Finance Holding Co., LLC vs. American Inst. of Certified Tax Coaches, Inc.

The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:

SUMMARY:

A California appellate court has held that a post-judgment examination of a non-debtor third-party is restricted to matters involving the judgment debtor’s property held by that third party or debts owed to the judgment debtor. [Finance Holding Co., LLC vs. American Inst. of Certified Tax Coaches, Inc., 2018 Westlaw 6257480 (Cal.App.).]

Facts: A lender extended a line of credit to an LLP. One of the partners issued her personal guarantee for that line of credit. After the primary obligor defaulted, the assignee of the original letter brought suit against the guarantor and obtained a judgment against her.

During post-judgment enforcement proceedings, the creditor conducted a judgment debtor examination. The debtor stated that she worked for a certain company, allegedly her employer, but denied any ownership interest in her employer’s business. The creditor then conducted a judgment debtor examination of the employer; the judgment debtor herself appeared at that examination in her capacity as her employer’s Chief Executive Officer. She still denied any ownership interest in her alleged employer.

The creditor then sought an order compelling the employer to produce documents. The request was very broad and was not restricted to documents specifically relevant to the judgment debtor. The creditor did not assert an alter ego theory when requesting those documents. Over the employer’s objection, the trial court granted the order. The employer appealed.

Reasoning: The appellate court reversed the discovery order as overbroad. The court first held that the order was appealable, despite a split of authority on that issue. The court then turned to the merits, holding that the order was beyond the scope of relief permitted under California Code of Civil Procedure §708.120(a):

Upon ex parte application by a judgment creditor . . . and proof by the judgment creditor . . . that a third person has possession or control of property in which the judgment debtor has an interest or is indebted to the judgment debtor . . . , the court shall make an order directing the third person to appear before the court . . . to answer concerning such property or debt . . . .

The court then described the permissible limits of discovery under that statute: “Under its plain meaning, this statutory language provides the trial court with the authority to permit a creditor to seek information regarding the existence of the debtor’s property in the third party’s possession and/or a debt owed to the debtor.”

The court held that the discovery order in this case went beyond the scope of the statute:

[T]he order compelling production of the requested documents exceeded the statute’s scope. [The judgment creditor] sought all of the [employer’s] business, tax, and bank records during a five-year period. The court essentially ordered the [employer] to produce every single sheet of paper (or computer document) that [it] (or its agents) have produced or maintained over the past five years without any limitation for documents that are relevant to [the judgment debtor] or assets in which she has an interest or any debts owed to her. [The judgment creditor] acknowledged that it was not seeking documents to support an alter ego theory, and it was requesting the information solely to determine the existence or location of [the judgment debtor’s] assets, including property or outstanding debts owed to her. On this record, the court did not have the authority to require [the employer] to produce all of its documents regardless of their relevance to [the judgment debtor].

The judgment creditor argued that other sections of the Code of Civil Procedure contained language authorizing a broader scope of discovery. The court held, however, that those other statutes were more general in nature, while §708.120 specifically focused on third-party post-judgment discovery. The court noted a split of authority between Fox Johns Lazar Pekin & Wexler, APC v. Superior Court, 219 Cal. App. 4th 1210, 162 Cal. Rptr. 3d 571(4th Dist. 2013), which construed the statute narrowly, and Yolanda’s, Inc. v. Kahl & Goveia Commercial Real Estate,11 Cal.App.5th 509, 217 Cal.Rptr.3d 624 (2d Dist. 2017), taking a much more expansive view.

The court was critical of the analysis in Yolanda’s, which had held that C.C.P. §187 supplemented the scope of discovery available under §708.120(a). Section 187 states: “[I]n the exercise of [the court’s] jurisdiction, if the course of proceeding be not specifically pointed out by this Code or the statute, any suitable process or mode of proceeding may be adopted which may appear most conformable to the spirit of this Code.”

The court in Finance Holding disagreed with that approach:

Even assuming compelling reasons support an expansion of third party discovery in a particular case, we disagree with Yolanda’s that courts have the authority to order the discovery beyond the confines of section 708.120. The decision whether to enlarge a judgment creditor’s rights to obtain discovery is one for the Legislature and not the courts. (See Fox Johns, supra, . . . ; see also Schechter, Post-Judgment Examination of Non-Debtor Third Party May Delve Into Alter Ego and Fraudulent Transfer Issues, Despite Narrow Wording of Statute (Thomson Reuters 2017) 2017-19 Comm. Fin. News NL 38 [noting the conflict between Fox Johns and Yolanda’s on scope of third party judgment enforcement discovery; opining that Fox Johns “correctly” interpreted “the current statutes”; and concluding that although the result in Yolanda’s reflects better public policy, its approach requires an amendment of the relevant statutes].) The determination involves the examination and balancing of various private interests and public policies, a task best left to the legislative arena.

As a fallback, the court held that even if the broader scope of Yolanda’s were the rule, the requested discovery must still be relevant to the judgment debtor:

The requirement that a third party witness (representing a third party entity allegedly controlled by the debtor) answer direct questions about specific transferred property in which the debtor has or had an interest is materially different from requiring a third party (who is not alleged to be an alter ego of the debtor) to produce every single piece of business, bank, and tax document for the past five years without any showing of relevance to the debtor. Accordingly, even if the court here had some form of equitable powers beyond section 708.120, these powers did not support the expansive order in this case.

The court remanded the matter to the trial court, so that the trial court could narrow the order to require production of information regarding the judgment debtor’s compensation, property, and services.

Author’s Comment: Given the current language of the statute, I believe that the court reached exactly the right result. However, as discussed in the Commercial Finance Newsletter item cited by the court, I continue to believe that the scope of the current statute is too narrow. It does not expressly permit an expanded inquiry into a third party’s affairs, even if the judgment creditor has shown that the third party has engaged in improper conduct with respect to the judgment debtor and her assets. Anyone who has ever tried to collect a debt knows that judgment debtors will often play endless “shell games” to thwart their creditors.

I am not advocating unlimited fishing expeditions into the affairs of third parties. The documents sought must be directly relevant to the judgment debtor’s affairs. It makes sense to require the judgment creditor to show the court that the third party to be examined has some nexus to wrongful transactions involving the judgment debtor’s assets; otherwise, innocent strangers who have had ordinary dealings with the judgment debtor would be subject to the inconvenience of an examination. Presumably, the judgment creditor will gather the evidence necessary for that threshold showing during its initial examinations of the judgment debtor. (For a discussion of a case in which the judgment creditor was empowered to gather that evidence, see 2016-02 Comm. Fin. News. NL 4, Judgment Creditor May Compel Judgment Debtor to Produce Documents Concerning Non-Debtor Third Parties.)

In an effort to protect judgment creditors from debtors who use alleged third party entities to hide their assets, I have proposed the following amendment of the statute. Item (iii) contains the new language:

(a) Upon ex parte application by a judgment creditor who has a money judgment and proof by the judgment creditor by affidavit or otherwise to the satisfaction of the proper court that a third person (i) has possession or control of property in which the judgment debtor has an interest, (ii) is indebted to the judgment debtor in an amount exceeding two hundred fifty dollars ($250), or (iii) has received or transferred property to or from the judgment debtor in a transaction described in Civil Code § 3439.04(b), the court shall make an order directing the third person to appear before the court, or before a referee appointed by the court, at a time and place specified in the order, to answer concerning such property or debt.

Civil Code § 3439.04(b) sets out the “badges of fraud” under the Uniform Voidable Transactions Act. Once the judgment creditor has made a prima facie showing that the non-debtor third party was involved in a potential fraudulent transfer involving the judgment debtor or its insiders, the judgment creditor should be permitted to examine the third party to gather more evidence about those transfers and the locations of the judgment debtors’ assets that were no longer in possession of the third party. That examination will also enable the creditor to determine whether the third party is an alter ego of the judgment debtor, thus permitting the creditor to seek a post-judgment amendment to add the third party to the judgment.

For discussions of cases involving that type of post-judgment amendment, see 2014-27 Comm. Fin. News. NL 55, Judgment Creditor May Amend Judgment to Add Alter Ego of Corporate Borrower, Even Though Creditor Did Not Prevail on Guaranty Claim Against Same Party, and 2011 Comm. Fin. News. 3, Even Though Trust Cannot Be Liable As Alter Ego Because It Is Not a Legal Entity, Trustee of Trust May Be Added As Judgment Debtor to Enable Judgment Creditor to Reach Trust Assets.

These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.