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Financial Services FLASHPOINTS February 2020

February 14, 2020Print This Post Print This Post

Michael L. Weissman, Levin Ginsburg, Chicago
312-368-0100 | E-mail Michael L. Weissman

Lender’s Perfected Security Interest Primes Federal Tax Lien

In SE Property Holdings, LLC v. United Recovery Group, LLC, 357 F.Supp.3d 537 (E.D.La. 2018), the court applied Louisiana and federal law to find that a lender’s perfected security interest took precedence over a federal tax lien. At issue were funds St. Bernard Parish received from the Federal Emergency Management Agency intended to reimburse St. Bernard for payments to be made to a contractor, United Recovery Group, LLC (URG). URG had done debris removal work after Hurricanes Katrina and Isaac. The parish was prepared to disburse the funds to URG but was withholding them because of conflicting claims to them made by URG and the IRS asserting the contractor was tax delinquent.

After Katrina, St. Bernard Parish had entered into a contract with URG for the removal of storm debris, a second contract between St. Bernard and URG (the Katrina contract) was executed in December 2005, and a third debris removal contract (the Isaac contract) was also signed by St. Bernard and URG.

To obtain working capital for its work for St. Bernard, URG executed a $10 million note, loan agreement, and security agreement with its lender on August 29, 2008. (URG’s original financing was provided by Vision Bank. SE Property Holdings, LLC (SEPH), became the successor-in-interest to Vision Bank by reason of a merger in 2012.) The security agreement granted the lender a security interest in “all of [URG’s] accounts of any kind . . . whether now existing or hereafter arising.” 357 F.Supp.3d at 542. A UCC financing statement was filed on September 2, 2008.

In June 2011, URG executed two additional promissory notes, also secured by the above-mentioned security interest, for $4,000,000 and $2,681,000, respectively.

The lender’s first advance to URG was made on September 2, 2008, and the last on February 24, 2012. In 2013, the loans were in default, and the lender; SEPH, obtained a $20 million money judgment against URG. The IRS filed a notice of tax lien against URG with the East Baton Rouge Clerk of Court on January 29, 2013, for unpaid federal taxes and interest.

Since both URG and the IRS claimed the moneys held by St. Bernard, it filed an interpleader action seeking instructions from the court. It deposited $610,081.45 of the funds into the court’s registry. The IRS intervened in the case claiming $302,803.37 pursuant to its tax lien plus interest and costs. In response, SEPH argued it had priority as to all of the funds held by St. Bernard because its security interest had attached and was perfected on September 2, 2008. And in answer to the assertion by the IRS that SEPH’s security interest was not choate (the rule that property must be in existence for a security interest to attach), SEPH stated that URG had completed all of its work by the end of 2012 (before the IRS tax lien was filed). But that was not the end of the matter.

The IRS pursued an alternative argument quoting the text of the security agreement that read as follows:

Section 2.01. Grant of Security Interest. [URG] hereby grants and confirms that it has granted to [SEPH] a security interest, subject only to Permitted Liens (as defined in the Agreement) in . . . all of [URG’s] accounts of any kind whether now existing or hereafter arising. 357 F.Supp.3d at 546.

The IRS claimed that its tax lien was a “Permitted Lien” within the meaning of the above-quoted §2.01, thereby giving it priority. Dealing with the question of whether the IRS had a “Permitted Lien” entitled to priority, the court ruled that it didn’t, saying the qualifier on priority “merely acknowledge[d] that certain liens, such as mechanic’s liens,” might arise. 357 F.Supp.3d at 549. The IRS then contended that URG did not acquire the right to the FEMA funds until St. Bernard and FEMA “found URG’s documentation of its work acceptable.” 357 F.Supp.3d at 545. FEMA had not approved $279,205 of URG’s work on the Isaac contract until June 25, 2016, almost six months after the IRS tax lien was filed.

The resolution of that issue required the application of the UCC priority rules. Noting both the IRS 45-day (a perfected security interest in commercial financing security enjoys priority over a federal tax lien if it arises within 45 days after the tax lien is filed) rule and the requirement of “choatness” for a security interest to attach, the court ruled in favor of SEPH with respect to work done pursuant to the Katrina contract but ordered additional data be submitted concerning work done under the Isaac contract.

Although the IRS admitted that the debris removal work was finished prior to December 31, 2012, it argued that contractual performance giving rise to Isaac accounts receivable was not completed until June 25, 2016, when FEMA approved the reimbursement payments to St. Bernard. Thus, said the IRS, SEPH’s Isaac receivables from URG did not become choate until June 25, 2016, and the tax lien had been filed before that.

The Katrina contract and the Isaac contract differed somewhat. In the words of the court, “[t]he Katrina Contract appears to define performance simply and with no mention of any documentation to be provided by URG,” whereas the Isaac contract “required URG to pick up the debris and also document debris removal with load tickets and hanger courts, review this documentation for compliance with FEMA regulations, and ‘[a]ssist in preparation of documentation for claims submitted for reimbursement.’ ”357 F.Supp.3d at 552.

Based on the difference, the court said URG had an obligation under the Isaac contract that went “past the physical labor of uprooting tree stumps and picking up tree limbs.” 357 F.Supp.3d at 553.

The court’s ultimate ruling with respect to the Isaac contract was, “if an invoice was approved before March 16, 2013, then SEPH is entitled to priority as to funds traceable to that invoice,” but an invoice approved after that date ran afoul of the 45-day rule. The court invited further proof of the date of St. Bernard’s approval of the Isaac contract invoices.

What’s the point? This case once again demonstrates that a properly perfected security interest can prime an IRS tax lien but that the security interest must relate to collateral that is choate (i.e., the case of accounts receivable, that everything has been done called for in the contract to make it enforceable).

Funds Withheld from Contractor Constituted an Asset of Its Bankruptcy Estate

Carrier Enterprise, LLC v. City of Dunedin (In re Climate Control Mechanical Services), Inc., 570 B.R. 673 (Bankr. M.D.Fla. 2017), raised the question of whether funds withheld from a general contractor on a public improvement contract were part of its bankruptcy estate, subject to a security interest of the general contractor’s bank, or weren’t because they had been specifically earmarked for a subcontractor.

Climate was a commercial heating, ventilation, and air-conditioning contractor. Its lender was Community Bank & Trust of Florida, which had a perfected security interest in its assets. When it filed a voluntary petition for bankruptcy relief under Chapter 11 on May 18, 2015, Climate owed the bank roughly $1.8 million.

Prior to its bankruptcy petition, Climate had entered into a contract with the City of Dunedin, Florida, to replace various HVAC systems on property owned by the city. The parties were not in dispute as to whether the work called for in the contract had been completed. Apparently, Carrier Enterprise, LLC, had provided equipment that Climate installed as part of its contract performance. Carrier was not fully paid for the equipment it supplied when Climate sought bankruptcy protection.

As of November 2014, the city had paid Climate $98,930.42 for its services but retained $77,611.59 (the retention). Faced with conflicting claims by Climate (effectively representing the bank) and Carrier, the city sought instructions from the court as to the disposition of the funds.

Carrier’s position was that $42,657.96 of the retention had been “earmarked” to pay for equipment furnished to Climate and installed on city property. 570 B.R. at 676. Climate’s position was that it was the party solely entitled to claim the money as there was nothing in the contract with the city identifying any funds to a third party such as Carrier.

The court ruled the retention was an asset of Climate’s estate. Finding that the Climate contract had been fully performed by Climate prior to May 18, 2015, and full payment was due to Climate prior to May 18, 2015, and observing that “the City did not specifically allocate or ‘earmark’ any portion of the Withheld Funds to any person/entity other than Debtor,” the court concluded “the only conclusion is that the funds are property of the estate.” 570 B.R. at 678 – 679.

And noting that there was no dispute about the validity and continued effectiveness of the bank’s security interest, the court ruled: “The Withheld Funds are property of the bankruptcy estate subject to a perfected security interest of Community Bank.” 570 B.R. at 679.

What’s the point? A bank’s perfected security interest in a contractor’s withheld contract proceeds continues after the contractor’s bankruptcy filing and cannot be defeated by earmarking claims of subcontractors unless the earmarks are specifically designated in the contractor’s agreement with the party for whom the work is performed. From the perspective of a lender financing a general contractor, it is important to note whether any funds have been earmarked for subcontractors and to obtain subordination agreements from them. Conversely, a lender financing a subcontractor or material supplier should determine whether there is a set-aside in the general contract for their borrower in evaluating the creditworthiness of such collateral.

For more information about financial services, see COMMERCIAL AND INDUSTRIAL LOAN DOCUMENTATION — 2018 EDITION. Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit www.iicle.com/subscriptions.

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