) What if the letter is returned to the creditor by the post office? Then the notice must be sent
   to the defendant in care of the place of employment of the
   defendant if known, in an envelope bearing the legend
   "personal and confidential" and not indicating on the outside
   thereof, by the return address or otherwise, that the
   communication is from an attorney or concerns a judgment
   or order.... (407)

Here we again see that the CPLR aspires to avoid shaming a debtor in front of his employer. This is a major motivation in the CPLR's regulation of the income execution. (408)

A return from the post office is likely to be after the four-day period. Nevertheless, the restraining notice continues to be effective, as mailing to a known address is all that is required. (409) But the above-quoted language indicates that the creditor cannot rest on her laurels in light of the unsuccessful mailing. (410) Apparently a second mailing to the employer's address is required. (411) By what time must this second mailing occur? The statute does not say. The instinct of a commercial lawyer would be to say that the second mailing must occur in "a reasonable time." (412)

Finally, if the creditor knows neither the residence nor the place of employment, then the mailing must be made "to the defendant at any other known address." (413) Presumably the "known address" must bear a reasonable relation to the debtor. (414) Mailing to a known friend of the debtor, for instance, might suffice. Mailing to 1600 Pennsylvania Avenue would not, for most debtors.

In McCahey u. L.P. Investors, the court declined to rule the post-Deary regime was unconstitutional, but it left at least one question open. (415) When a debtor is deprived of the use of property by an ex parte order, due process requires that the debtor be guaranteed a prompt hearing:
   It is true that the statutory scheme in question does not
   provide a mandatory outside time limit on according a
   hearing on an exemption claim. It is also true that the
   majority of courts that have squarely addressed the issue
   have stated that only a mandatory period can withstand
   constitutional scrutiny. (416)

In New York, a motion to vacate a restraining notice is made under CPLR sections 5239 or 5240, neither of which set a limit on the promptness on the post-restraint remedy. (417) The plaintiff in McCahey, however, "made no effort to recover her property by using New York's procedures. We are therefore not faced with a concrete example of the New York statute in action, and we are unwilling to invalidate a statute because it might, but need not, be applied in an unconstitutional manner." (418) Therefore it might still be open to challenge the restraining notice procedure for its failure to guarantee a prompt hearing on vacating orders that wrongly restrain exempt property. (419)

This remaining ambiguity no longer exists when a bank is the garnishee. After 2008, special rules apply to banks in consumer cases, and these provide for a very prompt hearing. (420) To those rules we will return later. (421)

6. Fraudulently Conveyed Property

One contentious issue is the effect of a restraining notice when the debtor is alleged to have made fraudulent conveyances. Suppose a judgment debtor has fraudulently conveyed property to a garnishee. A judgment creditor then serves the restraining notice on the garnishee. The restraining notice
   is effective only if, at the time of service, [the garnishee] ...
   is in the possession or custody of property in which he or she
   knows or has reason to believe the judgment debtor ... has
   an interest, or if the judgment creditor ... has stated in the
   notice that ... the judgment debtor ... has an interest in
   specified property in the possession or custody of the person
   served. (422)

Fraudulent conveyance law presents a difficult conceptual issue: If a debtor fraudulently conveys a thing to the garnishee, does the debtor still own the thing?

Properly, the answer is no. The transfer is voidable but not void. The debtor has conveyed the thing once and for all and can never get it back. Only the creditors can reach the fraudulently conveyed property on an in rem basis with their judicial liens. (423) A garnishee holds such property in trust for the creditors of the debtor. So ownership of the fraudulently conveyed thing must be viewed as owned by a garnishee in trust for the creditors. The debtor has no interest in the fraudulently conveyed things at all. (424)

Although it is literally true that the debtor "alienates" all right title and interest of the debtor when he fraudulently conveys, this does not imply that a restraining notice cannot affect fraudulently conveyed property under the literal terms of CPLR section 5222(b)'s second sentence. (425) If the restraining notice falsely states that the debtor has an interest in a thing, it is an effective restraining notice. (426) It is a striking feature of CPLR section 5222(b)'s second sentence that, if we read it literally, a restraining notice can restrain on the basis of a known falsehood. Yet, as we shall see, courts have concluded, not unreasonably, that restraining notices that falsely allege that the debtor has an interest in a thing does not restrain the thing. In any event, in a fraudulent conveyance case, a creditor is not always in a position to designate a specific thing as having been the subject of a fraudulent conveyance. Therefore, a deeper inquiry is required as to whether a restraining notice is capable of affecting garnishee property that is founded on a fraudulent conveyance.

Account must be taken of the remedial section of the Uniform Fraudulent Conveyance Act (still the law in New York). (427) According to New York Debtor & Creditor Law section 278(1):

Where a conveyance or obligation is fraudulent as to a creditor, such creditor, when his claim has matured, may...

a. Have the conveyance set aside or obligation annulled to the extent necessary to satisfy his claim, or

b. Disregard the conveyance and attach or levy execution upon the property conveyed. (428)

This emphasized portion states that the creditor may levy execution against the garnishee's property as if it were still the debtor's property. (429) We may observe in passing that creditors may not levy at all. Only sheriffs can do this. (430) But clearly this archaic statutory language is intended to empower the sheriff to take the garnishee's property to satisfy the creditor's claim against the debtor. (431)

This emphasized passage is consistent with the proposition that a debtor still owns property after she fraudulently conveys it. But it does not require any such view. It could be the case that the garnishee (not the debtor) is the legal owner of property (though the garnishee holds in trust for the creditors of the debtor). Yet the sheriff is invited (without any notice or hearing to the garnishee) to simply take the garnishee's property.

On the basis of Debtor and Creditor Law section 278(l)(b), the court in Blue Giant Equipment Corp. v. Tec-Ser, Inc., (432) held that a creditor of the debtor could validly bind a garnishee by serving her with a restraining notice, where the garnishee has received a fraudulent transfer from the judgment debtor. (433) Such a holding implies that a debtor still owns property after he fraudulently transfers it. (434) The lower court had vacated the restraining notice because the debtor had no interest in a fraudulently conveyed thing once it was conveyed. (435) In reversing, the appellate division noted that, under New York's fraudulent conveyance law:
   [P]laintiff has the option of ignoring the conveyance of [the
   debtor's] interest and pursuing its remedies to enforce its
   judgment, including the device of service of restraining
   notices.... Section 278 (subd 1, par b) of the Debtor and
   Creditor law clearly provides, however, that a judgment
   creditor has the alternate remedy to "[disregard] the
   conveyance and... levy execution upon the property
   conveyed." In pursuance of its right to levy execution on its
   judgment in the first action, plaintiff also had the right to
   employ the device of a restraining notice to preserve the
   property upon which it sought to execute. (436)

On the basis of Blue Giant, a garnishee has to assume that, under New York law, a restraining notice will encumber property that the garnishee received from the debtor, provided the debtor conveyed it fraudulently. (437)

How can a garnishee know whether a transfer was fraudulent? At least the garnishee knows that if the garnishee bought the thing from the debtor in good faith for value, the garnishee received the thing free and clear of a fraudulent conveyance right. According to New York Debtor & Creditor Law section 278(1), the judgment creditor has no rights against "a purchaser for fair consideration without knowledge of the fraud at the time of the purchase, or one who has derived title immediately or mediately from such a purchaser." (438) Where the garnishee paid no consideration, she risks liability to the judgment creditor if she conveys away property received from the debtor. (439)

In Blue Giant, the judgment creditor served a garnishee. (440) A different case is where the judgment creditor serves a third party's bank where the third party has not yet been held liable as the recipient of a fraudulent conveyance. In Save Way Oil Co. v. 284 Eastern Parkway Corp., (441) the judgment creditor tried to stretch the restraining notice to cover the third party's bank from paying the account to the third party. (442) Such restraining notices the court would not allow:
   What is sought here is to extend the creditor's reach to a
   third tier. Plaintiff is not seeking to restrain money owed
   directly to the judgment debtor, but rather money owed to
   one who in turn is allegedly indebted to the judgment debtor.
   It is eminently clear that CPLR 5222 does not encompass
   this step. (443)

This is put rather confusingly. If a third party has received a fraudulent conveyance from the debtor, she is not "indebted to the judgment debtor." Rather, she holds property that could be used to satisfy the creditor's judgment against the debtor. In New York, this is strictly an in rem relation between the third party transfer and the creditor. (444) Nevertheless, putting this confusion aside, the point is valid. Under cases like Blue Giant, the judgment creditor could serve a restraining notice on the garnishee and the garnishee would be bound by it. (445) But the creditor cannot restrain the garnishee's bank until the creditor has a money judgment against the garnishee directly. (446)

A question not considered in Save Way Oil is that a third party's bank account might itself be proceeds of the fraudulent conveyance the garnishee has received. Suppose for instance that the judgment debtor gratuitously writes the third party a check, meaning that the proceeds of the check, when it clears, is a fraudulent conveyance. The third party then deposits the check with her bank. For simplicity's sake, let us assume that the bank account contains nothing but the proceeds of the fraudulent check. The bank's obligation to its customer is proceeds of the debtor's fraudulent conveyance. In general, if the third party holds a thing that is a fraudulent conveyance, and the third party sells that thing, the consideration received is held in trust for the judgment creditor. (447) Similarly, the bank's obligation to pay the third party is proceeds of a fraudulent conveyance that the creditors of the debtor could get. (448) Now, if the bank is served with a restraining notice, the bank must not honor the third party's checks. On a proceeds theory, the creditors of a judgment debtor can indeed restrain the third party's bank account.

7. Alter Ego Cases

In cases where the judgment debtor has fraudulently conveyed property to a garnishee and a creditor has served the garnishee with a restraining notice, courts have held that the garnishee is bound by the restraining notice on the metaphysically questionable premise that a fraudulent conveyance is no conveyance. (449) Such a conveyance is void, not voidable. What the debtor conveyed the debtor still owns. A restraining notice served on third party transferee's bank, however, is not effective, unless the bank account itself is proceeds of the fraudulent conveyance. (450)

A distinguishable case arises when the third party is the alter ego of the debtor and the judgment creditor serves a restraining notice on the third party's bank. (451) In such a case, the third party's bank account is the debtor's account, and the third party's bank is the debtor's bank, capable of being restrained. (452) Alter ego cases routinely uphold the restraint of the bank account merely on the allegation that the corporate veil between the third party and the judgment debtor ought to be pierced. (453)

In Sumitomo Shoji New York, Inc. v. Chemical Bank New York Trust Co., the court, in an alter ego case, made clear that the bank ignores the restraining notice at its own risk. (454) If indeed the corporate form is legitimate, the restraining notice has no effect, and the bank may honor checks on the account. But if the alter ego theory is correct, the bank owes damages for disobeying the restraining notice. (455)

In ruling that, where the restraining notice expressly indicates that the bank account is property of a judgment debtor, the restraining notice is invalid, the court exceeds the text of section 5222(b). In fact, the second sentence of section 5222(b) says that the restraining notice is binding whether their allocations are true or not: "A restraining notice served upon a person other than the judgment debtor... is effective... if the judgment creditor... has stated in the notice that a specified debt is owed by the person served to the judgment debtor." (456) But in this interpretation, the Sumitomo court behaved sensibly, as the restraining notice is about maintaining the status quo with regard to property that could actually be used to satisfy a judgment. (457) Thus, a restraining notice that falsely designates property as belonging to the debtor is, apparently, entirely ineffective. Why should a court order built on a lie be accorded any respect, especially where no public official issues it?

On this view, if the "alter ego" claim is substantively correct (though not yet adjudicated), the bank violates the restraining notice by honoring checks:
   A judgment creditor's specification of debt or property in a
   restraining notice is binding on the person served to the
   extent of forbidding payment or transfer except pursuant to
   an order of the court. If such person does make payment or
   transfer in disregard of the restraining notice, he takes the
   risk of liability for damages and contempt if the judgment
   creditor can establish that the debt was owed to the
   judgment debtor or that he had an interest in such property.
   Judgment debtor's "interest" in property must be understood
   to mean a direct interest in the property itself which, while it
   may require a court determination, is leviable, and not an
   indirect interest in the proceeds of the property, such as that
   of a stockholder in the entity to which the property
   belongs. (458)

In Sumitomo, the garnishee bank honored checks on the corporate account, even though the corporation was not the judgment debtor. (459) This was inappropriate if the alter ego theory was true. This put the garnishee bank in the odd position of litigating, in a special proceeding, (460) the genuineness of its customer's corporate form. Meanwhile, the customer, having cleaned out its account, may have no clear motive to cooperate in this litigation, except for a possible liability for having received an unjust enrichment or payment by mistake. This is small incentive where the bank's customer is insolvent. (461)

New York Banking Law section 134(5) does not, apparently, protect a bank that honors checks on the corporate account. (462) According to that provision:
   Notice to any bank ... of an adverse claim ... to a deposit of
   cash ... standing on its books to the credit of ... any person
   shall not be effectual to cause said bank ... to recognize said
   adverse claimant unless said adverse claimant shall also
   either procure a restraining order, injunction or other
   appropriate process against said bank ... from a court of
   competent jurisdiction in the United States in a cause
   therein instituted by him wherein the person to whose credit
   the deposit stands ... is made a party and served with
   summons.... (463)

When the bank is served with a restraining notice designating a corporate account as property of the debtor, the corporation has never been made a party to an action which culminated in an injunction. (464) The Sumitomo court ruled that the judgment creditor was not making an adverse claim against the bank account. (465) This is true; the restraining notice does not create a lien. The claim of a lien would be an adverse claim, (466) but no lien arises from the issuance of a restraining notice. (467) Thus, restraining notices served on banks are more powerful than levies of banks. A bank is empowered by Banking Law section 134(5) to ignore the levy. (468) But the bank owes damages if it violates the supposedly weaker restraining notice. (469)

The Sumitomo court implied that a garnishee acts correctly in restraining the debt or property, even if the judgment creditor is mistaken that the judgment debtor has an interest in the restrained thing. (470) A bank that, for example, refuses to honor checks is not guilty of wrongful dishonor because it is compelled to dishonor the check by a valid court order. (471) Therefore, banks have every incentive to honor a restraining notice, no matter how exotic and wrong the theory of the judgment creditor is. (472)

The court in JSC Foreign Economic Ass'n Technostroyexport v. International Development & Trade Services, Inc., (413) denied that a restraining notice on a nondebtor can be sustained on the allegation that the served person is the alter ego of the debtor. (474) In so ruling, the court had to get rid of the above-discussed contrary authorities from New York state courts. (475) Ignoring, at least for this purpose, the Sumitomo case (476)--direct authority for the validity of the restraining notice--the JSC court thought it could get rid of just one of the many authorities upholding the restraining notice and then call it a day. The case it chose to distinguish was Plaza Hotel Associates u. Wellington Associates, which upheld a restraining notice on an allegation that a nondebtor was an alter ego of a judgment debtor. (477) According to the JSC court, Plaza Hotel was a fraudulent conveyance case, where restraining notices should be upheld. (478) In fact, even a casual glance at this opinion shows that it upheld the restraining notice on an alter ego theory. (479) It was no fraudulent conveyance case. (480) JSC should therefore be viewed as a feeble Erie guess of New York law.

G. Debts

One of the many errors of judgment by the drafters of the CPLR was its very narrow definition of "debt." According to CPLR section 5201(a), "[a] money judgment may be enforced against any debt, which is past due or which is yet to become due, certainly or upon demand of the judgment debtor." (481) Contingent debts are not debts at all. It has been suggested that
   [c]ertitude is the key to the kingdom of debt. This morbid
   dread of contingency is entirely outmoded.... Article 9 of
   the UCC sees no reason why contingent debts cannot be
   collateral. Yet New York courts have a woeful history of
   equating contingent debt with no debt at all. This anxiety
   has been legislated into the CPLR to no good end. (482)

Section 5222(b) says of debts, so defined, that the garnishee is not to "pay over or otherwise dispose of any such debt, to any person other than the sheriff or the support collection unit." (483) So if the garnishee is served on a Monday at a time when he owes a debt (as narrowly defined) and if the garnishee pays on a Tuesday, the garnishee has violated the restraining notice. (484) What if the garnishee mailed a check on Sunday the day before he received the restraining notice? The garnishee is expected to stop payment on that check. (485)

Payment of a debt on Tuesday after receipt of a binding restraining notice on Monday gives rise to a suit for damages, but it does not imply that the creditor, as of Monday, has expropriated the debtor's right to be paid. Any such conclusion implies that the restraining notice is a lien, which is strictly prohibited. After Tuesday, the creditor may not insist that the garnishee pay a second time, but the creditor does have a suit for damages, which may or may not equate with the amount of the debt that the garnishee should not have paid. This distinction makes a difference with the regard to the accrual of interest on the creditor's remedy. Because the creditor is not the owner of anything on Monday, the creditor cannot claim that interest begins to accrue on Monday, rather than on the date when damages are awarded. (486)

Greatly complicating the restraint of debt-paying is the fact that restraining notices apparently do not restrain setoffs at all. This will lead to puzzles which threaten to undermine the restraining notice altogether.

H. Right of Setoff

Banks jealously guard the common law right of setoff. If a bank has received a restraining notice from a judgment creditor, does the creditor violate it by declaring the setoff?

The metaphysics of setoff have never been well understood. A setoff is the unilateral but reciprocal right of any creditor to declare a mutual countervailing debt to be canceled. (487) Is canceling through setoff a debt the same as paying it? If so, the setoff would seem to violate CPLR section 5222(b) (fourth sentence). In this regard, it may be pointed out that section 5222(b)'s fourth sentence prohibits not only paying a debt, but also "otherwise disposing" of it. (488) In the context of a third party garnishee, what could "otherwise disposing" mean but setting it off against some mutual debt?

The Court of Appeals, nevertheless, has vindicated the setoff right against restraining notice in Aspen Industries, Inc. v. Marine Midland Bank. (489) The court did so on the strength of New York Debtor and Creditor Law section 151, which holds:

Every debtor shall have the right upon:

(a) the filing of [bankruptcy] petition ...;

(b) the making of an assignment by a creditor for the benefit of its creditors;

(c) the application for the appointment ... of any receiver...;

(d) the issuance of any execution against any of the property of a creditor;

(e) the issuance of a subpoena or order, in supplementary proceedings, against or with respect to any of the property of a creditor; or

(f) the issuance of a warrant of attachment against any of the property of a creditor,
   to set off and apply against any indebtedness, whether
   matured or unmatured, of such creditor to such debtor, any
   amount owing from such debtor to such creditor, at or at any
   time after, the happening of any of the above mentioned
   events, and the aforesaid right of set off may be exercised by
   such debtor against such creditor ... receiver or execution,
   judgment or attachment creditor of such creditor, or against
   anyone else claiming through or against such creditor ...
   receivers, or execution, judgment or attachment creditor,
   notwithstanding the fact that such right of set off shall not
   have been exercised by such debtor prior to the making,
   filing or issuance, or service upon such debtor of, or of notice
   of, any such petition; assignment for the benefit of creditors;
   appointment or application for the appointment of a receiver;
   or issuance of execution, subpoena or order or warrant. (490)

When enacted, a subpoena, per section 151(e), also entailed a restraining notice. (491) But when the CPLR divorced subpoenas and restraining notices, section 151(e) ceased referring to restraining notices. (492) In modern times, the restraining notice is no longer described in section 151(e), which refers to an "order, in supplementary proceedings ... with respect to any of the property of a creditor." (493) A restraining notice is an order, to be sure, but it may be issued without the commencement of a supplementary proceeding. (494)

In Aspen, the garnishee bank froze a segment ($9,677.60) of the debtor's bank account in accord with the sixth sentence of section 5222(b):
   If a garnishee served with a restraining notice withholds the
   payment of money belonging or owed to the judgment debtor
   in an amount equal to twice the amount due on the judgment
   or order, the restraining notice is not effective as to other
   property or money. (495)

The bank accepted post-service deposits and honored post-service checks, consistent with the "twice the amount" freeze. (496) After a while, however, the bank declared a partial setoff of its $124,597.64 claim against the debtor. (497) The creditor then brought a special proceeding to obtain a turnover order for the amount of its judgment ($4,846.51). (498)

A majority at the appellate division level thought that the bank had misbehaved, because it honored checks after receiving the restraining notice (even though this was always done by crediting that portion of the account that exceeded the "twice-the-amount" portion of the account). (499)

The Court of Appeals reversed, holding that no lien arose by virtue of the restraining notice. (500) The court found that the bank had not violated the restraining notice by honoring checks, since at no time did the balance in the account fall below $9,677.60. (501) As for the manifestation of the setoff, this was rightful under Debtor and Creditor Law section 151:
   Although the statute does not expressly refer to restraining
   notices, it seems abundantly clear that, by enacting section
   151 of the Debtor and Creditor Law, the Legislature
   intended to "cover the field" in terms of the garnishee's right
   of setoff vis-a-vis the various enforcement devices. (502)

This decision is in accord with the purpose of the restraining notice, which is to keep the bank account in place for the subsequent execution or turnover order. (503) Since the setoff right is guaranteed against such subsequent events, there is no sense in saying otherwise with regard to the restraining notice. Why should the bank be forced to seek relief from the restraining notice to manifest the setoff, where the creditor can never obtain the bank account by ordinary judicial process?

Suppose a bank has a setoff opportunity. That is, there are mutually countervailing debts, but the bank has not yet manifested its intent to set off. Setoffs, at least as a matter of state law, are subject to the rule of "use it or lose it." So, for example, a bank with a setoff opportunity honors a check, it is obviously too late to declare a setoff. The setoff horse has already left the barn.

Section 151 protects setoffs against judicial process and, per Aspen, against the restraining notice. (504) But section 151 does not protect honoring the debtor's checks in violation of the restraining notice. (505) Nevertheless, in Nielson Media Research, Inc. v. Carlton Hotel, LLC, (506) the court held that, where the payor could have set off, the payment of a debt to a judgment debtor does not violate the restraining notice. (507) In Nielson Media, the judgment debtor was a contractor. (508) The account debtor forwarded money to the debtor so that it could pay the subcontractors. (509) It can be pointed out, however, that in the context of real estate improvements, New York Lien Law section 72(2) makes the contractor the trustee of receivables for the benefit of subcontractors, and "[t]rust assets shall not be levied upon or subject to a restraining notice issued pursuant to section fifty-two hundred twenty-two of the civil practice law and rules as the individual property of the trustee." (510) A trust asset includes "any right to receive payment at a future time." (511) So Nielson Media was correctly decided without any reference to setoff, because the New York Lien Law applied. Under the law of setoff, a fiduciary may not set off a trust obligation against a personal obligation. (512)

Had the New York Lien Law not applied, Nielson Media suggests that a creditor with a setoff opportunity is free to pay a judgment debtor in spite of the restraining notice. (513) This is a very doubtful proposition. The Aspen court perhaps stretched Debtor and Creditor Law section 151 to cover setoffs in the face of a restraining notice, (514) but section 151 cannot be made to extend to payments where the creditor chooses to lose rather than use the setoff opportunity.

Nevertheless, the result in Nielson Media is consistent with dicta from the Aspen opinion. The Aspen court thought the restraining notice had never been violated, but conceding otherwise arguendo, the creditor could prove no damages on the premises that if the bank did not honor the checks, the bank would have taken the corresponding bank balance as part of the setoff. (515)

Another case that stretched the concept of setoff past its proper breaking point is Kates v. Marine Midland Bank, where a bank was a fiduciary of a trust and the judgment debtor was the beneficiary. (516) The bank had, in effect, a commitment to lend to the judgment debtor. (517) If it advanced funds, it could liquidate assets of the trust to reimburse the advance. (518) In effect, the bank had a security interest in the rest of the trust of which it was trustee. (519)

Half an hour before a restraining notice was served on the bank, the judgment debtor received an advance in the form of a wire transfer to an out-of-state bank. (520) After service of the restraining notice, the bank liquidated money market shares and took the proceeds in reimbursement for the wire transfer. (521) The judgment creditor claimed that this selling of the money market shares violated the restraining notice. (522) The court, however, declared the entire transaction to be a setoff, which could be manifested in spite of the restraining notice. (523)

The subsumption of this security interest in money market shares under the concept of setoff is most unwarranted. In effect, the bank was simply foreclosing on its security interest on Article 8 securities. The money market is nothing more than a series of mutual funds that invest for shareholders in short-term debt obligations. (524) Shares in these funds are redeemed rather than traded. (525) We have seen, for better or worse, that foreclosure sales are violations of the restraining notice. (526) Properly, the garnishee was in violation of the restraining notice by foreclosing on its security interest. However, as the bank was an over-secured creditor, damages would have been zero.

I. Paying Debts v. Setting off Debts

The setoff exception to the restraining notice is subversive of the entire idea of the restraint. Suppose a garnishee owes a debt (narrowly defined) of $100 and is served with a restraining notice. The garnishee violates the order by paying. Suppose on the other hand the garnishee does not pay the debt but instead lends $100 to the debtor. The lending of money does not violate the restraining notice and the debtor's subsequent setoff of the two countervailing debts doesn't either. Therefore, the setoff exception permits a cooperative garnishee to structure the payment as a loan free and clear of the restraining notice.

Obviously there is something very wrong with this picture. May a garnishee so easily avoid the restraining notice? Courts, jealous of their powers, are unlikely to allow this. They are likely to pierce the form of the loan and proclaim it in essence a payment, where the garnishee can tell no tale of ordinary course of business lending between the garnishee and the creditor. Because the concept of payment and setoff are so intimately intertwined, I can think of no other tactic--the privledge of substance over form--whereby the courts can protect the force of the restraining notice.

Yet such a tactic--accusing the garnishee of bad faith in characterizing the payment as a loan setting up a setoff opportunity--can be defeated if in fact the setoff is nevertheless undeclared. In that case, no debt has been "paid." Meanwhile, the debtor has the cash and can hide it from the sheriff as he will. Furthermore, a payment being a voluntary act of the debtor, it is up to the debtor--not the courts--to proclaim what the transfer of funds means. (527) Especially given the fact that the garnishee is initially not even a party to any lawsuit (other than by virtue of the restraining notice), it seems a dangerous assault on liberty for courts to announce that the garnishee may not lend funds to the debtor.

We may note, however, that this contradiction would not disappear if the restraining notice instituted a lien. In such a case, the payment intangible that the garnishee owes to the debtor would be transferred to the creditor, so that only payment to the creditor would satisfy the obligation. However, it is still true that the garnishee could defeat this by lending money to the debtor. Debtor & Creditor Law section 151 still protects the garnishee from liens if the garnishee elects to manifest a setoff in lieu of paying the creditor. (528) Although a lien interferes with setoffs in the absence of section 151, the very purpose of section 151 is to permit post-lien advances to be used in setoffs. (529) This contradiction is therefore endemic to New York law. Perhaps the only solution to it is terrorism. If the courts were to hang a few garnishees for their bad faith, it might discourage bad faith games and increase the efficiency of debt collection. If garnishees think that a setoff strategy buys litigation expense, perhaps they will think twice before trying it.
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Title Annotation:I. Restraining Notices F. Property 2. Secured Creditors as Garnishees through I. Paying Debts v. Setting off Debts, p. 1529-1561; New York; Chief judge Lawrence H. Cooke Eighth Annual State Constitutional Commentary Symposium
Author:Carlson, David Gray
Publication:Albany Law Review
Date:Jun 22, 2014
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