First Filed – Not Always First in Priority

October 2005

This past month, the Colorado Supreme Court carved out an unusual exception to the general rule that liens filed against real property by creditors are prioritized according to Colorado’s race-notice statute. Under Colorado’s race-notice statute, a lien filed first generally has priority over all liens filed thereafter. In Shepler v. Whalen, however, the Court held that when a debtor makes a fraudulent conveyance, and exposure of that fraud establishes an interest in real property, the creditor who first exposes the fraudulent conveyance by filing suit and a notice of lis pendens over the real property takes priority over senior creditors holding prior recorded liens.

In the Shepler case, a debtor paid off the mortgage on his wife’s townhouse in which the debtor had no interest. At the time of this payment the debtor owed money to several other creditors with recorded judgments against him. After learning of the mortgage payment, a junior creditor of the debtor filed a court action seeking a declaration of an equitable lien and a constructive trust, and seeking to collect against the wife’s townhouse on the basis that the pay-off transaction was fraudulent and undertaken in order to hinder, delay or defraud creditors.

Subsequently, the trial court imposed a constructive trust on the townhouse and established an equitable lien in favor of the debtor’s creditors. The imposition of the constructive trust acknowledged that the debtor did not have an interest in the townhouse, but because of the fraudulent conveyance, the debtor’s wife was considered to be holding the townhouse in trust for the debtor’s creditors. Thus, the trust was imposed because of the fraudulent transfer, not because the debtor and his wife intended te debtor to retain an interest in the townhouse.

Due the special circumstances of this case, the Supreme Court held that Colorado’s race-notice statute did not control the priority among the debtor’s creditors, because the debtor did not have a legal or equitable interest in the townhouse. Colorado’s race-notice statute only comes into operation when the debtor has an interest in a particular property to which the creditor’s judgment can attach. Because the townhouse was always solely titled in the wife’s name, the debtor never had any legal or equitable interest in the townhouse. The only interest the debtor had in the townhouse arose through the fraudulent payment of the mortgage balance.

Therefore, the Court held that the junior creditor of the debtor was entitled to first priority over the senior creditors of debtor because the junior creditor was the first to establish a lien that attached to the townhouse by bringing the action to uncover the fraudulent conveyance and to impose the constructive trust against the townhouse. The remaining creditors all intervened in the action at the same time; thus each established a lien capable of attachment to the townhouse simultaneously and were consequently accorded equivalent priority, sharing equally after the junior creditor that originally established the lien has his judgment satisfied. The Court did not address whether the creditor who first uncovered the fraudulent conveyance would have also had priority over any liens on the townhouse itself, in the case that the wife had recorded judgments against herself as well.

The Court’s holding is contrary to Colorado’s long established race-notice statute. Under the statute, judgment liens apply not only to property owned by the debtor at the time of the lien, but also to property thereafter acquired. If the debtor had subsequently purchased a townhouse (as opposed to simply paying off a mortgage on a townhouse), that townhouse would be subject to the judgment liens then of record in the order in which they were filed, yet the Court treated the judicial recognition of a constructive trust as something entirely different.

The Court justified its decision by reasoning that the holding rewards the creditor who puts forth the most effort, and that to hold otherwise would allow creditors to “lie idle until others have by their superior diligence discovered the fraud and commenced proceedings in equity to thwart it by obtaining the cancellation of the conveyance, and then step forward and reap the first fruits of their diligence.”

Although the Supreme Court’s holding ultimately may prove to be narrow given the unique circumstances of the case, creditors should beware that there may now be situations where, because Colorado’s race-notice statute is inapplicable, senior lien holders will not have priority over junior lien holders.

This legal update is for informational purposes only as a service to clients and other friends, is not a complete summary of the rules relating to the subject matter discussed above, and is neither to be construed as legal advice nor intended as basis for decisions in specific situations. For more information about this subject matter or other recent developments, please contact the attorneys in our Real Estate practice group or any other attorney in our firm with whom you normally consult by calling (303) 825-4200.