An often-overlooked statute that takes precedence over general unsecured creditor claims in out-of-court insolvencies is found at 31 U.S.C. 3713. The statute reads as follows:

1. (a)(1) A claim of the U.S. government shall be paid first when:

A. a person indebted to the government is insolvent; and

(i) the debtor without enough property to pay all debts makes a voluntary assignment of property;
(ii) property of the debtor, if absent, is attached; or
(iii) an act of bankruptcy is committed; or

B. the estate of the deceased debtor, in the custody of the executor or administrator, is not enough to pay all debts of the debtor.

2. (a) This subsection does not apply to a case under Title 11.

(b) A representative of a person or estate (except a trustee acting under Title 11) paying any part of a debt of the person or the estate before paying a claim of the U.S. government is liable to the extent of the payment for unpaid claims of the government.

Simply put, in non-bankruptcy insolvencies, the U.S. government's claim is entitled to priority over any creditor claim except for those claims of properly perfected lien (secured) creditors.² The statute also applies whether the government's claim is liquidated or not.³

Just how does this impact unsecured creditor claims? In many insolvencies, a debtor has pledged substantially all of its assets to secure financing of the enterprise. This includes equipment financing, asset-based lending and equity or venture capital financing, where the equity firm not only is an owner of the enterprise, but finances some or all of the operations and collateralizes the advances (in an effort to minimize its risk of loss in the event of the enterprise's failure). As stated above, the secured lender does not stand to lose the value of its lien by reason of this statute. The key is whether the secured creditor has perfected its security interest. Failure to properly perfect any security interest leaves the creditor at risk to the government's rights under the statute.

Nothing in the federal priority statute's text or its long history justifies the conclusion that it authorizes the equivalent of a secret lien as a substitute for the expressly authorized tax lien that the Tax Lien Act declares "shall not be valid" in a case of this kind. On several occasions, this court has concluded that a specific policy embodied in a later federal statute should control interpretation of the older federal priority statute, despite that law's literal, unconditional text and the fact that it had not been expressly amended by the later Act. United States v. Estate of Romani, et.al., 523 U.S. 517 (1998).

In Romani, real property was encumbered by both a judgment lien and a federal tax lien; however, the judgment lien was recorded prior to the notice of the federal tax lien that was filed. The court upheld the priority of payment on the judgment lien. "Here, all agree that by §6232(a)'s terms, the government's liens are not valid as against the earlier recorded judgment lien." Id. at p. 4-7. So this statute does not stand for the concept that the property right negotiated for between a secured lender and a debtor is subject to this intervening statute. However, the priority of the security interest is subject to the state law rules governing perfection, and the failure to perfect the security interest dooms the creditor to potential loss of collateral value on liquidation.

By application of this statute, priority wages, state and local tax claims and general unsecured claims are all subordinate to the U.S. government's claims. As an example, a bank that has a guaranty from the Small Business Administration (SBA) would be able to assert the priority through the SBA guaranty.⁴ Assessments and penalties from the Customs Service would be entitled to priority, as would Environmental Protection Agency (EPA)claims (separate and distinct from the joint and several nature of the EPA claims themselves). Any agency of the federal government, to the extent that agency is owed money by a debtor, is entitled to priority over other unsecured creditor claims.⁵

Another caution exists in the application of the statute. The Internal Revenue Service (IRS) has established guidelines for liability for a fiduciary that fails to pay U.S. governmental claims pursuant to this statute.⁶ "A fiduciary who fails to pay IRS claims may be held personally liable under [this section]." Internal Revenue Service Manual, Part 5, §5.5.1.6(1). The applicable statute of limitations for a suit against a fiduciary under this part of the IRS Manual is 10 years from the date the taxes were assessed. Internal Revenue Service Manual, Part 5, §5.5.1.6(4). Note that the above was only addressing tax claims. However, the potential liability to the fiduciary can reasonably be construed to any agency of the government, not just the IRS.

One case dealing in this area is In re Daniel and Pauline Webb, Case No. 697-67841-R7 (D. Ct. Civ. No. 91-6268-JO, 1991) (unpublished). "[O]nce priority status under §3713 is triggered, §3713(b) established personal liability for a representative of the debtor who pays other claimants before paying the claims of the federal government." United States v. Cole, 733 F.2d 651, 654 (9th Cir. 1984). Continuing on, the case reads, "in order to trigger the priority provisions of §3713(a), the following conditions must be met: (1) a person is indebted to the government; (2) that person is insolvent and (3) that person's insolvency is manifested in one of the three ways set forth in the statute." Id.⁷ What becomes clear is that the knowing failure to honor the priority in non-bankruptcy settings is done at the fiduciary's personal risk.

The other caveat to the application of the statute is §2(b), which states the statute does not apply to cases under Title 11. The Bankruptcy Code has established the priority for allowed unsecured claims of governmental units,⁸ and this priority effectively supercedes the general priority under the Title 31 statute. What is not addressed is the potential that in a non-bankruptcy setting the government gets paid all it is owed pursuant to the statute, and subsequently, the debtor gets relief from the bankruptcy court (and assume for this purpose within 90 days), thereby creating the potential of a preferential transfer. Is the pre-bankruptcy payment avoidable? Does the payment meet the definition of a preference (i.e., is the payment of 100 percent of the governmental claim more than the government would get in the event of a chapter 7 case)? As the priority for governmental claims is lower in the bankruptcy case than in the non-bankruptcy process, that potential exists.

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[I]n non-bankruptcy insolvencies, the U.S. government's claim is entitled to priority over any creditor claim except for those claims of properly perfected lien (secured) creditors.

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The same is true if the claim has no priority (the claim is a "general" unsecured claim because the requirements for priority under §507(1)(8) are not met) and may in fact be even more compelling as the government received 100 percent of its claim outside of bankruptcy, but unless general unsecured creditors receive the same 100 percent recovery on their claims (and that happens all too infrequently), then the government's recovery exceeds those of other unsecured creditors and should be recaptured for re-distribution to all unsecured creditors. The question, though, is this: In the event that last scenario occurs, would that leave the non-bankruptcy fiduciary liable for failure to pay the government's claim in full, or would the intervening bankruptcy mitigate, or even eliminate, that exposure?

What is certain is this: There is a need for anyone dealing with an insolvent debtor in a non-bankruptcy setting to be aware (1) of the existence of 31 U.S.C. §3713, (2) that the priority is provided to any agency of the government and (3) that failure to honor that priority outside of bankruptcy is done at the fiduciary's personal risk.

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Footnotes

¹ The author is a contributing editor to this column and a member of the ABI Board of Directors. Return to article

² See Bramwell v. U.S. Fidelity Co., 269 U.S. 483, 487 (1926); see, also, United States v. State Bank, 31 U.S. 29, 35-36 (1832) (bonds to be paid at a future date). Return to article

³ United States v. Moore, 423 U.S. 77, 80-83 (1975). Return to article

⁴ Of course, the governmental agency can also choose not to assert the priority. In those instances, the fiduciary might consider getting the "waiver" in writing so as to avoid future liability if the agency suddenly had a change of heart and later decided it wanted to be paid all it was otherwise entitled to. Return to article

⁵ This also assumes for those cases where the equity participant has taken a security interest for "bridge" financing that there are no equitable subordination issues or other bases for invalidating the perfected security interest. While an interesting question, it exceeds the scope of this article to address those possibilities. Return to article

⁶ See Internal Revenue Service Manual, Part 5, §5.5.1.6. Return to article

⁷ The case was remanded to the Bankruptcy Code for other reasons. Return to article

⁸ 11 U.S.C. §507(a)(8). Return to article