Although the Federal Priority Act[1] has been deemed to be “almost as old as the Constitution”[2] itself, its application to priority battles between secured creditors and the federal government poses a novel question in litigation today. In fact, the Supreme Court acknowledged, in United States v. Romani, that despite the “age of the statute, and despite the fact that it has been the subject of a great deal of litigation, the question whether it has any application to antecedent perfected liens has never been answered definitively.[3]

Understanding the FPA’s potential application to antecedent perfected liens is particularly significant for secured creditors with an interest in real or personal property owned by a debtor facing a federal investigation. The FPA mandates that government claims take ultimate priority over other creditors[4], but the statute is silent about the impact that a government claim may have on creditors who hold a prior perfected interest in such property. Therefore, litigators and parties interested in better understanding the application of the FPA to antecedent perfected security interests — and, in particular, to those security interests that may be threatened by a competing federal claim — must examine the application of the FPA in other contexts.

Although federal courts have not conclusively outlined the boundaries of the FPA and its applicability to secured creditors with an interest in collateral subsequently sought by the federal government to satisfy a claim, the body of case law interpreting the FPA demonstrates that the government will not always prevail in priority battles over real and personal property.

Note: This article offers an in-depth analysis of the FPA in the context of competing secured creditor interests. For a detailed analysis of the history and scope of the FPA, see my previous article, “Addressing the Language and Scope of the Federal Priority Act.”

The FPA and the Federal Tax Lien Act

One area where the courts have consistently endeavored to outline the scope of the FPA is tax law. Several federal cases have analyzed the interaction between the federal Tax Lien Act[5] and the FPA.

In United States v. Estate of Romani[6], the Supreme Court considered whether the FPA requires that a federal tax claim be given priority over a judgment creditor’s perfected lien on real property. In Romani, Romani Industries obtained a judgment against Francis J. Romani and recorded the judgment in the clerk’s office, which created a perfected lien on Romani’s property.[7] Afterwards, the IRS filed a series of notices of tax liens on the same property.[8] The question then became whether the government was entitled, pursuant to the FPA, to prevent the transfer of the property to the judgment lien creditor because of the government’s purported superseding priority.[9]

The Supreme Court held that the government was not entitled to priority.[10] First, the Court acknowledged that the judgment lien was fully perfected under Pennsylvania state law prior to the government serving the notices of tax liens upon the estate.[11] The Court then noted that the Federal Tax Lien Act of 1966, the final installment in a series of amendments to the Act, solidified congressional intent to broaden the protection of secured creditors from federal tax liens when no notice of those liens would have been available to the secured creditors.[12] Given the express language of the Tax Lien Act, and because the judgment creditor in this case was not notified of federal tax liens on the property until after the judgment lien was created, the judgment creditor was entitled to the property.[13]

In its analysis, the Court cited several decisions contemplating the impact of the FPA on priority battles between judgment creditors and the federal government, particularly in cases where the government is executing a judgment stemming from delinquent taxes. The Court discussed United States v. Gilbert Associates, Inc.[14], which held that the Town of Walpole, New Hampshire, had only a “general lien” on property because it did not take possession of the property.[15] Consequently, the town was not entitled to priority over a subsequent tax lien by the federal government since the town was not a “judgment creditor” within the meaning of the Tax Lien Act.[16] The Supreme Court in Romani seemed to depart from Gilbert’s possession requirement, however, acknowledging that the Court was not aware of any decision since Thelusson v. Smith[17] applying the possession theory to claims for real property, nor was it aware of “any reason to require a lienor or mortgagee to acquire possession in order to perfect an interest in real estate.”[18]

Priority in battles with government lending programs

The Supreme Court and lower federal courts have also analyzed the operation of the FPA in the context of business loans.[19] In particular, courts have addressed the applicability of the FPA in cases where debtors default on government loans and a creditor simultaneously seeks to exercise its priority rights.

In one such case, the Fourth Circuit Court of Appeals utilized the Gilbert “possession” test in analyzing whether the Small Business Administration was entitled to priority over mechanic’s liens that had been perfected pursuant to Virginia state law. In W.T. Jones & Company v. Foodco Realty, Inc.[20], the Small Business Administration assumed 90 percent of a private bank’s loan, and the debt was secured by a deed of trust on Foodco’s property.[21] After construction on the property began, the appellants filed proper and timely mechanic’s liens under Virginia law.[22] When Foodco eventually became insolvent, one of the appellants instituted a court action to enforce its mechanic’s lien, and a dispute arose when the United States intervened as a party defendant to recover its debt.[23] On appeal, the Fourth Circuit affirmed the district court decision awarding priority to the SBA.

The court held that the FPA applied, despite the appellants’ assertions that their mechanic’s liens were perfected according to state law, and the government’s interest therefore took priority.[24] Without deciding whether an exception exists in the FPA that would allow an unforeclosed mechanic’s lien to defeat a government claim, the court noted that the mechanic’s liens in question were not sufficiently specific and choate to defeat the government claim.[25] After observing that whether a lien is sufficiently “choate” is a matter of federal, not state, law[26], the court stated that a lien cannot be considered specific and choate unless it has been attached to property and the creditor has come into possession of the property.[27]

Although Foodco lends some support to the argument that the FPA might grant the government priority in some cases where a competing state creditor has perfected its interest, the case does not end the inquiry. For one thing, two leading Supreme Court FPA cases – United States v. Kimbell Foods and United States v. Estate of Romani – do not even cite the Foodco case in their analysis. In addition, the Supreme Court expressly stated, over 25 years after Foodco was decided, that the issue of whether an antecedent perfected interest takes priority in cases involving the federal government still had not been decided.[28] More importantly, much like a judgment lien, the mechanic’s lien in question in Foodco was not self-enforcing. According to the Virginia law at play in Foodco, a mechanic’s lien is extinguished unless the lienholder obtains a decree against the debtor’s property.[29] Filing and recording the lien does not actually divest the debtor of possession or title, which is required by federal law for a lien to qualify as “choate.”[30]

Further undermining the reach of Foodco in resolving FPA disputes between the government and secured creditors, the Supreme Court ruled in favor of a secured creditor over 15 years later in United States v. Kimbell Foods, Inc.[31] This time, however, the Court analyzed whether a loan made by the SBA would take priority in a battle between two lenders that had previously perfected their security interests in inventory and accounts pursuant to Texas’s Uniform Commercial Code. In Kimbell, both Kimbell Foods and Republic National Bank loaned money to O.K. Super Markets. The loans were secured by O.K.’s equipment and merchandise.[32] Kimbell properly perfected its interest in the collateral by filing a financing statement, pursuant to Texas law, and Republic later filed its financing statement securing its interest in the same collateral.[33] The SBA had guaranteed 90 percent of Republic’s loan, and Republic later assigned its security interest to the SBA.[34] Shortly after O.K. defaulted on its SBA-guaranteed loan, Kimbell filed suit to recover its inventory debt. However, Republic did not record its assignment of the loan to the SBA until after Kimbell filed suit.[35] The Court was then tasked with determining who was entitled to priority.

The Court held that in cases of federal lending programs like the SBA and the Federal Housing Administration, state laws and commercial codes governing secured transactions should govern.[36] The Court reasoned that complying with state law does not produce hardship on federal loan agencies, in part, because of the sophistication of the SBA’s lending practices.[37] Specifically, because the SBA engages in the practice of ‘individually negotiat[ing] in painfully particularized detail’ each loan, there would therefore be no adverse effect on the administration of such loans.[38] The Court also discussed the difference between tax liens and consensual liens like the type at issue in Kimbell, stating:

The importance of securing adequate revenues to discharge national obligations justifies the extraordinary priority accorded federal tax liens through the choateness and first-in-time doctrines. By contrast, when the United States operates as a moneylending institution under carefully circumscribed programs, its interest in recouping the limited sums advanced is of a different order. Thus, there is less need here than in the tax lien area to invoke protective measures against defaulting debtors in a manner disruptive of existing credit markets.[39]

Thus, read together, the Kimbell and Romani decisions demonstrate that in some disputes between secured creditors and the federal government, perfection under state law will afford those creditors priority in the event that the federal government subsequently pursues a competing claim to real or personal property.[40]

Priority in forfeiture actions: 21 U.S.C. § 853

Although not explicitly purporting to grant the government priority like the FPA, an examination of the federal criminal forfeiture statute[41] also suggests that in at least some instances, the rights of secured creditors take priority over the right of the government to obtain a debtor’s collateral. Section 853 of Title 21 of the United States Code provides that the right, title, and interest in property subject to forfeiture vests in the United States upon the commission of the criminal act in question.[42]

Under this statute, there are two exceptions to the relation-back of the government’s title that operate to protect the interests of innocent third parties.[43] Subsection (n)(6) of 21 U.S.C. § 853 states that the court must amend a forfeiture order if a third party petitioner demonstrates by a “preponderance of the evidence” that (1) the petitioner has a legal right, title or interest in the property that was vested in the petitioner or superior to any right, title or interest of the defendant at the time the criminal acts occurred”[44]; or (2) the petitioner is a bona fide purchaser for value of the right, title, or interest in the property and reasonably had no notice that the property was subject to forfeiture at the time of purchase.[45]

The Sixth Circuit Court of Appeals recently held that parties with a security interest in property — including intangible property — can be bona fide purchasers for value under the second exception, Section 853(n)(6)(B). In United States v. Huntington National Bank[46], the Sixth Circuit held that Huntington Bank was in fact a bona fide purchaser for value within the meaning of Section 853(n)(6)(B) because a security interest is a property interest.[47] Therefore, the Bank could qualify for the second exception if it could prove that it was an innocent purchaser of that interest. The court held that because the government had already stipulated to the fact that the Bank was indeed an innocent purchaser[48] and the Bank purchased its security interest in the debtor’s accounts for valuable consideration, the Bank was entitled to the protections of the criminal forfeiture statute as a bona fide purchaser for value.[49]

Significantly, to qualify for the bona fide purchaser exception, a party must be an innocent purchaser. In other words, a party must have had an objectively reasonable belief that the property was not subject to forfeiture at the time the party acquired an interest in the property.[50] Case law surrounding criminal forfeitures once again suggests that at least in some cases, courts will respect state secured creditor rights in collateral being seized to satisfy a government claim. Importantly, the case law also makes clear that creditors must conduct due diligence prior to obtaining an interest in collateral to ensure that their interest remains secure even if the debtor is eventually subject to a federal investigation and potential forfeiture action.

Prioritizing state law

Although neither Romani nor Kimbell clearly defines the contours of the FPA in cases where the federal government is investigating a potential claim or actively pursuing a claim, both cases — as well as the federal forfeiture statute — reflect a respect for secured creditors in some instances. There are, however, important distinctions to be made between those cases and the case of a secured creditor who may have an interest in collateral that is later sought by the federal government to satisfy a claim.

First, the Romani case involves a specific federal statute that conflicts with the mandate of the FPA. In its analysis, the Court concludes that one of the reasons for treating the Tax Lien Act as the governing statute in priority battles involving delinquent taxes is that the Tax Lien Act is “the later statute, the more specific statute, and its provisions are comprehensive, reflecting an obvious attempt to accommodate the strong policy objections to the enforcement of secret liens.”[51] Specifically, the Tax Lien Act prohibits the government from asserting priority in cases of perfected judgment liens, which precisely relates to the facts of the Romani case.[52] Similarly, Congress specifically accounted for innocent bona fide purchasers in the federal forfeiture statute, so creditors secured under state law and unaware of a forfeiture proceeding against a debtor are statutorily entitled to their interest in the collateral.

Conversely, the Kimbell case involves “claims” of the federal government that arise from the government’s voluntary entry into the debt or finances of an individual, such as by making a loan or assuming a loan obligation from a private bank. Unlike in Romani, the Kimbell case does not involve a superseding statute expressly carving out exceptions to the government’s priority. The Kimbell Court devotes a significant portion of its opinion to emphasizing the fact that in these cases, the government has less of a need to invoke “protective measures”[53] against defaulting debtors that run counter to pre-existing state creditor schemes. Unlike taxes, which are “vital to the functioning, indeed existence, of government”[54], there is less of a need for uniformity or for adopting superseding federal common law in cases where the United States is operating as a lender.

Federal government claims arising from statutory schemes such as the False Claims Act[55] may rest somewhere in the middle of the Romani and Kimbell lines of reasoning. On the one hand, the uniqueness of taxes may mandate a general preference for government priority in cases involving tax disputes absent explicit statutory exceptions, such as those found in the Tax Lien Act.[56] However, it may be said that government claims arising from civil or criminal violations are not equivalent to collecting delinquent taxes because these claims are not as substantial a source of revenue as the collection as taxes is. In fact, the federal criminal forfeiture statute has already been interpreted in such a way to reflect that even when claims arise from criminal violations, secured creditors may still retain their interest in real or personal property if they were innocent, bona fide purchasers for value.

On the other hand, there are some instances when the government relies on state law in order to function efficiently, such as in the case of federal lending programs. Because the government already engages in due diligence prior to distributing a loan, it may be more reasonable to expect the government’s rights to be subject to the state law rights of the debtor, since those rights often coincide with the desirability of a prospective debtor to begin with.[57] Therefore, in priority battles between secured creditors and the federal government, there may be an argument that non-tax government claims should not be afforded priority since these claims do not embody the unique characteristics of taxes and the courts have shown a willingness to subordinate government interests to the interests of perfected creditors in other contexts.

Conclusion

The FPA purports to give the government priority in all claims against insolvent debtors, but case law interpreting the FPA demonstrates that the government is not actually entitled to priority in every case. In cases where there is a conflict between the FPA and another, more specific statute, such as the Tax Lien Act, courts have determined priority rights based upon the mandate of the more specific statute. Similarly, in forfeiture cases, courts have interpreted the government’s apparent entitlement to property as being subject to the security interests of some secured creditors, so long as those creditors adhere to certain statutory requirements, such as being innocent bona fide purchasers for value.

Absent a conflicting or superseding statute, secured creditor rights in the face of a competing government claim are less certain. However, cases such as Kimbell demonstrate that some policy considerations favor granting secured creditors priority in the face of a competing government claim to real or personal property. Thus, the Kimbell case, combined with the reasoning supporting tax and forfeiture cases, suggests that courts will sometimes respect the priority rights of secured creditors notwithstanding the apparent mandate of the FPA.