Is Your Security Interest Perfected as Against Tax Liens or is it Inchoate?
The recent decision in SE Prop. Holdings, LLC v. Unified Recovery Grp., LLC, No. CV 14-2060, 2018 WL 6267183 (E.D. La. Nov. 30, 2018) (“SE Holdings”) illustrates potential problems for drafting, policing, and litigating security interests in accounts. The district court held that an IRS tax lien had priority over a security interest in accounts taken and perfected years before the tax lien arose, based on the judicially created “choateness” doctrine. Under that doctrine, an otherwise perfected security interest loses its priority to a subsequently filed tax lien in respect of property to which the debtor has not acquired rights at the time of filing of the tax lien, notwithstanding the inclusion of an after acquired property clause.
Courts dealing with conflicts between state law security interests and tax liens, including the SE Holdings Court, tend to cite the principle that “[w]hile the existence and precise nature of an interest is determined according to state law, the issue of priority between conflicting interests is settled according to federal law.” Id. at *8 (citing Aquilino v. United States, 363 U.S. 509, 513-14 (1960)). Under state law, a security interest in an account does not require performance of the obligation giving rise to the account. Instead, an account, as defined in UCC section 9-102(a)(2)(ii), is “a right to payment of a monetary obligation, whether or not earned by performance…for services rendered or to be rendered.”
This differs from federal law. Under the definitions section of the Code of Federal Regulations (“CFR”) relating to tax liens and their effect on security interests, “[a]n account receivable (as defined in paragraph (c)(2)(ii) of § 301.6323(c)-1) is in existence when, and to the extent, a right to payment is earned by performance.” 26 CFR 301.6323(h)-1.
However, these differences in the existence and precise nature of a security interest in accounts, which, if determined by state law, should favor the secured creditor, are negated by application of the choateness doctrine, a doctrine purportedly determining priority. Under the choateness doctrine, a security interest that has otherwise attached and been perfected under state law prior to the filing of the tax lien only “attaches” relative to that tax lien when it becomes choate. To become choate, three elements must be established: (i) the identity of the secured party, (ii) the property subject to the lien, and (iii) the amount of the lien. A security interest in an account does not become choate until the account comes into existence, and this is not until the services giving rise to the account are performed.
J.D. Court, Inc. v. United States, 712 F.2d 258, 263 (7th Cir. 1983).
Although this is problematic for secured creditors and certainly contrary to state law, the requirements and application of the choateness doctrine to security interests in accounts are neither profound nor novel. For example, in J.D. Court, Inc., supra, the Seventh Circuit applied the choateness doctrine to hold that a prior perfected interest in accounts arising from the provision of medical services was subordinate to a subsequent tax lien because those accounts did not come into existence until the services giving rise to them were performed. It relied on and cited the Tenth Circuit’s similar finding in American Investment Financial v. United States of America, 476 F.3d 810 (10th Cir. 2006). Numerous other cases support this holding.
In SE Holdings, however, the account at issue was in existence –the applicable services giving rise to the account had been performed – before the filing of the tax lien. Beginning in 2005, St. Bernard Parish entered into three debris removal contracts with United Recovery Group (“URG”) as the counter party. In August 2008, URG granted SE Property Holdings, LLC (“SEPH”) a security interest in its accounts. SEPH perfected its security interest by filing a financing statement and subsequently filed a continuation statement. By the end of 2012, URG completed the debris removal work contemplated under the contracts. On January 29, 2013, the IRS filed its tax lien. Saint Bernard Parish filed an interpleader as to FEMA funds it held for the contracts. SEPH and the IRS each filed summary judgment motions claiming those funds.
The Court held that, although URG performed the debris removal work required under the subject contract (described in the opinion as the Isaac Contract) well before the IRS filed the tax lien, URG had not fully discharged its duties under such contract because URG also had the “contractual responsibility” to “assist in preparation of documentation for claims submitted for reimbursement.” According to the Court, “accounts receivable under the Isaac Contract were not ‘acquired’ according to the choateness doctrine until URG completely performed its obligation.” SE Holdings, supra, at 10. It further held Saint Bernard Parish’s invoice approval, a matter out of URG’s control, was the triggering event marking completion of URG’s performance.
The secured party missed two issues that require consideration in drafting and litigating such security interests. First, the court observed there was no mention of any kind of a substantial performance argument or exception in the application of the choateness doctrine. Second, the Court admitted that there was a fair argument that the funds were proceeds of contract rights, and, under 26 CFR sections 301.6323(c)-1 and 301.6323(h)-1, contract rights are in existence when the contract is made. The Court did not make any rulings concerning these issues because the secured party failed to raise them.
The takeaway is that SE Holdings is a surprisingly aggressive application of the choateness doctrine in favor of the IRS. It demonstrates that an otherwise valid and perfected security interest in accounts can lose priority to a subsequently filed tax lien if some arguably minor performance obligation remains. This decision presents unique issues and problems which secured parties must consider.
This e-bulletin was prepared by Walter K. Oetzell, Walter K. Oetzell, APC, firstname.lastname@example.org.