Surety's Interest Page1

---

 

American States Insurance Co., Appellant v. United States of America , et al., Appellees.

U.S. District Court, No. Dist. Tex. , Dallas Div.; Civ. 3:04-CV-0834-N, Civ. 3:04-CV-0837-N, February 7, 2005 .

Vacating an unreported BC-DC Texas decision.

[ Code Secs. 6323 and 6871]

Bankruptcy: Priorities: Equitable subrogation: Federal tax lien. --

A surety company's claim to funds earned by a contractor, but retained pursuant to an underlying subcontract, had priority over an IRS tax lien. The surety company had issued performance and payment bonds on behalf of the contractor and subsequently made payments on those bonds when the contractor defaulted. Under the concept of equitable subrogation, the surety, by paying off the contractor's obligations, was entitled to any and all sums due or to become due the contractor. The District Court overturned the Bankruptcy Court, which by denying motions filed by both the surety company and the IRS, had ordered the withheld funds to be turned over to the Trustee. The District Court ruled that the Bankruptcy Court failed to give full effect to Pearlman v. Reliance Ins. Co., 371 U.S. 132 (1962), and unduly limited a surety's equitable subrogation right under Texas common law.

.

MEMORANDUM OPINION AND ORDER

GODBEY, District Judge: Before the Court is Appellant American States Insurance Co.'s ("ASIC") appeal from the Bankruptcy Court's Orders of January 13, 2004 and March 8, 2004 . Because the Court determines that the Bankruptcy Court failed to give full effect to Pearlman v. Reliance and unduly limited a surety's equitable subrogation right under Texas common law, the Court vacates those orders and finds for ASIC.

I. BACKGROUND

On August 28, 2000 , Debtor SSEM Corp. ("SSEM") entered into a subcontract with Manhattan Construction Co. (" Manhattan ") as general contractor in connection with the City of Dallas Convention Center Expansion and Renovation (the "Project"). ASIC, as surety, issued both performance and payment bonds for the Project on behalf of SSEM and for the benefit of Manhattan . SSEM performed some work on the subcontract and then defaulted.

Pursuant to the subcontract, SSEM was to submit payment applications monthly for work done. The subcontract further provided that Manhattan was not required to pay SSEM in the event of default, and could retain 5% of the amounts earned by SSEM. Apparently pursuant to those two provisions, Manhattan withheld approximately $88,631.73 (the "Withheld Balances"). Following SSEM's default, ASIC as surety paid $430,806.66 to complete SSEM's work on the Project.

On April 11, 2003 , SSEM filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code, which was converted to a Chapter 7 case. One of SSEM's significant creditors was the Internal Revenue Service ("IRS"), which had filed a pre-petition lien against SSEM for unpaid payroll taxes exceeding $500,000. On August 7, 2003 , the United States , on behalf of the IRS, filed a motion for relief from automatic stay, claiming that the Withheld Balances were property of the SSEM estate, and that the IRS had a priority claim on the Withheld Balances due to its pre-petition liens. ASIC disagreed with the IRS's motion and filed its own motion for relief from automatic stay on August 12, 2003, arguing that it was entitled to the Withheld Balances under its equitable subrogation rights and that the Withheld Balances were never earned by SSEM and thus never became part of the estate. The Trustee opposed the IRS's motion on the basis that the IRS tax lien may be subordinated to other claims under Section 724 of the Bankruptcy Code.

On January 13, 2004, the Bankruptcy Court entered its thoughtful and scholarly order (the "Order") denying both motions for relief from automatic stay, and ordering that the Withheld Balances be turned over to the Trustee. ASIC timely moved for reconsideration. On March 8, 2004 , the Bankruptcy Court issued an order denying the motion for reconsideration, except that it vacated that part of the Order requiring payment of the Withheld Balances to the Trustee. ASIC timely appealed from both of those orders.

This Court has jurisdiction to "hear appeals from final judgments, orders, and decrees from a bankruptcy court." 28 U.S.C. §158(a)(1). On appeal, this Court applies the same standard of review as a court of appeals would use reviewing a district court ruling. Id. §158(c). "[C]onclusions of law are reviewed de novo, findings of fact are reviewed for clear error, and mixed questions of fact and law are reviewed de novo." In re Nat'l Gypsum Co., 208 F.3d 498, 504 (5th Cir. 2000) (citation omitted).

II. THE NATURE OF SSEM'S INTEREST

Before considering ASIC's interests in the Withheld Balances, the Court must briefly consider what basis SSEM had to claim an interest in those balances. ASIC before this Court consistently refers to the balances as unearned, but also indicates the funds were withheld by Manhattan under two contractual provisions. See ASIC Brief at 4, 6. Counsel for the Trustee at oral argument below indicated that the Withheld Balances were entirely retainage, and that the debtor had additional claims for earned but unpaid balances not at issue in this appeal. R. 4:322. The Bankruptcy Court's Order stated: "The funds in question were funds retained under the contract between the Debtor and Manhattan Construction Company, the general contractor for the Project." Order at 2 (R. 3:241). The nature of SSEM's interest in the Withheld Balances may have been apparent to all parties and the Bankruptcy Court below, and that may be why the Order does not address that subject in greater detail. See R. 4:318 ("THE COURT: The facts are undisputed ....") (also reflecting counsel indicating no facts in dispute). Alas, the facts are not so evident to this Court sitting on appeal given the limited appellate record, so the Court must undertake some analysis of the subcontract.

The subcontract was for a face amount of $1,290,000. R. 3:199. SSEM was to make applications for payment monthly for work performed during the month. R. 3:219 (Art. 5.2.1). Subject to a variety of conditions, id. (Art. 5.2.2-.7), SSEM would eventually receive payment for each application. Payment for each approved application, however, was subject to five percent (5%) retainage. ¹ R. 3:199. Finally, the subcontract provides: "Notwithstanding any provision of the Subcontract to the contrary, Manhattan is not obligated to make any payment to [SSEM] under the Subcontract if any one or more of the following conditions exists: (a) Subcontractor ... otherwise is in default under the Subcontract or the Contract Documents." R. 3:219 (Art. 5.3.1(a)).

These two contractual provisions for withholding payment are the only provisions cited to the Court by the parties permitting Manhattan to withhold payment from SSEM. The parties do not point the Court to any factual basis in the record on appeal for SSEM's claim to the Withheld Balances, such as evidence that SSEM performed work, submitted payment applications that met the requirements of Article 5.2, and was due payment. The Court will, therefore, assume that the Withheld Balances comprise retainage and earned balances that were unpaid due to SSEM's default, pursuant to Article 5.3.1(a). Because the Court's analysis is the same for both of those categories, the Court will not dwell further on the distinctions between the two. ²

Both retainage and earned but unpaid balances involve balances for work actually done by SSEM but for which payment had not become due under the subcontract at the time of SSEM's filing for protection. By having actually performed the work, SSEM appears to have at least an equitable claim to the balances. Moreover, under certain circumstances SSEM could have a valid contractual claim to those balances. For example, if ASIC could have stepped in and completed the subcontract for no more than the unearned balance on the contract, and if SSEM had diligently paid its downstream subcontractors and suppliers, it would have a valid contract claim for the retainage and earned but unpaid balances. Property of the estate includes "all legal or equitable interests of the debtor in property as of the commencement of the case." 11 U.S.C. §541(a)(1). Thus, it would appear that retainage and earned but unpaid balances would become property of SSEM's estate absent any intervening factors. ³

III. PEARLMAN SURVIVES THE BANKRUPTCY CODE

The Court now turns to Pearlman v. Reliance Ins. Co., 371 U.S. 132 (1962). That case, decided under the Bankruptcy Act, considered whether a surety or trustee had the right to retainage held by the United States as owner, when the contractor failed to pay suppliers and subcontractors and the surety had to make those payments. The Court initially noted:

Property interests in a fund not owned by a bankrupt at the time of adjudication, whether complete or partial, legal or equitable, mortgages, liens, or simple priority of rights, are of course not a part of the bankrupt's property and do not vest in the trustee. The Bankruptcy Act simply does not authorize a trustee to distribute other people's property among a bankrupt's creditors. So here if the surety at the time of adjudication was, as it claimed, either the outright legal or equitable owner of this fund, or had an equitable lien or prior right to it, this property interest of the surety never became a part of the bankruptcy estate to be admin istered, liquidated, and distributed to general creditors of the bankrupt.

Id. at 135-36 (footnote omitted). The Court then proceeded to analyze the equitable subrogation rights of a surety under common law, and concluded:

We therefore hold in accord with the established legal principles stated above that the Government [owner] had a right to use the retained fund to pay laborers and materialmen; that the laborers and materialmen had a right to be paid out of the fund; that the contractor, had he completed his job and paid his laborers and materialmen, would have become entitled to the fund; and that the surety, having paid the laborers and materialmen, is entitled to the benefit of all these rights to the extent necessary to reimburse it. Consequently, since the surety in this case has paid out more than the amount of the existing fund, it has a right to all of it.

Id. at 141-42. Pearlman thus holds that a surety's equitable subrogation rights can prevent retainage from becoming part of the bankruptcy estate, at least under the Bankruptcy Act. The next two questions are whether the Bankruptcy Code changes the result of Pearlman, and whether the rights of a surety under Texas law are different from the common law rights that drove the result in Pearlman.

The Bankruptcy Court below attempted to create an intermediate position on Pearlman, after noting that "[m]ost courts have held that Pearlman survived the enactment of the Bankruptcy Code," Order at 3 (R. 3:242), but that "[s]ome courts have questioned the continued vitality of Pearlman after the enactment of the Code because the Code defines property of the estate more broadly than pre-Code law." Id. (citations omitted). After considering sections 541(a)(1) and (d) of the Code, the Bankruptcy Court concluded:

Certainly, then, to the extent that a surety is the "equitable owner" of funds under state law, those funds continue to be excluded from "property of the estate" under the Code. But, property in which a surety has an "equitable lien" or a "prior right" vis-a-vis other creditors of its principal under state law that the Court in Pearlman found to be excluded from the estate under the Act would not be excluded from the bankruptcy estate under §541 of the Bankruptcy Code because a lien claim or priority claim under the Bankruptcy Code is just that --a claim. This is where the Supreme Court's pronouncement in Pearlman may have been superseded by the new, expansive definition of "property of the estate" under the Code. Thus, to the extent that a surety cannot claim equitable ownership of the property under state law, but merely possesses an equitable lien claim or a priority claim against the property, the property becomes property of the bankruptcy estate. Likewise, if a surety has ownership of the funds at issue, an IRS lien against the surety's principal would not attach to those funds.

 

Thus, the resolution of the issue before this Court turns on whether, under Texas law, ASIC actually has an ownership interest in the withheld funds or merely a claim against the funds.

Order at 4 (R. 3:243) (emphasis in original).

This Court agrees with the Bankruptcy Court that the great weight of authority holds that Pearlman survives enactment of the Bankruptcy Code. See, e.g., First Indem. of Am. Ins. Co. v. Modular Structs., Inc. (In re Modular Structs., Inc.), 27 F.3d 72, 77-80 (3d Cir. 1994); Caribbean Resort Constr. and Maint., Inc. v. Coco Beach Util. Co. (In re Caribbean Resort Constr. and Maint., Inc.), 318 B.R. 241, 249-50 (Bankr. D. P.R. 2003) (citing Modular Structures); Mendelsohn v. Dormitory Auth. of State of N.Y. (In re QC Piping Inst., Inc.), 225 B.R. 553, 564-71 (Bankr. E.D. N.Y. 1998); J. Michael Frank & Michael E. Evans, A Defense of Established Landmarks: Claims of Construction Sureties to Contract Funds under Chapter 11, 25 TORT & INS. L.J. 28 (1989); 2 DANIAL R. COWANS, COWANS BANKR. L. & PRAC. §12.30, at 587-88 (1989). But see In re Nemko, 143 B.R. 980, 985-86 (Bankr. E.D. N.Y. 1992). ⁴ This Court concurs with the clear majority trend and holds that Pearlman survives the enactment of the Bankruptcy Code in its entirety, rather than in the limited form applied in the Order.

Under Pearlman, the label placed on the surety's equitable subrogation interest was not important; the outcome did not turn on whether that interest was characterized as a lien or an ownership interest. See Pearlman, 371 U.S. at 136 ("if the surety ... was ... either the outright legal or equitable owner of this fund, or had an equitable lien or prior right to it, this property interest of the surety never became a part of the bankruptcy estate ....") (emphasis added). The point was that under common law principles of equitable subrogation, the surety's interest prevented the res from becoming property of the bankruptcy estate. Application of that same principle here leads to the same result: ASIC's interest in the Withheld Balances prevents those balances from become part of SSEM's bankruptcy estate. Although this conclusion is sufficient to resolve the appeal, the Court is cognizant that its decision may be only a rest stop on the Order's journey from the Bankruptcy Court to the Fifth Circuit. The Court will, therefore, consider one further issue.

IV. A SURETY'S EQUITABLE SUBROGATION RIGHT IS NOT A CLAIM

Finally, the Court will address the character of ASIC's interest in the Withheld Balances. The Bankruptcy Court relied upon Section 53.151(b) of the Texas Property Code to determine that ASIC's interest was a claim, rather than an ownership interest. That portion of the Property Code, however, applies only to statutory payment bonds issued in accordance with Chapter 53, sometimes called Hardeman Act bonds, and not to contractual performance or payment bonds generally. ⁵ A bond under chapter 53 must be: in a penal sum at least equal to the total of the original contract amount; in favor of the owner; and executed by the original contractor as principal. TEX. PROP. CODE §53.202. See generally Laughlin Environ., Inc. v. Premier Towers , L.P., 126 S.W.3d 668 (Tex. App. --Houston [14th Dist.] 2004, no pet.). The bonds in this case did not meet those requirements. R. 3:210-11. Nor did they evidence by their terms intent to comply with Chapter 53. Id. ; see TEX. PROP. CODE §53.211(a)(2). Accordingly, Section 53.151(b) is inapplicable to ASIC's bonds.

Because the statutory basis the Bankruptcy Court used to categorize ASIC's subrogation rights is inapplicable, the Court turns to Texas common law. Texas case law regarding the nature of a surety's equitable subrogation interest indicates that it is not simply a claim. In InterFirst Bank Dallas, N.A. v. United States Fid. and Guar. Co., 774 S.W.2d 391 (Tex. App. --Dallas 1989, writ den.), the court considered whether a surety's subrogation rights were security interests under Article 9 of the UCC. The Court held they were not a lien:

Although there is some minor difference of opinion on this legal issue, the majority rule clearly appears to be the one which was sanctioned by Justice Rob ert Braucher in his definitive analysis of the subject in Canter v. Schlager, 358 Mass. 789, 267 N.E.2d 492 (1971). According to Justice Braucher's analysis, a surety's subrogation rights are not security interests within the purview of Article Nine. Id. at 494. This being the case, the promulgation of the UCC and the enactment of its progeny (such as the Texas Business and Commerce Code) do not adversely affect the pre-Code subrogation rights traditionally afforded to sureties. Id. ; see 2 WHITE & SUMMERS, UNIFORM COMMERCIAL CODE §23-6 (3d ed. 1988) (surety's subrogation rights not a security interest); accord National Shawmut Bank v. New Amsterdam Casualty Co., 411 F.2d 843, 847 (1st Cir. 1969). Further, it necessarily follows from Braucher's analysis that a surety's right to equitable subrogation is not adversely affected by the lack of perfection of lien claimants' rights if the surety is obliged to satisfy all lienable claims of laborers and materialmen, whether perfected or not.

 

The overwhelming and essentially unanimous post-UCC decisions have held that the interest of a surety, such as USF & G, continues to be superior to the claim of a contract assignee, such as Bank. Transamerica Ins. Co. v. Barnett Bank, 540 So.2d 113, 117 ( Fla. 1989); Mid-Continent Casualty Co. v. First Nat'l Bank & Trust Co., 531 P.2d 1370, 1377 (Okl. 1975); accord National Shawmut Bank v. New Amsterdam Casualty Co., 411 F.2d 843, 849 (1st Cir.1969); First Alabama Bank v. Hartford Accident & Indem. Co., 430 F. Supp. 907, 911 (N.D. Ala. 1977); Fidelity & Casualty Co. v. Central Bank, 409 So.2d 788, 790 (Ala. 1982); Alaska State Bank v. General Ins. Co., 579 P.2d 1362, 1368 (Alaska 1978); Argonaut Ins. Co. v. C & S Bank, 140 Ga. App. 807, 232 S.E.2d 135, 140 (1976); United States Fidelity & Guar. Co. v. First State Bank, 208 Kan. 738, 494 P.2d 1149, 1159 (1972); Finance Co. of America v. United States Fidelity & Guar. Co., 277 Md. 177, 353 A.2d 249, 254 (1976); Canter v. Schlager, 358 Mass. 789, 267 N.E.2d 492, 497 (1971); Travelers Indem. Co. v. Clark, 254 So.2d 741, 745-46 ( Miss. 1971); Jacobs v. Northeastern Corp., 416 Pa. 417, 206 A.2d 49, 55 (1965); Third Nat'l Bank v. Highlands Ins. Co., 603 S.W.2d 730, 734 ( Tenn. 1980).

Id. at 398-99 (footnote omitted). By the same logic, a surety's equitable subrogation interest is not a claim and takes precedence over mere claim interests.

Other Texas cases have acknowledged that one purpose of retainage is that "[i]t supplies a salvage fund for the contractor's surety in the event it makes good on defaults for which it is bound." Corpus Christi Bank and Trust v. Smith, 525 S.W.2d 501, 505 ( Tex. 1975). Accord Economy Forms Corp. v. Williams Bros. Constr. Co., 754 S.W.2d 451, 457 (Tex. App. --Houston [14th Dist.] 1988, no writ) ("The fact that these funds were retained by the general contractor rather than the property owner does not change the beneficiary or the purpose. ... (3) the retainage provides salvage funds for its surety if the surety makes good on defaults for which it is bound; ...."). Thus, under Texas law, if a surety's equitable subrogation right is not an ownership right, it is at least closer to ownership than it is to a claim.

Accordingly, even if section 541(a)(1) modified the result in Pearlman so that any earned portion of the Withheld Balances would enter SSEM's estate if ASIC's interest were only a lien, as the Order held, under Texas common law ASIC's equitable subrogation interest is greater than a lien; ASIC has an equitable ownership interest in the "salvage fund" to the extent of its completion costs. Thus, regardless whether or not Pearlman alone is sufficient to keep the Withheld Balances out of SSEM's estate, ASIC is still entitled to the Withheld Balances. Because the Withheld Balances never enter SSEM's estate, the IRS's priority is immaterial.

CONCLUSION

It is therefore ordered that the Bankruptcy Court's orders of January 14, 2004 and March 9, 2004 are vacated, that ASIC's motion for relief from automatic stay is granted, and that the United States' motion for relief from automatic stay is denied.

¹ "Retainage" was not otherwise defined or addressed in the subcontract. Black's defines retainage as "A percentage of what a landowner pays a contractor, withheld until the construction has been satisfactorily completed and all mechanic's liens are released or have expired." BLACK'S LAW DICTIONARY 1341 (8th ed. 2004).

² The Court can conceive of analytical frameworks that would treat retainage differently than earned but unpaid balances. In such a case, the Court would be required to remand for the Bankruptcy Court to give more detailed consideration to the nature of SSEM's claim to the Withheld Balances. Because the Court's analysis is the same for both categories, that is unnecessary in this case.

³ As indicated above, ASIC characterizes the Withheld Balances as money that "was never earned by SSEM, was not owed to SSEM under the subcontract ...." See ASIC Brief at 6. The Court understands ASIC's claim to mean simply that the balances were not due and payable to SSEM under the terms of the subcontract, although SSEM had done the work. Characterizing the balances as unearned, however, could be taken as meaning they included that portion of the $1.3 million contract price associated with work the SSEM did not perform before it defaulted, for which SSEM did not submit a payment application, and that ASIC had to complete. The Court does not understand that to be what ASIC is contending. If the Withheld Balances included such truly unearned contractual balances, SSEM would not have any legal or equitable claim to such balances. Because that produces the same result the Court reaches, it is not necessary to determine whether any of the Withheld Balances were truly unearned in that sense.

⁴ The Bankruptcy Court in Mendelsohn v. DASNY distinguished In re Nemko factually. 225 B.R. at 569.

⁵ "Subcontractors and suppliers are the 'beneficiaries' of a payment bond. By contrast, a performance bond is only for the benefit of the obligee/owner of the construction project. Subcontractors and suppliers generally do not have the right to seek payment from the performance bond surety if the principal defaults." Laughlin Environ., Inc. v. Premier Towers, L.P., 126 S.W.3d 668, 671 n.3 (Tex. App. --Houston [14th Dist.] 2004, no pet.).

 

[2000-2 USTC ¶50,562] Wayne County Board of County Commissioners , Plaintiff v. Mendel, Inc., et al., Defendants

U.S. District Court, No. Dist. Ohio , East. Div., 5:98 CV 1795, 5/30/2000

[Code Sec. 6321 ]

Lien for taxes: Validity and priority against third-parties: Property subject to tax liens.--A construction company that entered into a contract with a county board of commissioners to complete a bridge project had an interest in a fund containing monies to pay for the project that was held by the board after its completion. The contractor was not in breach of contract and owed no amounts to the county that would bar its claim to the funds. Therefore, it had an interest in the fund to which a tax lien could attach.

[Code Sec. 6323 ]

Lien for taxes: Validity and priority against third-parties: Equitable lien: Surety.--A claim by a surety, which made payments to a construction company's subcontractors pursuant to a performance bond, did not have priority over a federal tax lien to funds still owed to the contractor because it was not "first in time." The surety's purported equitable lien became choate when the subcontractors were paid, which was after the tax lien was assessed.

[Code Sec. 6323 ]

Lien for taxes: Validity and priority against third-parties: Surety: Security interest: Superpriority: Financing statement.--A surety, which made payments to a construction company's subcontractors pursuant to a performance bond, did not hold a security interest in funds still owed to the contractor that took superpriority over an earlier federal tax lien. The surety did not file a financing statement with the appropriate office, which is required in order to perfect a security interest.

ORDER

OLIVER, JR., District Judge:

On June 26, 1998, Plaintiff, Wayne County Board of County Commissioners ("Wayne County"), brought an interpleader action against Defendants, Mendel, Inc. ("Mendel"), the Internal Revenue Service ("IRS"), Ohio Farmers Insurance Co. ("Ohio Farmers") and All Ohio Insurance Agency, Inc., in the Court of Common Pleas of Wayne County to determine which of the Defendants is entitled to certain proceeds of a construction contract between Mendel and Wayne County. ¹ On August 6, 1998, the government removed this action to the United States District Court for the Northern District of Ohio pursuant to 28 U.S.C. §1444. The government and Ohio Farmers both claim an interest in the interpled funds. Presently before the court are the cross-motions for summary judgment by Ohio Farmers and the government on their respective claims to the interpled funds. For the reasons that follow, the court finds that the government is entitled to the interpled funds and therefore grants its motion for summary judgment (Doc. No. 36) and denies Ohio Farmers' cross-motion for summary judgment (Doc. Nos. 26 and 31). ²

I. FACTS

The facts are generally undisputed. On December 5, 1996 , the debtor-taxpayer, Mendel, entered into a contract with Wayne County to improve a bridge in Milton Township , located in Wayne County ("the bridge project"). To obtain the contract, Mendel secured a surety bond from Ohio Farmers under which Ohio Farmers guaranteed performance of the contract and also guaranteed payment to all persons supplying labor and materials to the project.

Mendel completed the project; it was therefore unnecessary for Ohio Farmers to make any payments with respect to its performance bond. However, Mendel did not pay all of its subcontractors. Pursuant to its obligation on the payment bond, Ohio Farmers paid United Precast's claim of $7,677.00 on December 1, 1997 , and Meredith Brothers' claim of $8,258.77 on February 11, 1998 . Neither United Precast nor Meredith Brothers filed mechanic's liens pursuant to Ohio Revised Code §1311.26.

Throughout its performance on the bridge project, Mendel also failed to pay all of its employees' share of federal income tax and social security withholding on wages. These tax liabilities were assessed on June 16, 1997 , August 25, 1997 , September 22, 1997 , December 8, 1997 and April 1, 1998 , and amounted to more than $100,000. Notices of federal tax lien with respect to these liabilities were filed on February 11, 1998 , May 28, 1999 and February 4, 1999 .

Wayne County made various payments to Mendel pursuant to the parties' contract. However, under the terms of the contract, Wayne County was authorized to retain and hold a percentage of estimated amounts due monthly until final completion and acceptance of all work covered by the contract. ³ Pursuant to this term, Wayne County had in its possession $10,261.51 of undistributed contract funds at the time the bridge project was complete. ⁴

On February 24, 1998 , the Wayne County Auditor received a Notice of Levy from the IRS regarding Mendel and providing for a lien on all monies in Wayne County 's possession which Wayne County was obligated to pay to Mendel. On June 1, 1998 , Wayne County received a letter from Ohio Farmers directing Wayne County to mail all remittances and checks to Ohio Farmers as surety for Mendel. The letter indicated that Ohio Farmers had been forced to make payments to subcontractors and suppliers furnishing labor or material on behalf of Mendel in connection with the bridge project. Thereafter, Wayne County filed the instant interpleader action, seeking to determine to whom the remaining contract funds (the "Fund") belong.

II. SUMMARY JUDGMENT STANDARD

Federal Rule of Civil Procedure 56(c) governs summary judgment motions and provides:

The judgment sought shall be rendered forthwith if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law. . . .

Rule 56(e) specifies the materials properly submitted in connection with a motion for summary judgment:

Supporting and opposing affidavits shall be made on personal knowledge, shall set forth such facts as would be admissible in evidence, and shall show affirmatively that the affiant is competent to testify to the matters stated therein. . . . The court may permit affidavits to be supplemented or opposed by depositions, answers to interrogatories, or further affidavits. When a motion for summary judgment is made and supported as provided in this rule, an adverse party may not rest upon the mere allegations or denial of the adverse party's pleading, but the adverse party's response, by affidavits or as otherwise provided in this rule, must set forth specific facts showing that there is a genuine issue for trial. If the adverse party does not so respond, summary judgment, if appropriate, shall be entered against the adverse party.

However, the movant is not required to file affidavits or other similar materials negating a claim on which its opponent bears the burden of proof, so long as the movant relies upon the absence of the essential element in the pleadings, depositions, answers to interrogatories, and admissions on file. Celotex Corp. v. Catrett, 477 U.S. 317, 106 S.Ct. 2548 (1986).

In reviewing summary judgment motions, this court must view the evidence in a light most favorable to the non-moving party to determine whether a genuine issue of material fact exists. Adickes v. S.H. Kress & Co., 398 U.S. 144, 90 S.Ct. 1598 (1970); White v. Turfway Park Racing Ass'n, Inc., 909 F.2d 941, 943-44 (6th Cir. 1990). A fact is "material" only if its resolution will affect the outcome of the lawsuit. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248, 106 S.Ct. 2505, 2510 (1986). Determination of whether a factual issue is "genuine" requires consideration of the applicable evidentiary standards. Thus, in most civil cases the court must decide "whether reasonable jurors could find by a preponderance of the evidence that the [non-moving party] is entitled to a verdict." Id. at 252, 106 S.Ct. at 2512.

Summary judgment is appropriate whenever the non-moving party fails to make a showing sufficient to establish the existence of an element essential to that party's case and on which that party will bear the burden of proof at trial. Celotex, 477 U.S. at 322, 106 S.Ct. at 2552. Moreover, "the trial court no longer has a duty to search the entire record to establish that it is bereft of genuine issue of material fact." Street v. J.C. Bradford & Co., 886 F.2d 1472, 1479-80 (6th Cir. 1989) (citing Frito-Lay, Inc. v. Willoughby, 863 F.2d 1029, 1034 (D.C. Cir. 1988)). The non-moving party is under an affirmative duty to point out specific facts in the record as it has been established which create a genuine issue of material fact. Fulson v. City of Columbus , 801 F.Supp. 1, 4 (S.D. Ohio 1992). The non-movant must show more than a scintilla of evidence to overcome summary judgment; it is not enough for the non-moving party to show that there is some metaphysical doubt as to material facts. Id.

III. LAW AND ANALYSIS

Ohio Farmers and the government have filed cross-motions for summary judgment on their respective claims to the Fund. Ohio Farmers asserts its entitlement to the Fund on the basis that Mendel has no interest in the Fund to which a tax lien could attach. Ohio Farmers contends that this is so because Mendel did not satisfy all of the requirements of its contract with Wayne County since Mendel did not pay all of its subcontractors. According to Ohio Farmers, the money Wayne County withheld pursuant to paragraph 25(a) of its contract with Mendel was never earned by Mendel, and thus was not available for attachment by the IRS lien.

Section 6321 of the Federal Tax Lien Act, 26 U.S.C. §§6321-6327, gives the United States a lien for unpaid taxes on "all property and rights to property" of a taxpayer who neglects to pay his taxes after demand. This lien reaches every interest in property that a taxpayer may have, U.S. v. National Bank of Commerce [85-2 USTC ¶9482], 472 U.S. 713, 720, 105 S.Ct. 2919, 2924 (1985), arises on the date of assessment and continues until the assessment is fully satisfied or becomes unenforceable. 26 U.S.C. §6322. A tax lien can attach even if a taxpayer's interest in property is less than full ownership or is one among several claims of ownership. United States v. Safeco Ins. Co. of Am. [89-1 USTC ¶9227], 870 F.2d 338, 341 (6th Cir. 1989). See also In re Construction Alternatives [93-2 USTC ¶50,569], 2 F.3d 670 (6th Cir. 1993). "Unresolved questions concerning the ultimate ownership of the property will not prevent provisional attachment of a federal tax lien." Safeco [89-1 USTC ¶9227], 870 F.2d at 341.

In the instant case, it is undisputed that the bridge project was completed by Mendel. The fact that Ohio Farmers paid two of Mendel's subcontractors on the project is immaterial for the purpose of determining completion of the project. See In re Wm. Cargile Contractor, Inc., 203 B.R. 644, 646 (S.D. Ohio 1996). Mendel owed nothing to Wayne County ; thus, no payments to the county were required or other expenses incurred to perfect Mendel's claim to the retained funds. Moreover, Wayne County has never declared Mendel in breach of its contract and disavows any claim to the retained funds. See Menuez Declaration ¶5; Complaint ¶7. Mendel thus earned the right to receive the retained funds, and under the principles stated above, the government has a valid tax lien on the Fund. See Construction Alternatives [93-2 USTC ¶50,569], 2 F.3d at 674 (finding that general contractor who had completed project and owed no obligations to owner of the project but who had not paid several subcontractors had earned right to receive its final progress payment and therefore federal tax lien could attach to progress payment).

Having determined that Mendel had an interest in the Fund to which a tax lien could attach, the next issue is whether Ohio Farmers also has a lien on the Fund, and if so, whether that lien is superior to the government's tax lien. Ohio Farmers contends that it has an equitable lien on the Fund through subrogation to the rights of United Precast and Meredith Brothers, the two subcontractors that it paid in Mendel's stead, and also through subrogation to the rights of Wayne County . It asserts that its equitable lien is superior to the government's tax lien because it was perfected prior to the time the federal tax lien was filed.

Even assuming that Ohio Farmers has a valid equitable lien on the Fund through subrogation, see Pearlman v. Reliance Ins. Co., 371 U.S. 132, 83 S.Ct. 232 (1962) (holding that surety who completed general contractor's contract and paid contractor's laborers and materialmen held equitable lien on retained contract funds through subrogation to rights of government owner, to rights of laborers and materialmen and to rights which contractor would have had he completed job), the court finds that the government has priority to the Fund and is thus entitled to it. When there is a competition between a federal tax lien and a state law lien, priority is determined by the "first in time, first in right" rule. Terwilliger's Catering Plus, Inc. v. Baverly [90-2 USTC ¶50,460], 911 F.2d 1168, 1176 (6th Cir. 1990) (quoting United States v. City of New Britain, Conn. [54-1 USTC ¶9191], 347 U.S. 81, 85, 74 S.Ct. 367, 370 (1954)). If the competing state law lien falls into one of the limited categories of liens enumerated in §6323(a), the federal tax lien is only perfected once the notice of the federal tax lien is filed. See United States, ex rel. IRS v. McDermott [93-1 USTC ¶50,164], 507 U.S. 447, 113 S.Ct. 1526, 1528 (1993). If the state law lien is not among the enumerated categories in §6323(a), then the federal tax lien need not be filed to gain priority over other interests; it is perfected at the time the lien is assessed. Terwilliger's [90-2 USTC ¶50,460], 911 F.2d at 1176; IRC §6322.

Under §6323(a), the tax lien is not effective against "any purchaser, holder of a security interest, mechanic's lienor, or judgment creditor until notice [of the lien] . . . has been filed by the Secretary." There is nothing in the record to indicate that Ohio Farmers is subrogated to any such rights. Thus, the tax lien has priority over any equitable lien that Ohio Farmers can claim to the Fund as long as it was assessed prior to Ohio Farmer's lien becoming choate. A state created lien interest is usually held to be choate " 'when the identity of the lienor, the property subject to the lien, and the amount of the lien are established.' " Terwilliger's [90-2 USTC ¶50,460], 911 F.2d at 1176 (quoting New Britain , 347 U.S at 84, 74 S.Ct. at 369). See also Construction Alternatives [93-2 USTC ¶50,569], 2 F.3d at 676. Ohio Farmer's equitable lien, if it exists, became choate on December 1, 1997 with respect to United Precast's claim, and or February 11, 1998 , with respect to Meredith Brother's claim. By December 1, 1997 , the IRS had already assessed a tax lien in the amount of $58,789.52 against Mendel, well over the amount in the Fund. Thus, Ohio Farmer's equitable lien would not have been perfected at the time the tax lien was assessed and therefore, the tax lien takes priority.

However, Ohio Farmers contends that under §6323(c), it has a security interest in the Fund that has priority over the government's tax lien even though its equitable lien may not have been perfected at the time of tax lien filing. Under §6323(c), a surety's "security interest" has priority over a tax lien even though the security interest came into existence after the tax lien was filed, provided the following circumstances are applicable: "1) the surety's security interest . . . is an obligatory disbursement agreement such as a suretyship agreement; 2) . . . the surety's interest is in "qualified property" covered by the terms of a written agreement entered into before the tax lien filing; and 3) the security interest would be protected under local law against a judgment lien that arose at the same time as the tax lien." Construction Alternatives [93-2 USTC ¶50,569], 2 F.3d at 677-678 (citing 26 U.S.C. §6323(c)).

A "security interest" under §6323(c) exists if "the property is in existence and the interest has been protected under local law against a subsequent judgment lien creditor." 26 U.S.C. §6323(h). Thus, before Ohio Farmer's alleged security interest in the Fund would take priority over a subsequently-arising judgment lien under local law, Ohio Farmers would have been required to perfect its security interest by filing a financing statement in the appropriate office. Construction Alternatives [93-2 USTC ¶50,569], 2 F.3d at 678 (citing Ohio Rev. Code §§1309.21, 1309.23). For example, the court in Construction Alternatives rejected the surety's argument that it was entitled to priority over the government under §6323(c) on the basis that the surety had not filed a financing statement. Id. Similarly, Ohio Farmers never filed a financing statement and thus does not possess a security interest under §6323(c). Accordingly, Ohio Farmers cannot come within the superpriority provisions of §6323(c) and it remains true that the IRS has priority to the Fund.

IV. CONCLUSION

For the foregoing reasons, the court finds that the government has a valid tax lien on the Fund and that such lien is superior to any equitable lien on the Fund that Ohio Farmers may claim. Accordingly, the court holds that the United States is entitled to the interpled funds and therefore grants its motion for summary judgment on its claim to such funds (Doc. No. 36). Ohio Farmers' motion for summary judgment on its claim to the interpled funds (Doc. Nos. 26 and 31) is hereby denied.

IT IS SO ORDERED.

JUDGMENT ENTRY

Pursuant to a separate order of this same date, judgment in this interpleader action is hereby entered in favor of the United States in the amount of $10,261.51; Ohio Farmer's claim to this same amount is hereby denied.

IT IS SO ORDERED.

¹ After indicating that it had no interest in the funds, Defendant All Ohio Insurance Agency, Inc. was dismissed from this case on November 24, 1998 .

² On May 23, 2000 , the court held a telephonic conference wherein the parties were permitted to orally address several legal arguments discussed in their briefs. However, for purposes of deciding the parties' cross-motions for summary judgment, the court has relied on only factual information addressed in the parties' memoranda.

³ Paragraph 25(a) of the contract provides:

Not later than the 15th day of each calendar month the Owner shall make a progress payment to the Contractor on the basis of a duly certified and approved estimate of the work performed during the preceding calendar month under this contract, but to insure the proper performance of this contract, the Owner shall retain ten percent (10%) of the amount of each estimate until final completion and acceptance of all work covered by this contract . . . Provided . . . that the Owner at any time after fifty percent (50%) of the work has been completed, if it finds that satisfactory progress is being made, may make any of the remaining progress payments in full. . . .

While it is undisputed that Mendel completed the bridge project, it is not clear from the record whether Wayne County actually accepted the project. If it did, then, upon its acceptance, Wayne County would have had no right to continue withholding the funds retained pursuant to this provision. However, for purposes of the pending cross-motions for summary judgment, the court will assume that Wayne County did not accept the project and rightfully withheld the disputed funds.

⁴ Ohio Farmers asserts that Wayne County was entitled to hold the undistributed contract funds pursuant to paragraph 25(d) of the contract. This provision states in pertinent part:

The Contractor shall, at the Owner's request, furnish satisfactory evidence that all obligations [owed to subcontractors, laborers, etc.] have been paid, discharged, or waived. If the Contractor fails so to do then the Owner may, after having served written notice on the said Contractor, either pay unpaid bills, of which the Owner has written notice, direct, or withhold from the Contractor's unpaid compensation a sum of money deemed reasonably sufficient to pay any and all such lawful claims until satisfactory evidence is furnished that all liabilities have been fully discharged. . . .

There are several prerequisites to Wayne County being permitted to withhold money pursuant to this provision, including that Wayne County first request from Mendel evidence that subcontractors, laborers and the like have been paid. In his declaration, Judson Menuez, President of Mendel during the term of the bridge project, stated that Wayne County never requested such evidence from Mendel, Menuez Declaration ¶4, and Mendel has offered no evidence to the contrary. Accordingly, Wayne County could not withhold any contract funds from Mendel pursuant to paragraph 25(d).

 

 

[98-2 USTC ¶50,609] Reliance Insurance Company, a Pennsylvania corporation, Plaintiff v. United States of America , acting by and through the Internal Revenue Service, Defendant

U.S. District Court, Dist. Ore., Civ. 97-803-HA, 7/17/98

[Code Secs. 3401 and 6323 ]

Liens and levies: Wrongful levy: Superior interest: Surety: Set-off: FICA liability: Who is the employer.--The IRS was entitled to set off contract funds to which an insurance company possessed a superior interest against the company's unpaid Federal Insurance Contribution Act (FICA) liability. Since the company controlled the payroll and disbursed its own funds to pay the employees of a contractor that defaulted on a bridge repair project, it qualified as an "employer" liable for FICA taxes. The insurance company failed to contest the IRS's right to set-off.

[Code Sec. 7426 ]

Liens and levies: Wrongful levy: Superior interest.--An insurance company's interest in contract funds was superior to that of the IRS in connection with a contractor that defaulted on a bridge repair project. The IRS conceded that the company, which was the surety of the contractor, possessed a superior interest in the funds with respect to its wrongful levy claim.

Jan D. Sokol, Thomas A. Larkin, Stewart, Sokol & Gray, One S.W. Columbia St., Portland, Ore. 97258-2097, for plaintiff. Kristine Olson, United States Attorney, Portland, Ore. 97204, Sanford W. Stark, Department of Justice, Washington, D.C. 20530, for defendant.

OPINION AND ORDER

HAGGERTY, District Judge:

Both parties seek summary judgment regarding an Internal Revenue Service (IRS) levy of funds from an Oregon Department of Transportation (ODOT) project involving a contractor that defaulted. The contractor's surety (plaintiff) argues that its interest in the project funds was superior to the IRS's interest. The government does not dispute this, but contends it is entitled to a set-off regarding employment tax funds for which plaintiff remains responsible. For the reasons that follow, the government is entitled to summary judgment, and plaintiff Reliance Insurance Company's cross motion for summary judgment is denied.

BACKGROUND

In September 1995, a company called "Great Western Coatings, Inc.," ("GWC") contracted with the ODOT to repair and install a cathodic protection system on the approach spans to the Yaquina Bay Bridge in Newport , Oregon . Plain tiff Reliance Insurance Company was the surety for GWC, guaranteeing GWC's performance on the project in the event GWC defaulted. Reliance and GWC posted performance and payment bonds to ODOT as obligee on 19 September 1995 totaling over $2,220,000.

Reliance was notified on 1 October 1996 that GWC was suffering cash flow difficulty and was unable to make its 4 October 1996 payroll. Per an agreement with Reliance, GWC voluntarily defaulted on 7 October 1996 , well before the project was completed. Reliance agreed to finance GWC's completion of the work, and directed ODOT to withhold further payments to GWC. Reliance provided funding between October 1996 and February 1997. Reliance made several payroll payments directly to GWC employees, but claims that it never asserted control over employees directly.

On 26 November 1996 , the IRS issued and served a tax levy on ODOT demanding payment of $110,135.86 for past years' assessments against GWC. On 21 December 1996 , ODOT paid the IRS $34,121.57 from the project's contract funds. Reliance received remaining payments from ODOT totaling approximately $1,000,000, minus the payment ODOT made to the IRS. Reliance argues that as financing surety, it had an interest in the contract funds paid to the IRS that was superior and paramount to any interest of the IRS. Accordingly, Reliance initiated this action for wrongful levy under 26 U.S.C. §7426, seeking to compel the United States to remit the levied funds to Reliance.

Reliance sues to recover the $34,121.57 ODOT paid to the IRS, and seeks summary judgment on this claim and against the IRS's counterclaim. In its counterclaim, the IRS contends that the unpaid employer's share of Federal Insurance Contribution Act (FICA) funds totals $28,287.82 for the fourth quarter of 1996, and $17,521.91 for the first quarter of 1997, and that Reliance is responsible for these FICA payments. The IRS seeks summary judgment against plaintiff's claim and in favor of its counterclaim, on the theory that regardless of whether its levy was wrongful, the IRS is entitled to a set-off for the FICA payments.

STANDARDS

Summary judgment is proper under Fed. R. Civ. P. 56(c) "if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law." Celotex Corp. v. Catrett, 477 U.S. 317, 322 (1986). The substantive law underlying the claims in issue identifies which facts are material. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986). When assessing a motion for summary judgment, the court must make all factual inferences in favor of the party opposing the motion. Matsushita Elec. Indus. Co., Ltd. v. Zenith Radio Corp., 475 U.S. 574, 587 (1986).

The parties' motions raise the following legal questions: (1) Whether the government wrongfully levied contract funds to which Reliance maintained a superior interest; and (2) Whether the government should nevertheless be entitled to set off the levied funds against outstanding FICA liabilities that Reliance is obligated to pay.

ANALYSIS

A. Wrongful levy

Section 7426 of Title 26, United States Code, provides the exclusive remedy for an innocent third party whose property is confiscated by the IRS to satisfy another person's tax liability. Section 7426(a)(1) provides, in relevant part:

If a levy has been made on property or property has been sold pursuant to a levy, any person (other than the person against whom is assessed the tax out of which such levy arose) who claims an interest in or lien on such property and that such property was wrongfully levied upon may bring a civil action against the United States in a district court of the United States.

26 U.S.C. §7426(a)(1).

If the court finds that the property was wrongfully levied upon, §7426(b)(2) provides that the court may:

(A) order the return of specific property if the United States is in possession of such property;

(B) grant a judgment for the amount of money levied upon; or

(C) if such property was sold, grant a judgment for an amount not exceeding the greater of--

(I) the amount received by the United States from the sale of such property, or

(ii) the fair market value of such property immediately before the levy.

26 U.S.C. §7426(b)(2).

In order to state a cause of action under §7426, the plaintiff must show: (1) that a levy has been filed against property in plaintiff's hands, (2) that plaintiff has an interest in or a lien on the property which is senior to the interest of the United States, and (3) that the levy was wrongful. A levy is wrongful where the property levied upon "does not, in whole or in part, belong to the taxpayer against whom the levy originated." Arth v. United States [84-2 USTC ¶9601], 735 F.2d 1190, 1193 (9th Cir. 1984).

Reliance is entitled to summary judgment on its wrongful levy claim, because it has a paramount interest in the funds. Under 26 U.S.C. §6323(c), which recognizes that certain security interests having priority over tax liens, Congress provided:

(1) . . . To the extent provided in this subsection, even though a notice of a lien . . . has been filed, such lien shall not be valid with respect to a security interest which came into existence after tax lien filing but which

(A) is in qualified property covered by the terms of a written agreement entered into before tax lien filing and constituting--. . .

(iii) an obligatory disbursement agreement, and

(B) is protected under local law against a judgment lien arising, as of the time of tax lien filing, out of an unsecured obligation.

The government concedes that if the conditions of the statute are met, a surety's interest in contract proceeds pursuant to a bond executed before a tax lien is filed will prevail over the lien. Furthermore, for the purposes of this motion, the government does not dispute that under 26 U.S.C. §6323(c), Reliance's interest in the levied funds is superior to the IRS's interest.

Accordingly, the court grants plaintiff's motion for summary judgment on its wrongful levy claim. The government asserts no argument against there being a "wrongful levy," but agrees that Reliance has a superior interest.

B. Government's right to set-off

The government contends that Reliance qualified as the project workers' "employer" for the fourth quarter of 1996 and the first quarter of 1997 and is responsible for FICA payments. Therefore, the government argues, it is entitled to a "set-off" of the FICA amounts due. The government contends that it is not obligated to refund the levied money, because the IRS may exercise its rights to a set-off, and apply the levied funds to Reliance's outstanding FICA liabilities.

Courts recognize the government's right to set-off. See United States v. Munsey Trust Co., Receiver, 332 U.S. 234, 239 (1947) ("The government has the same right which belongs to every creditor, to apply the unappropriated moneys of his debtor, in his hands, in extinguishment of the debts due to him"); Capuano v. United States [92-1 USTC ¶50,163], 955 F.2d 1427, 1430 (11th Cir. 1992); United Sand and Gravel Contractors, Inc. v. United States [80-2 USTC ¶9626], 624 F.2d 733, 736 (5th Cir. 1980).

The government properly filed a counterclaim to exercise its common law right of set-off. To establish the right to set-off in a counterclaim, the government bears the burden of showing that the plaintiff is indebted to the government. See Cherry Cotton Mills v. United States [46-1 USTC ¶9218], 327 U.S. 536 (1946) (holding that illegally collected taxes may be used to set off any indebtedness that the government establishes is owed by the plaintiff to the government). Plaintiff Reliance makes no argument against the government's set-off rights. The only question presented by the government's counterclaim, therefore, is whether the government has met its burden by establishing that Reliance owes FICA taxes to the government.

The Internal Revenue Code provides that an employer bears responsibility for withholding FICA and FUTA taxes. 26 U.S.C. §§3101-02, 3111 & 3301. The Internal Revenue Code addresses the taxes imposed on employees regarding FICA under §3101(a),(b). Employers must withhold the employees' shares and pay the shares to the IRS under §3102(a). Section 3111 of the Code addresses the employer's share of FICA taxes. Employers are obligated to pay their own shares of FICA under this section.

The government argues that Reliance qualifies as the "employer" on the project from 29 September 1996 through 15 February 1997, and has failed to meet its obligation to pay the employer's share of FICA under §3111 for this time period. The term "employer" is defined in section 3401(d) of the Internal Revenue Code as follows:

(d) Employer.--For purposes of this chapter, the term "employer" means the person for whom an individual performs or performed any service, of whatever nature, as the employee of such person except that--

(1) if the person for whom the individual performs or performed the services does not have control of the payment of the wages for such services [then] the term "employer" . . . means the person having control of the payment of such wages.

26 U.S.C. §3401(d)(1).

The Supreme Court has held that this definition of "employer" is equally applicable to FICA obligations. See Otte v. United States [74-2 USTC ¶9822], 419 U.S. 43, 51 (1974); Winstead v. United States [97-1 USTC ¶50, 322], 109 F.3d 989, 991 (4th Cir. 1997).

In Otte the question presented was whether a trustee in bankruptcy was required to make appropriate withholdings when making payment of wage claims representing wages earned before bankruptcy. Referring to §3401(d)(1), the Court said the statute "obviously was in tended to place responsibility for withholding at the point of control." Id. at 50.

The Ninth Circuit has addressed FICA liability in In re Southwest Restaurant Sys., Inc. [79-2 USTC ¶9578], 607 F.2d 1237 (9th Cir. 1979). The court held that no one "other than the person who has control of the payment of the wages is in a position to make the proper accounting and payment to the United States . It matters little who hired the wage earner or what his duties were or how responsible he may have been to his common law employer. Neither is it important who fixed the rate of compensation. When it finally comes to the point of deducting from the wages earned that part which belongs to the United States and matching it with the employer's share of FICA taxes, the only person who can do that is the person who is in 'control of the payment of such wages.' " Id. at 1240 (quoting Otte).

The undisputed evidence in this case is that Reliance controlled the payment of wages to the project workers through the fourth quarter of 1996 and the first half of the first quarter of 1997. Plaintiff alone financed every weekly payroll during this period, beginning with the 11 October 1996 payroll (for work performed from 29 September 1996 through 5 October 1996 ) until GWC was terminated from the contract in February 1997. Reliance initially provided cashier's checks to GWC to distribute to workers. GWC would provide payroll information to Reliance, and Reliance would draw the appropriate amounts by purchasing cashier's checks from Sterling Savings and Loan in Federal Way , Washington .

At the end of November 1996, the parties established an account at the Bank of America. This account was governed by an agreement prepared by Reliance and dated 26 November 1996 . The agreement required two signatures for any check drawn on the account, and one signature was required to be from a Reliance representative. Reliance could refuse to countersign any check it believed was improper. After opening this account, GWC would still provide payroll information, and Reliance would review the information for accuracy before countersigning checks and returning them to GWC. Reliance alone funded the Bank of America account.

On 13 February 1997 Reliance terminated GWC's involvement with the ODOT project, effective 17 February 1997 . On that date a different contractor, Abhe & Svoboda, replaced GWC and completed the project. The new contractor assumed responsibility for processing payroll, and Reliance's last payroll payment was made on 21 February 1997 , for work completed during the week ending 15 February 1997 .

In essence, Reliance acknowledges that it paid weekly payroll from 29 September 1996 through 15 February 1997 based upon invoices of labor GWC submitted to it. The evidence from Reliance's documents establishes that Reliance controlled the payments of wages to the workers for that time period. Since it controlled payroll, and used its own funds to disburse pay, Reliance qualified as the workers' "employer" under §3401(d)(1).

Reliance disputes that 26 U.S.C. §3401(d)(1) is applicable. It argues that 26 U.S.C. §3505 is the statute that establishes tax responsibilities for third parties paying wages. Enacted in 1966, §3505 pertains to third parties (such as sureties) who make direct payments to employees. It provides:

(a) direct payments by third parties. For purposes of sections 3102, 3202, 3402, and 3403, if a lender, surety, or other person, who is not an employer under such sections with respect to an employee or group of employees, pays wages directly to such an employee or group of employees, employed by one or more employers, or to an agent on behalf of such employee or employees, such lender, surety or other person shall be liable in his own person and estate to the United States in a sum equal to the taxes (together with interest) required to be deducted and withheld from such wages by such employer.

Reliance contends in its Reply brief that "Section 3505 is specifically applicable to the situation in this action where Reliance and [GWC] established a joint control trust account . . ." Reply at 3.

The court concludes that §3505 concerns only subsections 3102, 3202, 3402, and 3403 of the Internal Revenue Code, and that these subsections relate to the amount of taxes to be withheld from an employee's pay. Section 3505(a) pertains to the employee's share of employment taxes and does not address a third party's liability for the employer's share of FICA taxes that are at issue in this case. The taxes at issue in this case arise pursuant to §3111. Reliance is properly construed as the "employer" under §3401(d)(1), and the government is entitled to a set-off of the unpaid employer's share of FICA.

CONCLUSION

For the reasons stated herein, the court grants plaintiff's motion for summary judgment (doc. #20-1) on its wrongful levy claim on the undisputed grounds that Reliance has a superior interest. The government, however, is granted summary judgment on its motion (doc. #26-1) as well, because Reliance qualified as the project workers' "employer" for the fourth quarter of 1996 and the first quarter of 1997 and is respon sible for FICA payments. The government is entitled to a set-off of the FICA amounts due.

Counsel for the government are ordered to file a proposed Judgment to opposing counsel and this court by 7 August 1998 . Plaintiff shall file any objections by 14 August 1998 .

IT IS SO ORDERED.

 

[98-1 USTC ¶50,168] Titan Indemnity Company, Plaintiff-Appellant v. The Triborough Bridge and Tunnel Authority, Inc., Quadrozzi Equipment Leasing Corp., Quadrozzi Concrete Corp. and Helen Carr Corp., Defendants, Internal Revenue Service and NYS Dept. of Labor, Defendants-Appellees

(CA-2), U.S. Court of Appeals, 2nd Circuit, 96-6299, 1/26/98, 135 F3d 831, Affirming an unreported District Court decision

[Code Sec. 6323 ]

Lien for taxes: State lien law: Funds held in trust: Priority: Claim of surety.--A surety company's claim did not have priority, ahead of several other parties including the IRS, with regard to funds withheld from a contractor following its default on a public improvement contract. The funds were held in trust under state ( New York ) lien law, which determined the order of priority. The IRS claim for income and FICA taxes was entitled to first priority after deduction of a state claim for back wages that had been withheld from the contractor pursuant to notice before default occurred. The unsupported argument that state lien law accorded first priority status only to state claims, not federal tax claims, was rejected.

Neil B. Connelly, Kroll & Tract, 520 Madison Ave. , New York , N.Y. 10022 , for plaintiff-appellant. Jeffrey S. Oestericher, United States Attorney's Office, New York, N.Y. 10007, Patricia Smith, Department of Labor, New York, N.Y. 10271, for defendants-appellees.

Before: KEARSE and MCLAUGHLIN, Circuit Judges, and TRAGER, District Judge. ^*

MCLAUGHLIN, Circuit Judge:

Titan Indemnity Company appeals from a judgment of the United States District Court for the Southern District of New York (McKenna, J.) determining competing claims to the proceeds of a public improvement contract. We reject all of Titan's arguments, and affirm the district court.

BACKGROUND

On October 26, 1990 , D.H. Farney Contractors, Inc. ("Farney") entered into a contract with the Triborough Bridge and Tunnel Authority ("TBTA") to repair both the Triborough Bridge and the Verrazano Narrows Bridge ("TBTA Project"). The contract required Farney to get performance and payment bonds from a surety company. Accordingly, Titan Indemnity Company ("Titan"), a Texas corporation licensed to write surety bonds in New York , issued the customary performance bond and a labor and material payment bond on behalf of Farney. On or about November 15, 1990 , Farney commenced work.

In the fall of 1991, Farney stopped working on the TBTA project; and sometime thereafter Farney was declared in default of its contract obligations. At this time, TBTA held a fund of $97,601.88 that it admittedly owed Farney for its work ("Contract Fund").

The Contract Fund lies at the vortex of this litigation. TBTA withheld $91,153.90 pursuant to liens, levies, and restraining orders, including $21,495.65 withheld pursuant to a "notice to withhold" from the New York Department of Labor (NYDOL). The remaining $6,447.98 was withheld as "contract retainage," that is, money withheld from each contract payment as security for future performance.

After default, TBTA demanded that Titan complete the project. Titan and TBTA entered into a completion agreement, whereby Titan hired another company as a completion contractor to finish the job. The repairs were then completed, and on June 8, 1994 , the TBTA issued its final certificate of completion.

All the while, the TBTA continued to hold the $97,601.88 Contract Fund. Five creditors made claim to this money--(1) the IRS demanded $16,721.39 for income and FICA taxes that had been withheld on behalf of Farney employees who had worked on the project; (2) the New York State Department of Labor (NYDOL) had issued a notice to withhold $48,450, pursuant to §220-b of New York Labor Law, which represented its estimate of Farney's liability, including wages, interest, and penalties for failure to pay two of its employees the prevailing wage rate under New York law; (3) Quadrozzi Concrete Corp. and Quadrozzi Equipment Leasing Corp. ("Quadrozzi") sought $3,458.30 for concrete and other materials provided to Farney for the TBTA project; (4) Helen Carr Construction Corp. asserted a claim arising from an unrelated judgment against Farney on another project; and (5) Titan, the surety, claimed the lion's share including $90,350, the amount it had to pay to complete the project, giving TBTA appropriate credit for the amounts TBTA had already paid Titan.

The Lawsuit

In March 1994, Titan sued in the Supreme Court of the State of New York seeking a determination of the parties' rights in, and distribution of, the Contract Fund. The TBTA filed an answer and an interpleader claim admitting that it had the Contract Fund and seeking to deposit it with the court pending adjudication of the parties' claims. As a disinterested stakeholder, the TBTA made no claim to the Contract Fund.

The IRS removed the action to the United States District Court for the Southern District of New York (McKenna, J.) and all the parties moved for summary judgment. Granting some of the motions and denying others, the district court made the pivotal ruling that the Contract Fund was a trust fund under section 70 of Article 3-A of the New York Lien Law ("3-A trust fund"). As such, said the court, the order of priority for claims against the fund is set forth in Lien Law, Article 3-A, section 77. Accordingly, the court determined that the IRS' claim for taxes arising from the TBTA project received first priority.

While no one disputes that the Contract Fund is an Article 3-A trust fund, it is not as simple as all that. As the district court noted, New York has introduced into the calculus the paradoxical notion of "super-priority," which means that certain claims jump to the head of the line and are deducted from the Fund before the priority of the other liens is even evaluated. The district court determined that under New York law some of NYDOL's claims earned "super-priority" status and, consequently, were deducted from the $97,601.88 Contract Fund before the other creditors even lined up.

NYDOL's claim ultimately consisted of three parts: (1) $22,931.50 in back wages owed because Farney failed to pay an employee the prevailing wage rate under New York law; (2) $9,174.22 in interest due on those back wages; and (3) a 25% penalty assessed for Farney's failure to pay the prevailing wage rate. The district court ruled that the wages owed and actually withheld by TBTA pursuant to NYDOL's withholding notice "are properly deducted from the funds retained by the [TBTA] before they form the corpus of [the] 3-A trust." Those wage funds, the district court determined, were entitled to a "super-priority" under section 220-b of the New York Labor. Accordingly, because the money TBTA actually withheld pursuant to NYDOL's withholding notice amounted to $21,495.65, the district court granted NYDOL a "super-priority" for that sum.

The remainder of NYDOL's claim--$10,610.67 in remaining back wages and interest, and the 25% penalty--was determined not to enjoy this "super-priority." Rather, the court determined that the remaining back wages and interest constituted an Article 3-A trust claim entitled to second priority after the IRS's tax claim. NYDOL's 25% penalty claim was not considered an Article 3-A trust claim at all.

Quadrozzi's claim for payment for materials was treated as an Article 3-A trust claim and awarded third priority. All the remaining funds were awarded to Titan as surety.

The claims of Helen Carr Corp. and the penalty portion of the NYDOL's claim were granted nothing, the court concluding that those claims did not constitute trust beneficiary claims under Article 3-A of the New York Lien Law. The district court determined that NYDOL, insofar as its claim for the penalty, and Helen Carr would have to pursue their claims against Farney independently of this action.

The following, therefore was the ultimate priority and distribution fixed by the district court:

  A.    $21,495.65  NYDOL super-priority (money withheld pursuant to

                      notice)

          * * * * *

  1.    $16,721.39  IRS

  2.    $10,610.07  NYDOL (remainder of back wages and interest claim

                      not

                      covered by money withheld)

  3.    $ 3,458.30  Quadrozzi

  4.    $45,316.47  Titan (remainder after above claims satisfied)

        ----------

Total:  $97,601.88

 

Titan appeals, arguing that the district court erred: (1) by according priority to the trust fund beneficiaries over Titan's suretyship claim; (2) by according NYDOL's claim priority over Titan's claim; (3) by finding that New York Lien Law, rather than the parties' agreement, established the priority of claims; and (4) by applying state rather than federal law in determining the IRS's rights.

DISCUSSION

A. Titan's Claim v. Article 3-A Trust Fund Beneficiaries

Titan maintains that the district court erred when it determined that Titan's claim as a completing surety was inferior to Article 3-A trust claims. Titan argues that its claim to the Contract Fund is superior to 3-A trust claims, a priority it earned when it became equitably subrogated to the rights of both Farney and TBTA in the Contract Fund.

Section 70(1) of New York Lien Law states that funds "received by a contractor under or in connection with a contract for . . . a public improvement in this state, . . . and any right of action for any such funds due or earned or to become due or earned, shall constitute assets of a trust." N.Y. Lien Law §70(1). It is undisputed that the proceeds of the contract at issue are trust funds under Section 70 of the New York Lien Law.

That said, the next inquiry is the order of priority. The priority of claimholders is established by section 77 of the Lien Law. First priority is given to claims for taxes and for unemployment insurance and other contributions due by reason of employment. N.Y. Lien Law §77(8)(A).

Second priority is given to trust claims of laborers for daily or weekly wages. Id. at (8)(B).

Third priority is given to trust claims of laborers for benefits or wage supplements. Id. at (8)(C).

Fourth priority is given to certain claims to a laborer's wages made by third parties. Id. at (8)(D).

Remaining trust claims are distributed pro rata. §77(8).

Titan misunderstands its rights under New York law. Generally in a public improvement contract, the contractor is required to find a surety that will secure the performance of his contract. Upon default by the contractor, the surety, pursuant to a performance bond, completes the contract, at its own cost and expense. It then becomes equitably subrogated to the rights of the contractor and certain of the rights of the owner in the unpaid balance of the contract price. See Tri-City Electric Co., Inc. v. New York, 96 A.D.2d 146, 149 (N.Y. App. Div. 1983); Scarsdale Nat'l Bank & Trust Co. v. United States Fidelity & Guaranty Co., 190 N.E. 330 (N.Y. 1934). Under a performance bond, a completing surety becomes entitled to the money still owed by the owner to the defaulting contractor, but only after the claims of all 3-A trust fund beneficiaries are first satisfied. Tri-City Electric Co., Inc., 96 A.D.2d at 149. It is perfectly clear that the rights of a surety in the trust proceeds do not trump those of the Article 3-A trust fund beneficiaries. Id. at 152.

Titan places great faith in Scarsdale Nat'l Bank & Trust Co. v. United States Fidelity & Guaranty Co., 190 N.E. 330 (N.Y. 1934), to demonstrate that its claim should have taken priority over the claims of the 3-A trust beneficiaries. Titan argues that, like the surety in Scarsdale , it was entitled to the entire amount of the Contract Fund. Titan's faith is misplaced.

Scarsdale dealt with a priority fight between an assignee of a defaulting contractor and a completing surety. There were no trust beneficiaries. Scarsdale held that the assignee was entitled only to whatever rights the assignor, the defaulting contractor, had. The surety, having completed the duties the contractor owed to the property owner, became subrogated to the rights of the owner as against the contractor; and because the surety completed the project it had a claim to withheld money superior to the defaulting contractor. A fortiori, the surety also had priority over the claim of a mere assignee of the contractor.

Scarsdale and its progeny stand for the unremarkable proposition that an assignee stands in the shoes of his assignor when it comes to awarding priorities. The district court's decision is in complete accord with Scarsdale . After the claims of all the designated Article 3-A trust beneficiaries were paid, Titan was awarded the remainder (almost 50%) of the Contract Fund over the claims of Farney's judgment creditor. It is entitled to no more.

B. Titan's Claim v. NYDOL's Claim

Titan maintains that the district court erred by giving the New York Department of Labor's claim under section 220-b of New York Labor Law priority over its claim.

New York Labor Law §220, known as the "prevailing wage law," requires that all employees on public work projects be paid the prevailing rate of wages and supplements for the locality in which the project is located. N.Y. Labor Law §220. Whenever the Commissioner of Labor determines that there are unpaid wages or supplements due under a contract that is subject to the New York prevailing wage law, the Commissioner must notify the concerned public agency to withhold from money due the contractor a sufficient sum to satisfy the law. 220-b(2)(A).

In the fall of 1991, NYDOL determined that Farney had failed to pay prevailing wages and supplements to two employees. Following §220-b, NYDOL issued a notice to TBTA to withhold $48,450.00 from payments due Farney, representing NYDOL's estimate of underpayments, interest and a possible penalty. At the time of Farney's default, the TBTA had actually withheld $21,495.65 from Farney pursuant to this notice.

Titan believes that the $21,495.65 should not have been awarded to NYDOL because Farney had already defaulted before NYDOL sent the notice to TBTA to withhold payment to Farney. Titan argues that, once Farney had defaulted, Farney was no longer owed any money; and therefore, no money could properly be withheld pursuant to section 220-b. This argument will not detain us long, because we do not agree that Farney was already in default when TBTA received NYDOL's notice.

In August 1995, the Internal Revenue Service submitted a Rule 3(g) Statement setting forth the facts as to which the IRS believed there was no genuine issue. In paragraph 8 of the 3(g) Statement, the IRS asserted that "[a]t the time of Farney's default, the TBTA was holding $97,601.88 . . . which Farney had earned, but had not been paid under the Contract." Titan took no exception to this assertion. Because it is undisputed that the $21,495.65 withheld pursuant to NYDOL's notice is part of the $97,601.88 TBTA already held at the time of Farney's default, the IRS's statement obviously means that the $21,495.65 was held by TBTA at the time of default. Because this money was withheld pursuant to NYDOL's notice, the notice must have been received by TBTA prior to Farney's default.

It is well established that if a party fails to object or respond to the factual assertions in an opposing party's 3(g) Statement, those factual assertions will be deemed true. See Champion v. Artuz, 76 F.3d 483, 486 (2d Cir. 1996) (per curiam). This Court has recently cautioned that it will not accept the "tactic of contending on appeal that summary judgment was inappropriate on the ground that there were issues of fact to be tried after [a party] had declined to dispute the government's Rule 3(g) Statement." United States v. All Right, Title and Interest in Real Property and Appurtenances, 77 F.3d 648, 658 (2d Cir.), cert. denied, 117 S. Ct. 67 (1996). Because Titan did not object to the IRS's implicit statement that Farney was not yet in default when TBTA received NYDOL's notice to withhold, we will not entertain an argument that now contradicts an undisputed 3(g) statement.

Titan makes a last ditch effort (in its reply brief) to call into question the granting of "super-priority" to a claim under Labor Law §220-b, noting that "super-priority" status has to date been granted only to a perfected mechanic's lien. Titan contends that, because a labor lien under §220-b is not the equivalent of a mechanic's lien, it was inappropriate to grant NYDOL's labor lien "super-priority" status. The core of Titan's argument is that giving any recognition at all to NYDOL's claim under §220-b was improper because Farney was already in default when Titan received NYDOL's notice. We have earlier rejected this argument, supra. Because we find that no substantial issue has been raised regarding the granting of "super-priority" status to §220-b claims we will leave resolution of that unbriefed issue to a more appropriate time.

C. New York Lien Law v. the Parties' Surety Agreement

Titan contends that the district court erred when it determined that the priority of claims was governed by New York Lien Law rather than by the parties' surety agreement.

New York Lien Law specifically establishes the priority of claims to funds received in connection with a public improvement contract. N.Y. Lien Law §77(8). Nowhere in Article 3-A of the New York Lien Law does it provide that the priority of claims prescribed therein is to apply only when the parties have not otherwise agreed. The purpose of Article 3-A is to safeguard the rights of those working on construction projects by providing for the payment of obligations incurred in performing the contract. See Atlas Building Sys., Inc. v. Rende, 635 N.Y.S.2d 694, 695-96 (2d Dep't 1997 ); Ingalls Iron Works Co. v. Fehlhaber Corp., 337 F. Supp. 1085 (S.D.N.Y. 1972). The statute would be disemboweled if the parties to a construction contract could provide that one of them is to receive contract funds ahead of other workers and creditors protected by the legislature.

Titan concedes that the trust beneficiaries' claims are valid under New York Lien Law, but Titan claims it should have received the money first and then been allowed to settle the trust beneficiaries' claims itself. Such an arrangement would leave the trust beneficiaries at the mercy of Titan and therefore, obviously defeat the salutary purpose of Article 3-A.

D. Federal Law v. State Law

Lastly, Titan maintains that the district court erred when it determined the priority of the IRS's tax claim under New York Lien Law rather than federal law.

Section 70 of the New York Lien Law provides for the creation and enforcement of statutory trusts out of the funds earned by a contractor working on a public improvement of real property. The purpose of the trust fund is to provide for the payment of obligations incurred in performing the contract, including tax obligations. See Flintkote Co. v. United States [69-1 USTC ¶9242], 47 F.R.D. 322, 325 (S.D.N.Y. 1969), aff'd [71-1 USTC ¶9184], 435 F.2d 556 (2d Cir. 1971).

Tax claims arising from the performance of a public improvement contract are expressly granted first priority. N.Y. Lien Law §77(8)(A); see also Onondaga Commercial Dry Wall Corp. v. 150 Clinton Street, Inc., 25 N.Y.2d 106, 110 (1969). These tax claims have often included claims for federal taxes as well as state and local taxes. See General Fire-Proof Door Corp. v. Citibank, N.A., 544 F. Supp. 191 (S.D.N.Y. 1982); Marv Laxer Associates, Inc. v. Moredall Realty Corp., 533 F. Supp. 8 (S.D.N.Y. 1981).

Titan makes a novel and unsupported argument that the provision of Article 3-A granting tax claims first priority applies only to state and local taxes, asserting that federal tax claims are governed solely by federal law. Titan misunderstands the law governing the priority of federal tax liens.

It is true that, as a general rule, the priority of competing liens against a taxpayer's property, including tax liens, is governed by federal law. See Aquilino v. United States [60-2 USTC ¶9538], 363 U.S. 509 (1960). But in Aquilino, the Supreme Court held that it is state law that determines the nature of the interest each claimant has in disputed proceeds. Id. at 515. For example, it is state law that determines whether a claim is recognized as an ordinary lien or accorded trust claim status. Id.

It is New York that determines what interest competing claimants have in the proceeds of a public improvement contract. New York has spoken clearly on this issue in Article 3-A, directing that the proceeds of a public improvement contract constitute a trust for certain claimants. New York has determined that the most important of those claimants, and those receiving first priority are those asserting tax claims. There is nothing in Article 3-A or elsewhere that indicates that New York chose to limit that priority to only certain types of tax claims. Absent convincing proof to the contrary, we see no reason to narrow the plain language of Article 3-A to deny the IRS its claim under New York Lien Law.

We have considered all of Titan's additional arguments and find them to be without merit.

Accordingly, the judgment of the district court is affirmed.

^* The Honorable David G. Trager of the United States District Court for the Eastern District of New York, sitting by designation.

 

 

[94-2 USTC ¶50,558] Amwest Surety Insurance Company v. United States of America

U.S. District Court, Dist. Conn., Civ. 3:92CV00221 (PCD), 9/26/94, 870 FSupp 432

[Code Secs. 6323 and 7426 ]

Priorities: Equitable subrogation: Federal tax lien.--The claim of a surety company that had issued a performance bond on behalf of a contractor and that subsequently made payments on that bond when the contractor defaulted had priority over an IRS tax lien in regards to certain payments due the defaulting contractor pursuant to the insured contracts. Under the concept of equitable subrogation, the surety, by paying off the contractor's obligations, was entitled to any and all sums due or to become due the contractor. This assignment was effective as of the execution date of the bond, signed before the IRS perfected its tax liens against the contractor. The surety was not required to file a Uniform Commercial Code financing statement with the state to perfect its interest in the proceeds of its principal's contract. The IRS was, thus, ordered to remit to the surety monies the IRS had levied from a debtor of the contractor.

RULING ON CROSS MOTION FOR SUMMARY JUDGMENT

DORSEY, District Judge:

Cross motions for summary judgment are pending in this case. Plaintiff, as surety for SMP Developers, Inc., was obliged to perform on its bond when SMP defaulted in the performance of its contract with Credo Housing Development Corporation. Amwest has made payments of $87,199.89. The Internal Revenue Service (IRS) assessed SMP for unpaid taxes and filed liens therefor. It subsequently levied on Credo's payments due SMP. Credo paid the IRS pursuant to the levy. Amwest claims a priority interest over the IRS lien and claims a wrongful levy in the payment to the IRS. I.R.C. §7426 . Based on stipulated facts, the parties agree their priorities are to be decided on the cross motions.

FACTS:

On May 24, 1991 SMP contracted with Credo. Amwest then issued a performance bond naming financiers, Credo and the State of Connecticut , as obligees. Exs. 1 and 2. SMP's failure to pay employees or subcontractors constituted a default as to Credo. Ex. 1. Work began on June 2, 1991 and on July 9, Credo paid SMP for work done in June. Through August 10, 1991 , SMP defaulted on payments owed to employees, Exs. 6, 8, and for materials, services and equipment used on the job. Checks issued on June 21 and July 14 were not covered by sufficient funds. Credo terminated the contract by letter dated August 16, 1991 , Exs. 10, 11, and invoked Amwest's bond obligations. Commencing September 11, 1991 , Amwest paid $54,523.65 due suppliers and laborers and incurred $6,471.55 in performance costs. SMP assigned to Amwest, on default, any and all sums due or to become due pursuant to such contracts. Ex. 3, ¶3A.3. The assignment was "effective as of the date of each [] bond, but only in the event of Default . . ." id. A default occurred when SMP failed "to pay for any labor or materials when such payment [was] due . . .". Ex. 3, ¶3 C.

On July 28, 1991 , SMP submitted to Credo its requisition for work performed in July in the amount of $42,476.64. Ex. 5.

On five dates in 1989, 1990 and 1991, most recently June 3, 1991, the IRS assessed SMP taxes totalling $102,957.82. Despite notice and demand for payment, SMP did not pay. Tax liens arose on the dates of the assessments in favor of the IRS and against all of SMP's property. Notices of liens were filed with the Secretary of the State of Connecticut on June 25, 1991, in the amount of $36,117.94, and on July 31, 1991, in the amount of $30,147.55. On August 5, 1991, the IRS served Credo with copies of the notices of liens and a Notice of Levy.

On August 15, 1991, Credo paid the IRS $42,476.64 requisitioned by SMP and representing its work in July, 1991.

DISCUSSION:

The question presented is whether Amwest's claim to a payment due SMP from Credo, that was subsequently paid to the IRS, is superior to IRS's claim to that same payment. Amwest began making payments under its bonds on September 11, 1991. SMP had defaulted on payments for labor and materials as of August 15, 1991, Additionally, by July 6 SMP had issued 21 checks which were not honored by SMP's bank for want of sufficient funds. The surety obligation was invoked when Amwest was notified of the claimed defaults by Credo's letter of August 16, 1991 . Amwest met its obligations by paying SMP's established obligees and the expense necessary to complete the project.

During July 1991, SMP performed its contract for which it submitted its invoice on August 5, 1991 , then becoming entitled to payment therefor.

Plaintiff was SMP's surety, not its insurer. As surety, Amwest seeks reimbursement for payments made by receiving the contract payments owed to SMP. Its claim is for equitable subrogation. Pearlman v. Reliance Insurance Co., 371 U.S. 132, 136 (1962); Balboa Insurance Co. v. Bank of Boston Connecticut , 702 F.2d 33, 36 (2d Cir. 1983). "When a surety performs its obligations under a . . . bond, it stands in the shoes of the contractor. Thus, if the contractor has the right to the retained funds, the surety accedes to those rights when it meets its obligations under the bonds." Id. at 37. (Emphasis added, citations omitted).

The question presented is whether the surety's interest in the contract payments, though not a fully ripened enforceable right when the government perfected its lien, has nonetheless been endowed with a priority which defeats the government's claim. Plaintiff's accrual of its interest in the Credo payments is the date of its bond, May 24, 1991 .

By that date, the government on four occasions had assessed taxes on four occasions totaling $74,934.40. See Stipulation ¶64. It is undisputed that United States tax liens arise on the assessment dates against all SMP property. See Stipulation ¶67; I.R.C. §6322 . Tax liens reach after acquired property. Notices of liens were filed on June 25 and July 31, 1991 . Notice perfects liens. Miller v. United States [91-1 USTC ¶50,269 ], 763 F.Supp 1534 (N.D.Cal. 1991).

The government's claim to the proceeds is based on statutorily created tax liens, notices of which predated the plaintiff's payments. They also claim plaintiff is entitled to no relation back of its interest in the Credo payment.

In 1966 Congress added I.R.C. §6323(c) which dated tax liens to the date of notice but prioritized certain security interests over tax liens:

(1) . . . To the extent provided in this subsection, even though a notice of a lien . . . has been filed, such lien shall not be valid with respect to a security interest which came into existence after tax lien filing but which

(A) is in qualified property covered by the terms of a written agreement entered into before tax lien filing and constituting-- . . .

(iii) an obligatory disbursement agreement, and

(B) is protected under local law against a judgment lien arising, as of the time of tax lien filing, out of an unsecured obligation.

Id.

The government concedes that if the conditions of the statute are met, a surety's interest in contract proceeds pursuant to a bond executed before a tax lien is filed, will prevail over the lien even if the surety payments are made after liens are filed. It does not dispute plaintiff's bond as an obligatory disbursement agreement. See I.R.C. §6323(c)(1)(B) . What it does dispute is that plaintiff does not meet the requirement that plaintiff's interest be protected under local law. Id. In effect the government argues that plaintiff's claim is not shielded from a judgment lien which was valid and enforceable at the time of the filing of the tax liens. Particularly it notes the absence of the filing of a financing statement to perfect a security interest as required by Conn.Gen. Stat. §42 -9-302. It follows says the government that an unperfected security interest gains no priority over a judgment lien creditor as a matter of state law, citing Conn.Gen.Stat. §42 -9-301(1)(b). Only the statute is given as authority for the proposition.

Plaintiff's claim is premised on I.R.C. §6323 asserting that it should prevail against a theoretical judgment lien perfected as of the filing of the tax liens. It does however, concede the lack of any U.C.C. filing. In view of the parties' focus on this provision, the plaintiff's payment after the lien filings is irrelevant.

The government's claim is premised on the applicability of the cited U.C.C. sections. There is no reference in the U.C.C. to sureties. There is no explicit requirement that sureties file to ensure their claim. It has been found by this court that the omission was intentional, Recommendation of the Editorial Board for Changes in the Test and Comments of the Uniform Commercial Code, U.C.C. §9-312, at 24-5 (Proposed Official Draft, Text and Comments Edition, 1953), and thus no such filing is required to perfect a surety's interest in the proceeds of its principal's contract. Balboa Insurance Co. v. Bank of Boston Connecticut , 702 F.2d 33, 36 (2d Cir. 1983); In re J.V. Gleason Inc., 452 F.2d 1219, 1222 (8th Cir. 1971); National Shawmut Bank v. New Amsterdam Casualty Co., 411 F.2d 843 (1st Cir. 1969). In addition, the U.C.C. does not address a surety claim in its reference to security interests in "personal property or fixtures." A surety claim is derived from equity and not from a contract, nor the ordinary financing contemplated by U.C.C. §9. Further, to create a contract obligation to its principal, a surety would be obliged to expend funds to only then to go unreimbursed if required to file to gain a priority over an earlier filed competing claim. No unfairness to the competitor results because sureties' involvement in contracts is generally known. An inequity does result if sureties' later expenditures accrue to the benefit of prior claims. If sureties were not reimbursed because they stand in line with other creditors, bonds would not be issued. Finally, uniformity, the purpose of the U.C.C., is achieved as opposed to disparate results if states' laws control.

A tax lien has a priority interest if filed before execution of a bond, but would not prevail against an unrecorded equitable surety interest from a bond executed before a noticed tax lien. United States v. Trigg [72-2 USTC ¶9642 ], 465 F.2d 1264 (8th Cir. 1972), cert. den. 410 U.S. 909 (1973); Kansas City v. Tri-City Construction Co., 666 F.Supp. 170 (W.D.MO. 1987): Housing Authority v. General Ins. Co. [75-2 USTC ¶9631 ], 392 F.Supp. 65 (E.D.Mo. 1974). The government argues that the relation back principle by which a surety's payments make choate its inchoate claim does not apply. This argument flies in the face of the Priority Statute of 1966 and the legislative history. See S. Rep. No. 1708, 89th Cong. 2d Sess., reprinted in 1966 U.S. Code Cong. & Adm. News 3722, 3730. No convincing authority is cited for the argument. See The Employers Liability Assurance Corp. v. Crandall, 22 Conn Supp. 404 (1961). The surety's right to the contract proceeds arises from its undertaking to guaranty the performance of the contract. The right to enforce the claim to the proceeds results from making expenditures in performing the guaranty. This result insures the project owner against liens otherwise imposable for costs of constructing the project by having its contract payments apply to the of [sic] the costs of construction.

Likewise the government's waiver and estoppel arguments are not substantiated by the record, by the statutes nor by convincing authority.

CONCLUSION:

As Amwest has demonstrated that the proceeds payable by Credo were subject to its equitable rights arising from its bond issued before the tax liens were perfected by filing, plaintiff's motion (doc. # 12) is granted and judgment shall enter for plaintiff in the amount of $42,476.54. Plaintiff may substantiate its claim for interest by a further submission in support therefor within 10 days hereof. The government's motion (doc. # 10) is denied.

SO ORDERED.

 

 

[96-1 USTC ¶50,222] Capitol Indemnity Corporation, Plaintiff v. United States of America , Defendant/ /Third Party Plaintiff v. Mt. Vernon Township High School District 201, Third Party Defendant

U.S. District Court, So. Dist. Ill. , 92-CV-4141-JPG, 2/27/96

On remand from CA-7

94-2 USTC ¶50,618 .

[Code Secs. 6323 and 7426 ]

Lien: Priority: Surety's interest: Assignment of funds: Judgment creditor: State law.--A perfected tax lien placed by the IRS on a progress payment owed to a construction company had priority over the claims of subcontractors and of the surety company that finished the project after the construction company's default. The subcontractors did not have any property rights to the payment because they failed to perfect their liens, as required under state ( Illinois ) law. The surety company possessed only an unperfected security interest in the payment until after the construction company defaulted on the contract, and the IRS perfected its lien before the default occurred. Thus, since the IRS was the first party to perfect a lien on the payment, it was entitled to the funds.

David M. Duree, Bernard A. Reiner, Joseph M. Krutzsch, Reinhart, Duree & Crane, P.C., 812 N. Collins, Laclede's Landing, St. Louis, Mo. 63102, for plaintiff. Rob ert L. Simpkins, Assistant United States Attorney, St. Clair County, 9 Executive Dr., Fairview Heights, Ill. 62208, Richard J. Gagnon, Jr., David S. Newman, Department of Justice, Washington, D.C. 20530, for defendant.

MEMORANDUM AND ORDER

GILBERT, Chief Judge:

Pending before this Court is a cause of action remanded from the Seventh Circuit Court of Appeals for further proceedings consistent with that court's ruling. [94-2 USTC ¶50,618 ], 41 F.3d 320 (7th Cir. 1994). Prior to the Seventh Circuit's decision, this Court denied the motion of the United States for summary judgment, (Doc. #45), and granted motions for summary judgment in favor of the plaintiff and the third party defendant. (Doc. #45).

The facts of that case are adeptly set forth by the Seventh Circuit, therefore, this Court will set forth only those facts necessary to clarify this order. B & H Construction entered a contract to perform asbestos removal services for the Mount Vernon Township High School District 201 ("the District"). The District was to pay for the services of B & H in progress payments. When B & H failed to perform properly Capitol Indemnity Corporation ("CIC"), B & H's surety, stepped in and finished the contract. Prior to B & H's default on the contract with the District, the Internal Revenue Service placed a lien on the second progress payment. B & H applied for but had not received this second payment. CIC brought suit against the government, challenging the levy as unlawful and claiming that B & H had no property interest in the $102,341.00 progress payment. CIC also sought a declaration that it its rights were superior to those of the United States , and an injunction prohibiting the United States from enforcing the levy. This Court entered judgment in favor of CIC and the District. Thus, the United States was denied recovery of the funds in controversy.

On appeal, Capitol Indem. Corp. v. United States [94-2 USTC ¶50,618 ], 41 F.3d 320 (7th Cir. 1994), the Seventh Circuit held that the subcontractors involved in the project had no property rights in the second progress payment. The Seventh Circuit reasoned that because the subcontractors failed to perfect their liens, as required under Illinois law. 770 ILCS 60/23 (1994), these subcontractors did not have any property rights to the payment.

Next, the Seventh Circuit addressed the property rights that CIC had in the second progress payment. The court held that CIC only possessed an "unperfected security interest in the Contract proceeds until the time B & H actually defaulted and CIC had to perform on the bonds." Capitol Indem. Corp. v. United States [94-2 USTC ¶50,618 ], 41 F.3d 320, 325 (7th Cir. 1994). Thus, prior to default by B & H, B & H held the only property interest in monies already paid. Therefore, CIC had no property interest in any monies until after B & H's default. The Seventh Circuit further noted that the Internal Revenue Service placed and perfected the lien on the progress payment before the District declared B & H in default on the contract for asbestos removal. This lien "disposes of CIC's direct rights as assignee as well as its right of equitable subrogation in other valid claims." Id. at 326.

The court pointed out that the first party to perfect a lien on monies is entitled to those monies. Id. Therefore, the United States is entitled to the funds as the first party to perfect a lien on the second progress payment. The court also dismissed any validity to CIC's "super-priority" exception set forth in the Internal Revenue Code. Id. at 327.

Accordingly, Defendant's motion for summary judgment is GRANTED. (Doc. #26). Capitol Indemnity Corporation's motion for summary judgment (Doc. #32) is DENIED and Mt. Vernon Township High School District 201's motion for summary judgment is DENIED. (Doc. #32). Judgment in the amount of $102,341.00 plus statutory interest from May 21, 1992 , is GRANTED to the United States against Capitol Indemnity Corporation and Mt. Vernon Township High School District 201. The United States is further ORDERED to file a brief, with this Court, setting forth its calculations as to the amount of interest owed. These calculations shall be filed on or before March 14, 1996 .

IT IS SO ORDERED.

 

 

[94-2 USTC ¶50,618] Capitol Indemnity Corporation, Plaintiff-Appellee v. United States of America , Defendant- -Third-Party Plaintiff-Appellant v. Mt. Vernon Township High School District 201, Third-Party Defendant-Appellee

(CA-7), U.S. Court of Appeals, 7th Circuit, 93-3633, 11/30/94, Reversing and remanding a District Court decision, 93-2 USTC ¶50,603

[Code Secs. 6323 and 6331 ]

Lien: Priority: Surety's interest: Assignment of funds: Judgment creditor: State law.--A notice of levy against a progress payment due to a construction company (who possessed the sole property interest in such payment at the time of the tax lien) was valid, and the IRS tax lien had priority over claims by subcontractors and a surety company that completed the project. The subcontractors did not have a property right in the progress payment because they forfeited their priority interest by not following the procedural prerequisites of the state's ( Illinois ) mechanics lien act. Although a contract assigned the rights of the contractor to the surety when the payment and performance bonds were issued, the surety merely had an unperfected security interest until an actual default by the contractor, which occurred after the IRS lien was issued. The surety did not fit within the superpriority exception regarding post-tax lien obligatory disbursement agreements because its claim was unperfected and, therefore, unprotected under state law ( Illinois ) against a judgment lien.

Before CUMMINGS, FERGUSON, ^* and COFFEY, Circuit Judges.

CUMMINGS, Circuit Judge.

This appeal involves competing rights in a "progress payment" earned during the course of an ill-fated construction contract. The payment was designated for the general contractor, levied on by the Internal Revenue Service, and claimed by the completing surety for itself and a host of subcontractors. On cross-motions for summary judgment, the district court found that the funds belonged in part to the subcontractors and in part to the surety. The government has appealed this determination and we reverse.

FACTS

In May 1991, Mt. Vernon Township High School District No. 201 (the "District") contracted (in the "Contract") with B & H Construction Company ("B & H") for asbestos removal and other work. B & H was to complete the project by August 9, 1991 , in time for the new school year. The District agreed to a contract price of $248,340, due in monthly progress payments upon certification by the project architect that B & H had completed its work satisfactorily and paid its subcontractors and suppliers. The monthly payments would represent the work performed to date, less 10 percent "retainage" to be withheld until completion of the project and extinction of all liabilities to subcontractors, suppliers or other creditors. B & H agreed to obtain performance bonds and payment bonds for the protection of the subcontractors. The Contract further provided that "[n]either the Owner nor the Architect shall have any obligation to pay or to see to the payment of any moneys to any Subcontractors except as may otherwise be required by law." Contract article 9, section O.

B & H procured the necessary payment and performance bonds on May 31, 1991, from the surety, Capitol Indemnity Corporation ("CIC"), with whom it had a general indemnity agreement dating back to May 1989 (the "Agreement"). In the Agreement, B & H assigned all of its rights under future contracts to CIC; this assignment was subject to defeat if B & H did not default on its obligations. ¹ Section 11 of the Agreement also purported to create a trust in the contract funds, "for the benefit of and for payment of all obligations for labor and material furnished in connection with such contract * * * for which the Surety would be liable under said bond or bonds" (Gov. Br. App. 39).

Work on the project commenced on June 4, 1991 , followed almost immediately by problems: B & H fell behind schedule, and subcontractors began complaining about delayed or inadequate payments. The subcontractors did not then or at any other time file notices of liens pursuant to sec. 23 of Illinois' Mechanics Lien Act, 770 ILCS 60/0.01 et seq., which governs liens against public funds. The District modified the contract in an effort to ensure completion before school started but B & H was unable to make up lost time, and the August 9 deadline came and went with no end to the work in sight.

By early September, B & H had completed $143,993 of the work and had submitted its application for the second progress payment. Hovering over that sum (which, minus previously paid sums and agreed-upon retainage, totaled $102,341), however, was the long shadow of the Internal Revenue Service ("IRS"). In late July 1991, the IRS informed B & H of a federal tax obligation (unrelated to the District work) in the amount of $124,448.51. B & H failed to pay this sum and on September 12, 1991 , the IRS served a notice of levy on the District for all property owned by B & H and in the District's possession. IRS officials instructed the District not to pay B & H any money owed it, but instead to send funds to the IRS.

The District's architect had forwarded B & H's application for the contested progress payment to his home office on September 9, 1991, with a recommendation that it be paid. After hearing about the IRS lien, however, District officials decided not to issue the funds to B & H. Although the District's architect formally certified the pay application on September 17, neither B & H nor the IRS was ever paid. On October 7 the District declared B & H in default, and on October 9 formally demanded that CIC perform on its bonds and complete the project. ² CIC finished the job, paid the subcontractors, and received the withheld payment of $102,341 from the District in May 1992, along with the remainder of the Contract funds.

CIC subsequently filed suit against the government, challenging the levy as unlawful and claiming that B & H had no property interest in the $102,341 progress payment. CIC sought a declaration that its rights were superior to those of the United States , and an injunction against the United States from enforcing the levy. The government responded by counterclaiming that the progress payment was impressed with the lien, and also by filing a third-party counterclaim against the District for its failure to honor the levy.

The district court granted summary judgment against the government on both claims. The court held that the Illinois Mechanics Lien Act entitled the subcontractors to the portion of the progress payment that represented their work. Therefore, the court found that $85,921.70 was due the subcontractors and properly paid over to CIC on their behalf. As to the remaining $16,420, the district court held that the Agreement between CIC and B & H had transferred any remaining property right in the progress payment to the surety on the date that CIC issued the payment and performance bonds. The court concluded that B & H had no property right in the progress payment, and that the government thus had nothing to levy against.

DISCUSSION

If B & H possessed the sole property interest in the progress payment at the time of the tax lien, the IRS was empowered to levy on those funds and would prevail in the absence of a prior lien. See Avco Delta Corp. Canada Ltd. v. United States [72-1 USTC ¶359], 484 F.2d 692 (7th Cir. 1973), certiorari denied, 415 U.S. 931; 26 U.S.C. sec. 6321 . State law governs the initial inquiry of whether the progress payment constituted property of B & H; federal law determines whether the state-created property right is one which a tax lien can reach. Aquilino v. United States [60-2 USTC ¶9538 ], 363 U.S. 509, 512-514. If the progress payment was B & H's property to which a tax lien could attach, the focus shifts to examining lien priorities, which requires the application of federal law. Id. at 514.

I. Property Rights

It is to these questions that we now turn, with the first step an examination of whether B & H or some other entity--namely the subcontractors, the District, or the surety--possessed a property interest in the progress payment at the time of the IRS lien.

A. The Subcontractors

We begin by analyzing the subcontractors' interest. ³ CIC contends that Contract language stating that "Contractor shall pay each Subcontractor, upon receipt of payment from the Owner, an amount equal to the percentage of completion allowed to the Contractor on account of such Subcontractor's work" (Gov. Br. App. 74-75 para. J) created a trust for the benefit of the subcontractors in which B & H functioned as a "conduit" with only legal title to the funds. The above-quoted language manifests no intent to create a trust, however, but merely indicates that payment of the subcontractors was B & H's responsibility rather than the District's. The subcontractors' claim is further diminished by the fact that the Contract does not establish a discrete trust corpus. B & H was not required to pay the subcontractors out of specific funds or to turn over portions of the progress payment directly, but only to pay the subcontractors after the District paid B & H. See LaThrop v. Bell Federal Sav. and Loan Ass'n, 68 Ill. 2d 375, 370 N.E.2d 188 (1977) (lacking an "express provision in the contract indicating" that segregation of funds was contemplated, the court found no trust had been created), certiorari denied [93-2 USTC ¶50,569 ], 436 U.S. 925; see also In re Construction Alternatives, 2 F.3d 670, 676-677 (6th Cir. 1993) (segregation of funds critical to finding existence of trust). Section 11 of the Agreement, purporting to create a trust for the subcontractors and the surety in the Contract proceeds, is mere boilerplate, which Illinois courts generally view with suspicion. See, e.g., G.H. Miller & Co. v. Hanes, 566 F. Supp. 305, 308 (N.D. Ill. 1983). While the "boilerplate" characterization is not dispositive, as we will see, section 11 conflicts with limitations on rights implicit in the Illinois Mechanics Lien Act. This fact also militates against imbuing the "trust" provision with much significance. See In re Wm. Cargile Contractor, Inc., 151 B.R. 854, 859-860 (Bankr. S.D. Ohio 1993) (finding trust would be "contrary to requirements under the state mechanic's lien statutes, since subcontractors would not need to concern themselves with filing proper liens so long as the surety had executed a trust agreement similar to the ones herein"); see also Construction Alternatives [93-2 USTC ¶50,569 ], 2 F.3d at 676-677 (indemnity provision nearly identical to section 11 did not create express trust).

The Contract itself spells out the subcontractors' rights--more precisely, their lack of rights--in the progress payment. The relevant provision in the Contract, at article 9 section O, states that "[n]either the Owner nor the Architect shall have any obligation to pay or to see to the payment of any moneys to any Subcontractors except as may otherwise be required by law" (Gov. Br. 22). The first part of this directive dispenses with CIC's argument that the Contract explicitly contemplates giving rights in the progress payment to the subcontractors.

Thus CIC must rely on section O's final clause, which brings into play any state law that might offer the subcontractors additional recourse. See DC Electronics, Inc. v. Employers Modern Life Co., 90 Ill. App.3d 342, 348, 413 N.E.2d 23 (1st Dist. 1980) (under Illinois law, "statutory provisions applicable to a contract * * * are deemed to form a part of the contract and must be construed in connection therewith"), cited in Western Waterproofing Co., Inc. v. Springfield Housing Authority, 669 F. Supp. 901, 903 (C.D. Ill. 1987). Relevant here is the section of the Illinois Mechanics Lien Act, 770 ILCS 60/23, regarding publicly funded works. ⁴

The Act endows "[a]ny person who shall furnish material, apparatus, fixtures, machinery or labor to any contractor having a contract for public improvement for any * * * school district * * * in this State" with "a lien for the value thereof." 770 ILCS 60/23; see also Chicago Bridge & Iron Co. v. Reliance Ins. Co., 105 Ill. App. 2d 91, 99, 245 N.E.2d 127 (1st Dist. 1969), reversed on other grounds, 46 Ill. 2d 522 (1970). However, sec. 23 requires the would-be lienor to provide written notice to school officials and the general contractor in order to perfect the lien. 770 ILCS 60/23; Wilbur Waggoner Equipment Rental & Excavating Co. v. Johnson, 33 Ill. App. 3d 358, 362, 342 N.E.2d 266 (5th Dist. 1975). None of the subcontractors in the instant action complied with this procedural prerequisite; hence they forfeited their inchoate statutory lien. See Board of Education of School Dist. No. 108 v. Collom, 77 Ill. App. 2d 479, 222 N.E.2d 804 (3rd Dist. 1966) (failure to perfect lien according to sec. 23 places subcontractor in same position as other general creditors). For subcontractors performing work for public bodies, such as the District, adherence to the procedural dictates of sec. 23 is a necessary prerequisite to the attainment of rights in a progress payment.

CIC makes additional arguments concerning the subcontractors' alleged property rights in the progress payment, claiming that the subcontractors accrued rights under an equitable lien theory, as third-party beneficiaries or under an implied trust. All of these arguments are unavailing. Illinois case law recognizes subcontractors' equitable rights in construction contracts under the above theories in the context of disputes over retainage fees, which the Avco Delta court described as a sort of "liquidated damages clause." 484 F.2d at 701. Funds intended from the inception of a contract to settle potential claims differ vastly from progress payments, which belong to the free flow of commerce from the time they are properly paid over. See Northwest Water Comm'n v. Carlo V. Santucci, Inc., 162 Ill. App. 3d 877, 895, 516 N.E.2d 287 (1st Dist. 1987) (distinguishing between retainage and amounts already paid over), appeal denied, 119 Ill. 2d 559, 522 N.E.2d 1247 (1988); see also International Fidelity Ins. Co. v. United States [92-1 USTC ¶50,004 ], 949 F.2d 1042, 1046 (8th Cir. 1991). We are therefore unpersuaded by the rationales advanced in the case law presented by CIC. By failing to adhere to the Mechanics Lien Act, the subcontractors in this case lost their priority interest in the progress payment, and cannot be said to have any property right in that sum.

B. The Surety

But what about CIC? As the surety, CIC ostensibly succeeded to all of B & H's rights under the Contract through the Agreement, which assigned these rights when the payment and performance bonds were issued. If this assignment were effective as written, then at the time of the IRS lien the progress payment would have belonged to CIC, not B & H.

The "assignment," however, simply granted CIC an unperfected security interest in the Contract proceeds until the time B & H actually defaulted and CIC had to perform on the bonds. See United States v. R.F. Ball Construction Co. [58-1 USTC ¶9327 ], 355 U.S. 587 (similar assignment created "inchoate and unperfected" security interest). In this case, the Agreement itself was ambiguous in its attempt to create an effective assignment of rights: as noted above, the boilerplate language in section 11 purported to create a trust in future contract earnings for the benefit of the surety and the subcontractors. Had the "assignment" in the Agreement been effective before default, the "trust" provision would have made no sense. Section 11 's attempted trust is inconsistent with and thus renders additionally implausible B & H's ostensible assignment of all of its rights under the Contract to CIC, dating back to the time the bonds were issued. Prior to default, then, B & H and not CIC had rights in all monies already paid over. See Fidelity & Deposit Co. of Md. v. Scott Bros. Const. Co., 461 F.2d 640, 643 (5th Cir. 1972) ("Any payments made by the owner prior to default * * * are attributable to the contractor's performance, not the surety's.").

For purposes of analyzing CIC's direct interest, the question becomes one of timing: did B & H default before or after the IRS invoked its tax lien? ⁵ Although the district court reserved judgment on this issue, the record seems clear as a matter of law that only on October 7, 1991 , did the District terminate B & H's ability to perform on the Contract, and only on October 9 was CIC required to perform any of the duties inherent in its role as surety. While CIC now contends that B & H's concededly inadequate performance from day one constituted default, both the surety and the District appear to have anticipated that B & H would complete the project (albeit behind schedule) up until the day the IRS notified school officials of the pending lien. Indeed, the District made substantial efforts through September to ensure that B & H stayed on the project, frequently modifying the Contract through written change orders that reduced or altered work specifications and amounts owed to B & H. The District's actions served to waive their early opportunities to declare B & H in default under the Contract, and by extension to postpone CIC's accrual of rights.

As for the surety, CIC could not, upon hearing of B & H's performance problems or liquidity concerns, have forced the District to declare a default. See United States v. Continental Cas. Co. , 346 F. Supp. 1239 (N.D. Ill. 1972) (federal government could waive technical default of contractor despite warnings from surety; fact that surety's subrogation rights were impaired was less important than government's interest in completing the job efficiently). As Continental Casualty makes clear, the District was entitled to exercise discretion in deciding when to terminate B & H's performance; the fact that in doing so it curtailed CIC's rights is immaterial.

The conclusion that B & H did not default until after the IRS issued its lien disposes of CIC's direct rights as assignee as well as its right of equitable subrogation in other valid claims. As completing surety, CIC was subrogated to the rights of several parties: the original contractor, the subcontractors and suppliers, and the owner (here the District) for whom the job was completed. See National Shawmut Bank of Boston v. New Amsterdam Cas. Co. , 411 F.2d 843, 845 (1st Cir. 1969) (surety assumes rights of numerous parties on contractor's default). The right of subrogation, which entitled CIC to "step into the shoes" of any party whose obligations it assumed, would not take effect until CIC actually assumed these obligations. See American Cas. Co. of Reading, Pa. v. Line Materials Industries, 332 F.2d 393 (10th Cir. 1964) (noting "clear distinction" between right of subrogation, which exists from date bond is executed, and actual subrogation, which occurs only when payments are made on contractor's default), certiorari denied, 379 U.S. 960.

By the time CIC could assert its right of subrogation, no claims remained for the surety to be subrogated to: the subcontractors had lost their potential interest by failing to file notices of lien, B & H had had its property subjected to the IRS lien, and the District had neglected to take the opportunity to declare B & H in default and to withhold the progress payment on that basis. CIC's claim of subrogation rights, like its claim to a direct interest in the progress payment, thus fails.

II. Competing Lien Priorities

Having rejected CIC's contention that B & H did not have a property interest in the progress payment attachable by a federal lien, we must now determine whether CIC has a superior claim as completing surety. This answer is somewhat more straightforward: they do not. With respect to lien priorities, the well-known rubric that "first in time is the first in right" applies in this case. United States by and through I.R.S. v. McDermott [93-1 USTC ¶50,164 ], 113 S. Ct. 1526, 1528, quoting United States v. City of New Britain [54-1 USTC ¶9191 ], 347 U.S. 81, 87. CIC could not prime its state-created surety's lien until B & H defaulted and when there was "nothing more to be done * * * --when the identity of the lienor, the property subject to the lien, and the amount of the lien [were] established." City of New Britain [54-1 USTC ¶9191 ], 347 U.S. at 84. In this case, CIC did not step in and begin performing work and making payments on the project--prerequisites to priming its surety's lien--until October 9, 1991 , well after the tax lien was in place.

CIC was also not entitled to prevail under the "super-priority" exception set forth in the Internal Revenue Code to give priority to certain inchoate claims. 26 U.S.C. sec. 6323(c) . That statute provides in pertinent part that:

(1) * * * To the extent provided in this section, even though notice of a lien imposed by section 6321 has been filed, such lien shall not be valid with respect to a security interest which came into existence after tax lien filing but which--

(A) is in qualified property covered by the terms of a written agreement entered into before tax lien filing and constituting--

* * * (iii) an obligatory disbursement agreement, and

(B) is protected under local law against a judgment lien arising, as of the time of tax lien filing, out of an unsecured obligation.

Id. Although CIC's inchoate lien met the statutory definition of an "obligatory disbursement agreement," the surety's claim was not perfected, and thus not protected under local law against a judgment lien. See 810 ILCS 5/9-302 ( Illinois law requires sureties to file financing statement in appropriate office in order to perfect claim). Accordingly, with no protection against a judgment creditor, CIC has none against the federal tax lien under the super-priority structure. See Construction Alternatives [93-2 USTC ¶50,569 ], 2 F.3d at 678.

CONCLUSION

In attempting to persuade this Court that the court below decided correctly, CIC reserves its most impassioned rhetoric for arguments regarding the rights of subcontractors to the fruits of their labor. Yet the subcontractors had available the shelter of the Illinois Mechanics Lien Act (which they forfeited) and the protection of the payment bond supplied by CIC (which resulted in their full payment). The party with a quantifiable monetary stake in this action was CIC, which is in the business of taking risks and appears to have bet on the wrong horse. Finding that CIC's claims are without merit and that B & H did in fact possess a property right in the progress payment which the IRS properly attached, we reverse the judgment of the district court and remand for further proceedings consistent with this ruling.

^* The Honorable Warren J. Ferguson, United States Circuit Judge for the Ninth Circuit, is sitting by designation.

¹ The Agreement stated in pertinent part: [B & H does] hereby assign, transfer and convey to the Surety, all of their right, title, interest and estate in and to all of their property, real, personal or mixed, wherever situated or of whatever nature, in which [they] have, or may hereafter obtain, an interest including but not limited to [rights under the construction contract], such assignment to be effective as of the date hereof, subject to being defeated in the event there is no [breach] of the obligations contained in or covered by [this bond].

² B & H's owners filed for relief under Chapter 7 of the Bankruptcy Code on October 11, 1991 ; the corporation itself filed for Chapter 7 relief on October 30, 1991 .

³ Although the subcontractors press no claim in this action their rights are nonetheless important: if they originally had a valid claim to the progress payment, the IRS' attempted lien on the entire sum was unlawful. Moreover, CIC as surety succeeded to any rights the subcontractors had under the theory of equitable subrogation.

⁴ The district court relied exclusively on a 1953 Illinois appellate case, Rob ertson v. Huntley & Blazier Co., 351 Ill. App. 378, 115 N.E.2d 533 (4th Dist. 1953), for its conclusion that the subcontractors had property rights in the progress payment under Illinois law. That case involved private contracts and invoked a different section of the Mechanics Lien Act. Rob ertson, therefore, is inapposite to the resolution of this case.

⁵ This question also affects any rights claimed by the District. Upon a valid declaration of default, the District could legitimately have withheld unpaid Contract funds in order to finish the project. See Gunther v. O'Brien Bros. Const. Co., 369 Ill. 362, 364, 16 N.E.2d 890 (1938) (upon a contractor's default prior to the completion of the work, a public body may use withheld funds to complete the job), cited in Santucci, 162 Ill. App. 3d at 894-895. By waiving its right to declare default until after it had certified the progress payment, however, the District forfeited its claim in the funds.

 

 

[93-2 USTC ¶50,569] In re Construction Alternatives, Inc., Debtor. Indiana Lumbermens Mutual Ins. Co., Inc., Plaintiff-Appellant v. Construction Alternatives, Inc., United States of America, Defendants-Appellees

(CA-6), U.S. Court of Appeals, 6th Circuit, 92-3961, 8/10/93 , 2 F3d 670. Affirming an unreported District Court decision

[Code Sec. 6323 ]

Priority of tax liens: Surety's interest: State law.--The IRS, and not a surety, had a priority lien with regard to the proceeds of a construction contract that were placed in a fund pursuant to the bankruptcy of a construction company. The company earned the right to receive the payment that comprised the fund because it had completed the work on its project at the time that it petitioned for bankruptcy. The surety's claim to the proceeds was rejected because no express trust had been created in the suretyship agreement and no constructive trust arose by operation of law or fact. There is no state ( Ohio ) law that creates a constructive trust in favor of unpaid suppliers or contractors. Further, the General Agreement of Indemnity did not create an express trust because it did not require the taxpayer to keep any portion of its payments as a separate trust fund. Therefore, the taxpayer was vested with both the legal and equitable interests in the fund to which tax liens could attach. The tax liens took priority over the equitable lien claimed by the surety because the equitable lien was not perfected at the time the tax liens were filed. Affirming unreported DC Ohio.

Before KEITH and JONES, Circuit Judges; and BROWN, Senior Circuit Judge.

BROWN, Senior Circuit Judge.

Appellant Indiana Lumbermens Mutual Insurance Company ("Lumbermens") appeals the judgment of the district court affirming the decision of the bankruptcy court. Lumbermens contends that the bankruptcy court and district court erred in concluding that the Internal Revenue Service ("IRS") had a lien and that this lien gave it priority to the proceeds of a construction contract that the debtor-taxpayer, Construction Alternatives, Inc. ("CA"), received from a project on which Lumbermens paid as C.A. 's surety. For the reasons stated below, we AFFIRM the district court.

I

On May 16, 1990 , the debtor, CA, an Ohio corporation, entered into a contract with the Forest Hills, Ohio School District (" School District ") to remove asbestos from four of its schools. To obtain the contract, CA was required, under Ohio law, to supply a surety bond to assure performance of its obligations under the contract and to assure that it would pay the subcontractors, suppliers, and laborers that provided material and labor to the project. Lumbermens had issued a surety bond on April 6, 1990 , and the bond was submitted to the School District along with CA's bid.

Pursuant to tax assessments made against CA for unpaid taxes, the IRS filed a notice of tax lien against CA on May 14, 1990 in the amount of $13,146.61, and, on August 20, 1990 , the IRS filed a second notice of tax lien against CA for the additional amount of $30,194.90. ¹ The next day, August 21, 1990 , CA filed a petition for relief under Chapter 11 of the Bankruptcy Code.

On August 21, CA had completed all of its work on the asbestos removal project and was due to receive its final progress payment; however, CA had not paid all of its bills arising from the project. Pursuant to its obligation on the surety bond, Lumbermens paid at least two of the unpaid subcontractors or suppliers on the project, but the record does not reflect when or how much it paid them. ²

At the time that CA filed its bankruptcy petition, CA and the School District had not yet agreed on the final amount due on the contract, although, as stated, the work was completed. On September 4, 1990 , however, two weeks after CA filed its bankruptcy petition, CA and the School District agreed that $39,705 was the correct amount due. On September 6, 1990 , CA filed a turnover complaint in bankruptcy court, seeking to have the $39,705 turned over to CA as the debtor-in-possession, and to have the validity and extent of any claims to the funds adjudicated. The bankruptcy court entered a turnover order on September 27, 1990 , and the School District paid over the $39,705 to a cash collateral account established for the purpose of holding this final payment on the contract (referred to hereinafter as the "Fund"). The order provided that any party that wished to assert a claim to the Fund would be required to file an answer or the claim would be lost. Lumbermens and the IRS then filed answers.

Thereafter, CA filed a motion for partial summary judgment, alleging that no claimant to the Fund had a lien superior to the IRS' lien, that the amounts owed to the IRS exceeded the balance of the Fund, and, therefore, the IRS was entitled to the whole Fund. Lumbermens also filed a motion for partial summary judgment, asserting that CA holds the Fund in trust for Lumbermens' benefit; therefore, it argued, CA only has a legal interest in the Fund while Lumbermens has the equitable interest; thus, it contended, its equitable interest had never become part of the bankruptcy estate and had never been subject to the federal tax liens. Lumbermens also argued that it has an equitable lien on the Fund, through subrogation to the rights of the School District and the suppliers and subcontractors that it paid, that is superior to the IRS' lien. Last, Lumbermens contended that it has a lien superior to any that the IRS might have pursuant to 26 U.S.C. §6323(c) (1988).

On September 30, 1991 , the bankruptcy court entered an order granting CA's motion for partial summary judgment and denying Lumbermens' motion. The court rejected Lumbermens' contention that CA held the Fund in trust for Lumbermens, reasoning that no express trust had been created in the suretyship agreement and that no constructive trust arose by operation of law or fact; therefore, it held, the Fund was property of CA's bankruptcy estate to which the tax lien had attached. It also held that Lumbermens had no equitable lien or interest in the Fund. The district court affirmed the bankruptcy court, and Lumbermens then appealed to this court.

Before this court, it is the position of the IRS that it has a lien on the Fund and that Lumbermens has no interest in the Fund. It is the position of Lumbermens that it has an equitable lien or beneficial interest in the Fund and that the IRS has no lien. It is Lumbermens' alternative position that, even if the IRS has a lien, Lumbermens' lien or interest has priority over the lien of the IRS.

II

This court reviews de novo the decision of the district court reviewing a grant of summary judgment by the bankruptcy court. Stephens Indus., Inc. v. McClung, 789 F.2d 386, 391 (6th Cir. 1988).

III

Lumbermens first contends on appeal that the bankruptcy court erred in granting summary judgment to CA on the theory that the IRS has a valid lien because, it contends, CA has no interest in the Fund to which a tax lien could attach. This is so, Lumbermens contends, because CA had not, when it filed its Chapter 11 petition, satisfied all of the requirements of the contract inasmuch as it had not complied with certain provisions of Ohio law governing contracts with the state and with certain provisions in the contract between CA and the School District requiring CA to pay its subcontractors and materials suppliers. It also contends that, though CA had completed the work when it filed the Chapter 11 petition, CA has no interest in the Fund because CA and the School District had not agreed on the final amount due on the contract at the time the bankruptcy petition was filed. Thus, Lumbermens argues, since CA did not have the right, at the time CA filed its bankruptcy petition, to receive the final payment, CA has no property interest in the final payment to which a tax lien could have attached.

The issue we must initially decide, therefore, is whether CA has an interest in the Fund to which a tax lien could attach. A tax lien arises "upon assessment and attaches to 'all property and rights to property, whether real or personal, belonging to [the taxpayer]' including property which the taxpayer subsequently acquires." United States v. Safeco Ins. Co. of Am. [89-1 USTC ¶9227 ], 870 F.2d 338, 340 (6th Cir. 1989) (quoting 26 U.S.C. §6321 (1988)) (alteration in original). State law determines what rights a taxpayer possesses in property; however, federal law determines whether those state-created rights are "property" or "rights to property" under §6321 . Id. It is settled that a tax lien can attach to "a taxpayer's interest in property regardless of whether that interest is less than full ownership or is only one among several claims of ownership." Id. at 341. "Unresolved questions concerning the ultimate ownership of the property will not prevent provisional attachment of a federal tax lien." Id.

In the case at bar, it is undisputed that the work on the project was complete at the time that CA petitioned for bankruptcy. There were several bookkeeping and admin istrative matters, pursuant to state law and CA's contract with the School District, to be completed and several subcontractors to be paid, but CA owed nothing to the School District, ³ and therefore, no payments to the School District were required or other expenses incurred to perfect CA's claim to the final progress payment. Thus, we conclude that CA had earned the right to receive its final progress payment, and, under the principles stated above, we hold that the government has two valid tax liens on the Fund. See J.A. Wynne Co. v. R.D. Phillips Constr. Co. [81-1 USTC ¶9305 ], 641 F.2d 205, 208-09 (5th Cir. 1981). The question to which we now turn is whether Lumbermens also has a lien on the Fund, and if so, whether that lien is superior to the tax liens.

IV

Lumbermens contends that as a surety obligated to pay any unpaid contractors, laborers, or suppliers on the project, it has an equitable lien on the Fund, to the extent of its losses, through subrogation to the rights of the suppliers, laborers, and contractors that it paid in CA's stead, and also through subrogation to the rights of the School District . Citing Western Casualty & Surety Co. v Brooks, 362 F.2d 486 (4th Cir. 1966), a Fourth Circuit case applying Ohio law, it contends that its equitable lien relates back to the date the surety bond was issued.

The nature of the surety's interest is ascertained by reference to state law. Western Casualty & Surety Co. v Brooks, 362 F.2d 486, 490 (4th Cir. 1966); see Safeco [89-1 USTC ¶9227 ], 870 F.2d at 341. All parties agree that Ohio law controls on state law issues. Under Ohio law, a surety that pays amounts owed to a subcontractor, laborer, or supplier is subrogated to the rights of those it has paid and to the rights of those persons whose obligations the surety has discharged, i.e., the owner and the contractor. Ohio ex rel. Star Supply v. Greenfield , 528 F. Supp. 955, 959 (S.D. Ohio 1981). A surety's rights, however, are no greater than the rights of the party to whom it is subrogated. United States v. Munsey Trust Co., 332 U.S. 234, 241-42 (1947); Miami Conservancy Dist. v. New Amsterdam Casualty Co., 118 F.2d 604, 606 (6th Cir.), cert. denied, 314 U.S. 640 (1941); Western Casualty, 362 F.2d at 491 (applying Ohio law). Therefore, in the instant case, Lumbermens has no greater rights to the Fund than does the School District , CA, or the unpaid subcontractors.

Lumbermens first contends that it has an equitable lien on the Fund by subrogation to the rights of the School District . It reasons that CA has not earned the right to receive the final payment on its contract with the School District because it failed to complete the contract by failing to pay the subcontractors. Thus, Lumbermens contends, the School District had a right to recoup enough of the final payment to pay the subcontractors and, therefore, Lumbermens has the same right to recoup from the Fund through subrogation to the rights of the School District .

The contract between CA and the School District required the School District to disburse payments to CA under a "progress payments" arrangement: every two weeks, CA could request another progress payment, and the amount due would be determined by the value of the work that CA had done during the two-week period. Further, the School District had no right, under its contract with CA, to retain any portion of the progress payments to CA pending CA's payments of subcontractors and suppliers. Once the work and bookkeeping details were completed, the final payment was due and was made, and, as we have previously noted, the School District had no right to retain the final progress payment. Thus, in short, the School District has no claim to the Fund under the terms of its contract with CA, and likewise, Lumbermens has no claim to the Fund through subrogation to the rights of the School District . Western Casualty, 362 F.2d at 492.

Lumbermens contends, however, that under the rule in Pearlman v. Reliance Ins. Co., 371 U.S. 132 (1962), it has an equitable lien on the Fund that is superior to the tax lien. We disagree. There, a contract between a contractor and the government provided that a certain percentage of each progress payment would be retained by the government to pay any unpaid suppliers or subcontractors. The Supreme Court held that the surety had an equitable lien on the retained funds through subrogation to the rights of the government, the subcontractors that the surety had paid, and the bankrupt contractor itself. Id. at 141. In the case at bar, however, the contract between CA and the School District , as heretofore pointed out, provided for no such retained fund. The Fund is simply the final progress payment on the contract and the School District has no further rights in the payment because the contract was complete. The School District was nothing more than a stakeholder. Western Casualty, 362 F.2d at 492.

Lumbermens also contends that it has a claim to the Fund through subrogation to the rights of the unpaid subcontractors, the two unpaid contractors whom it paid. Again, we disagree. Under Ohio law, when a subcontractor, laborer or supplier files a mechanics lien against a state project and proper notice of the lien is given to the state entity, such entity is then obligated to retain money from payments to the general contractor in an escrow account in an amount sufficient to satisfy the mechanics lien. Ohio Rev. Code Ann. §1311.28 ( Anderson 1958); Ohio ex rel. Star Supply v. Greenfield , 528 F. Supp. 955, 959 (S.D. Ohio 1981). But, if the unpaid supplier or contractor does not file a mechanics lien, the governmental entity is not obligated or permitted to retain money from the contractor, and the unpaid suppliers and subcontractors have no rights to the progress payment. In the instant case, none of the unpaid suppliers or subcontractors filed a mechanics lien, so the School District was not required or permitted to retain any money from the progress payments to satisfy obligations to unpaid suppliers and subcontractors; thus, the School District has no rights to the Fund to which Lumbermens can be subrogated. Further, under Greenfield , subcontractors and suppliers that do not file a mechanics lien have no rights in the Fund. Id. at 959. In this priority contest against the IRS, an unsecured creditor loses, and therefore, Lumbermens, which is subrogated to the rights of the School District or an unsecured supplier or subcontractor, must lose.

Even assuming that Lumbermens does indeed have an equitable lien on the Fund through subrogation, Lumbermens would still lose in a priority contest with the IRS. As the Supreme Court has recently held, federal tax liens do not "automatically have priority over all other liens"; rather, they follow the "first in time, first in right rule"; however, a state law lien is not first in time unless it is "perfected" at the time the notice of the federal tax lien is filed. United States ex rel. Internal Revenue Serv. v. McDermott [93-1 USTC ¶50,164 ], 113 S. Ct. 1526, 1528 (1993). "Perfected" for purposes of the federal tax lien statute means that the identity of the lienholder, the property subject to the lien, and the amount of the lien are certain. Id. ; United States v. Pioneer Am. Ins. Co. [63-2 USTC ¶9532 ], 374 U.S. 84 (1963).

In the case at bar, the amount of Lumbermens' alleged equitable lien was not certain at the time that the tax liens were filed because the amounts owed to the unpaid persons on the project were not yet certain. Thus, the equitable lien, if indeed it exists, was not "perfected" when the tax liens were filed and, therefore, the tax liens take priority.

V

Lumbermens next contends that the tax liens did not attach to the Fund because, it contends, CA holds the Fund as Lumbermens' trustee under the General Agreement of Indemnity, which CA executed with Lumbermens as part of the bonding undertaking; therefore, it contends, CA has no more than a legal interest in the Fund, while Lumbermens holds the equitable interest. ⁴ Since CA has only a legal interest in the Fund, Lumbermens contends, the tax lien only attached to the legal interest and the equitable interest is not subject to the tax lien. Therefore, if the Fund were determined to be subject to a trust, Lumbermens' equitable interest would not be subject to the IRS' liens.

There are two situations in which the Fund could be subject to a trust: 1) Ohio law provided that a portion of the progress payments were subject to a constructive trust for the benefit of unpaid suppliers and subcontractors; or, 2) the suretyship agreement created an express trust with the Fund as the trust corpus. There is no Ohio law that creates a constructive trust in favor of unpaid suppliers or contractors. The only case that Lumbermens cites in its favor is a Third Circuit case, Universal Bonding Ins. Co. v. Gittens & Sprinkle Enters., Inc., 960 F.2d 366 (3rd Cir. 1992). There, the Third Circuit held that funds paid by the state to a bankrupt general contractor were held in trust pursuant to a New Jersey statute and were not part of the bankruptcy estate. Since, however, Ohio has no such statute, as the district court pointed out, Universal Bonding does not apply to the facts of this case. We conclude that no trust was created by operation of Ohio law.

Further, contrary to Lumbermens' contention, we conclude that the General Agreement of Indemnity does not create an express trust. To create an express trust in Ohio , there must be a manifestation of intent to create a trust, there must be created a trust corpus, and there must be a fiduciary relationship between the trustee and the beneficiary. Brown v. Concerned Citizens for Sickle Cell Anemia, Inc., 382 N.E.2d 1155, 1158 ( Ohio 1978). With respect to the creation of a trust, this court has stated, applying Ohio law:

It is a well-settled principle of law in this and other jurisdictions that if one person pays money to another it depends upon the manifested intention of the parties whether a trust or a debt is created. If the intention is that the money shall be kept or used as a separate fund for the benefit of the payor, or a third person, a trust is created. If the intention is that the person receiving the money shall have the unrestricted use thereof, being liable to pay a similar amount whether with or without interest to the payor or to a third person, a debt is created. The intention of the parties will be ascertained by a consideration of their words and conduct in light of surrounding circumstances.

Federal Ins. Co. v. Fifth Third Bank, 867 F.2d 330, 333 (6th Cir. 1989) (quoting Guardian Trust Co. v. Kirby, 199 N.E. 81, 83 (1935)). In this case, no provision of the General Agreement of Indemnity required CA to keep any portion of the progress payments as a separate trust fund, and the record does not indicate that CA kept the progress payments in a separate account. Thus, since there was no trust corpus, no trust was created. Accordingly, we conclude that CA was vested with both the legal and equitable interests in the Fund to which the tax liens could attach, and that Lumbermens was not vested with an equitable interest by the General Agreement of Indemnity.

VI

Lumbermens next contends that under the federal tax lien statute, sureties' liens are given priority over tax liens, even if they are not yet "perfected" at the time of tax lien filing. Title 26 U.S.C. §6323(c) does indeed give priority to certain liens and security interests that are inchoate when the tax lien is filed. Section 6323(c) provides that a tax lien is primed by a surety's "security interest," even though the surety's "security interest" came into existence after the tax lien was filed, under the following circumstances: (1) the surety's "security interest," as here, is an obligatory disbursement agreement such as a suretyship agreement; (2) as here, the surety's interest is in "qualified property" ⁵ covered by the terms of a written agreement entered into before the tax lien filing; ⁶ and (3) the "security interest" would be protected under local law against a judgment lien that arose at the same time as the tax lien. 26 U.S.C. §6323(c) (1988). ⁷ Lumbermens contends, relying on the General Agreement of Indemnity, that under §6323(c) its "security interest" is superior to IRS' tax liens.

We, however, conclude that the General Agreement of Indemnity does not create a security interest. Subsection 6323(h) states that a "security interest" exists if "the property is in existence and the interest has become protected under local law against a subsequent judgment lien creditor." 26 U.S.C. §6323(h) (1988). Before Lumbermens' alleged "security interest" in the Fund would take priority over a subsequently-arising judgment lien under local law, Lumbermens would have been required to perfect its "security interest" by filing a financing statement in the appropriate office. Ohio Rev. Code Ann. §§1309.21, 1309.23 ( Anderson Supp. 1992). Lumbermens did not do so; thus, we conclude that Lumbermens does not possess a "security interest" under §6323(c) , and, therefore, the IRS has priority to the Fund.

VII

The judgment of the district court is AFFIRMED.

¹ The IRS also served a levy on the School District on August 9, 1990 .

² In its motion for summary judgment in bankruptcy court, Lumbermens appended to the motion copies of two documents furnished by Central Acoustical Supply House and Grayling Industries, releasing it from any further obligation to them. The amount that Lumbermens paid them, however, is not specified.

³ As will be seen, the School District had no right under its contract with CA to retain any portion of progress payments to insure payment of unpaid suppliers and subcontractors.

⁴ The portion of the General Agreement of Indemnity upon which Lumbermens relies provides:

[I]t is expressly understood and declared that all monies due and to become due under any contract or contracts covered by the Bonds are trust funds, whether in the possession of the Indemnitor or Indemnitors [CA] or otherwise, for the benefit of and for payment of all such obligations in connection with any such contract or contracts for which the Surety [Lumbermens] would be liable under any of said Bonds, which said trust also inures to the benefit of the Surety for any liability or loss it may have to sustain under any said Bonds, and this Agreement and declaration shall also constitute notice of such trust.

J.A. at 39.

⁵ "Qualified property" includes "the proceeds of the contract the performance of which was ensured" by the surety bond. 26 U.S.C. §6323(c)(4)(C)(i) (1988).

⁶ The General Agreement of Indemnity, which is part of the bonding agreement between CA and the School District , provides:

[T]his Agreement shall constitute a Security Agreement to the Surety and also a Financing Statement, both in accordance with the provisions of the Uniform Commercial Code of every jurisdiction wherein such Code is in effect and may be so used by the Surety without in any way abrogating, restricting or limiting the rights of the Surety under this Agreement or under law, or in equity.

⁷ Section 6323(c) provides in relevant part:

To the extent provided in this subsection, even though notice of a lien imposed by section 6321 has been filed, such lien shall not be valid with respect to a security interest which came into existence after tax lien filing but which--

(A) is in qualified property covered by the terms of a written agreement entered into before tax lien filing and constituting--

. . .

(iii) an obligatory disbursement agreement, and

(B) is protected under local law against a judgment lien arising, as of the time of tax lien filing, out of an unsecured obligation.

 

 

[92-1 USTC ¶50,004] International Fidelity Insurance Company, Appellee v. United States of America , Appellant

(CA-8), U.S. Court of Appeals, 8th Circuit, 90-2974EM, 11/27/91 , 949 F2d 1042, 949 F2d 1042. Affirming and reversing an unreported District Court decision

[Code Sec. 6323 ]

Federal tax lien: Priority: Surety's agreement: Progress payments.--A competing surety's equitable lien on progress payments retained by the owner or obligee arose under state law ( Missouri ) on the date the contractor defaulted; the surety's lien did not relate back to the date the performance bond was executed. The IRS was entitled to progress payments seized pursuant to one tax levy because it properly perfected its lien and served the corresponding tax levy for the contractor's unpaid payroll taxes before the contractor began the work covered by the taxpayer's surety bond. The contractor could not have been in default, and thus the surety could not have a lien, before work began. However, the surety was entitled to a refund of the amount seized pursuant to the second tax levy because the IRS filed notice of that lien after the contractor defaulted and the surety had a lien.

Before ARNOLD, Circuit Judge, HEANEY, Senior Circuit Judge, and GIBSON, Circuit Judge.

ARNOLD, Circuit Judge:

This is a dispute over who is entitled to two progress payments earned by a contractor, Prudential Construction Systems, Inc., which defaulted on its obligation to install drywall at a construction site. The government, on behalf of the Internal Revenue Service, claims that it is entitled to the funds because Prudential has an outstanding tax debt. International Fidelity Insurance Company, which assumed Prudential's obligations after it defaulted, claims that it is entitled to the payments as Prudential's surety on the construction contract. Responding to cross-motions for summary judgment, the District Court held for International Fidelity. International Fidelity Ins. Co. v. United States , 745 F. Supp. 578 (E.D. Mo. 1990). On the government's appeal, we affirm in part and reverse in part.

I.

The parties stipulated to the following facts. On November 13, 1987 , Prudential agreed to install drywall at a St. Louis Housing Authority construction site. In order to guarantee completion of Prudential's work on the job and the payment of any bills it incurred in connection with the job, International Fidelity issued surety bonds on November 19, 1987 , on behalf of Prudential as principal and the Housing Authority as obligee.

Prudential began its full-time work on the job on June 13, 1988 . Despite Prudential's promise to complete its work by the end of July, it did not do so. Although the general contractor threatened on August 9 to have Prudential's work completed for it if it did not complete its work by August 12, Prudential's workers remained at the site through the beginning of September. At that point, Prudential hired another contractor to complete its work, but that contractor quit in mid-October before completing the job because Prudential did not pay it.

On September 22, 1988 , the Housing Authority warned Prudential in writing that it would replace Prudential if it did not complete its work on that date. That same day, the Housing Authority suspended further payments to Prudential. International Fidelity learned of these problems from the Housing Authority on October 7. On October 18, 1988 , the Housing Authority terminated Prudential. The next day, the Authority contacted International Fidelity and asked it to complete Prudential's job as surety. By paying the contractor Prudential had not paid and by hiring another contractor to complete the job, International Fidelity honored its obligations. Thus far International has spent a total of $48,388.50 pursuant to the bonds, with additional unpaid claims of $16,699.52 for labor and materials.

Prudential's inability to complete its contract with the Housing Authority was only one of its problems. On September 14, 1987 , and November 3, 1987 , the IRS assessed against Prudential unpaid payroll taxes in the amount of $38,616.23. The IRS filed a notice of tax lien for this deficiency on March 22, 1988 . On June 7, 1988, the IRS served a tax levy on the Housing Authority demanding that it pay any money it owed to Prudential to the IRS in order to satisfy the tax deficiency. In response to the levy, the Housing Authority paid $31,067.00--representing earned but unpaid payments for work in progress--to the IRS on August 8, 1988 .

The IRS served the Housing Authority with a second tax levy for any money owed to Prudential on August 30, 1988 . This levy reflected three assessments for unpaid payroll taxes made against Prudential: one on March 25, 1985 , with a tax lien filed on December 16, 1988 ; a second on June 27, 1988 , with a tax lien filed on November 28, 1988 ; and a third on a unknown date, without a tax lien's being filed. The Housing Authority again complied with the IRS's request by paying the IRS $16,562.28--this money was also earned for work in progress, but had yet to be disbursed--on September 28, 1988 . As of that date, the Housing Authority had not yet terminated its contract with Prudential. Prudential's workers, however, were no longer on the job site.

In February 1989, International Fidelity brought this wrongful-levy action against the government under 26 U.S.C. §7426 to recover the funds the Housing Authority paid to the IRS. It argued that as a completing surety, it had an equitable right of subrogation to the progress payments which dated back to the execution date of the surety bonds. Since International Fidelity issued the surety bonds prior to both of the tax levies, it argued that its claim had priority over the IRS's liens. The District Court adopted this reasoning and entered judgment for International Fidelity. The government appealed.

II.

In granting summary judgment in favor of International Fidelity, the District Court did not cite any provisions of the Internal Revenue Code. The parties agree, however, that 26 U.S.C. §6323(c) governs resolution of this case. We quote its relevant provisions:

Protection for certain commercial transactions financing agreements, etc.

(1) In general. To the extent provided in this subsection, even though notice of [tax] lien . . . has been filed, such lien shall not be valid with respect to a security interest which came into existence after tax lien filing but which--

(A) is in qualified property covered by the terms of a written agreement entered into before tax lien filing and constituting--

(i) . . . ,

(ii) . . . , or

(iii) an obligatory disbursement agreement, and

(B) is protected under local law against a judgment lien arising, as of the time of tax lien filing, out of an unsecured obligation.

Section 6323(c) gives certain claims which were not choate at the time of the tax-lien filing--i.e., definite in amount--priority over the federal tax lien. The dispute in this case, then, is over whether International Fidelity's claim to the progress payments qualifies for priority under the statute.

The parties agree that International Fidelity's interest in the progress payments meets most of the requirements of §6323(c) . There is no claim that International Fidelity's interest in the progress payments was choate at the time the IRS served the tax levies. The progress payments are "qualified property" covered by a written surety agreement or "obligatory disbursement agreement" entered into by International Fidelity in the ordinary course of its business. See 26 U.S.C. §6323(c)(4) (defining "qualified property" and "obligatory disbursement agreement"). The parties also agree that the relevant "local law" for purposes of §6323(c)(1)(B) is the law of Missouri .

The source of contention is whether International Fidelity's claim is "protected under local law against a judgment lien arising, as of the time of tax lien filing, out of an unsecured obligation." As a preliminary matter, International Fidelity argues that this provision gives the government only a judgment under Missouri law, not a lien. In order to establish a lien on Prudential's progress payments, International argues, the government must execute upon the judgment by providing "proper service of garnishment." Appellee's Brief at 13. Since the government did not secure a lien in accordance with Missouri law, International claims the government has no right to the funds. We decline International Fidelity's invitation to read "lien" out of the phrase "judgment lien." For purposes of the statute, "judgment lien" means the government is assumed to have a lien on the funds that has been perfected as a matter of local law. The focus of the "local law" dispute is not whether the government has a perfected lien, but whether International Fidelity's claim would nevertheless take priority over it.

Only if International Fidelity's claim has priority under Missouri law over a judgment lien obtained on the same date as the tax lien can it prevail. International Fidelity argued below, and the District Court agreed, that under Missouri law it had an equitable right of subrogation to the progress payments which related back to the date it issued the bonds. Since the bonds issued on November 19, 1987 --long before the government's tax liens--International Fidelity's equitable right to the funds preceded and therefore had priority over the government's liens. Under this view, the actual date of Prudential's default--which triggered the surety's obligation to perform under its bonds--is irrelevant. We disagree with this interpretation of Missouri law.

The District Court adopted the analysis used in Kansas City, Missouri v. Tri-City Construction Co. [89-1 USTC ¶9148 ], 666 F.Supp. 170, 173 (W.D. Mo. 1987), that "[s]uretyship law provides the surety an equitable lien to funds owing to a principal upon the surety's performance of the principal's obligation, which relates back to the time the contract of suretyship was executed." Relying on this general principle, the Tri-City Court held that a completing surety's claim to undisbursed progress payments had priority over a federal tax levy served after the date of execution of the suretyship agreement. In our view, Tri-City was wrongly decided in this respect.

Missouri decisions do contain language to the effect that a surety's interest in money retained by an obligee or owner relates back to the date of execution of the suretyship agreement. See, e.g., United States Fidelity & Guar. Co. v. Missouri Highway and Transp. Comm'n, 783 S.W.2d 516, 521 (Mo.App. 1990); Division of Employment Security v. Trice Constr. Co., 555 S.W.2d 65, 67 (Mo. App. 1977). These cases, however, involved retainages--percentages of progress payments withheld by the owner or obligee until successful completion of the contract--not undisbursed progress payments. The dispute here does not concern which party is entitled to the contract retainage of $15,127.33 currently held by the Housing Authority. Indeed, the government concedes that International Fidelity has priority to these funds as the party which successfully completed the contract. ¹

While the completing surety's equitable lien on the retainage relates back to the date of the suretyship agreement, its lien on progress payments does not. In National Surety Corp. v. Fisher, 317 S.W.2d 334 (Mo. 1958), the Missouri Supreme Court held that a surety's equitable lien on progress payments made to a contractor prior to the contractor's default did not relate back to the date of the suretyship agreement. The Court noted the Missouri general rule "that when sums earned under the contract are paid generally to the contractor, such funds are thereby freed of any equity or right of subrogation in the surety." Id. at 345. The animating principle behind the general rule is the free flow of commerce: parties which receive the progress-payment funds from the contractor should not have to concern themselves with potential future claims to the money.

It is true that National Surety Corp. involved progress payments already made to a contractor, instead of being held by the owner or obligee as was the case here. The policy of not encumbering earned progress payments with potential future liens applies equally, however, to those payments not yet in the hands of the contractor. In First State Bank v. Reorganized School District R-3, 495 S.W.2d 471 (Mo.App. 1973), the Missouri Court of Appeals was presented with the issue of which of two claimants had priority to a retainage and an undistributed progress payment of a defaulting contractor held by an obligee: a surety which completed the contract or a bank which had been assigned the contract's proceeds after execution of the suretyship agreement.

Consistently with the Missouri cases we have cited, the Court held that the surety had priority to the retainage because its equitable lien related back to the execution of the performance bond. The Court was not willing, however, for the surety's interest in an undisbursed progress payment to relate back to the same date. Rather, the Court held that the surety's interest in an earned, but undisbursed, progress payment did not arise until the date of the contractor's default. If the default occurred before the progress payment was due, then the surety was entitled to the progress payment. Since the lower court had not addressed the issue, the Court remanded the case for a determination of the contractor's default date.

The rationale of First State Bank governs here. ² International Fidelity's claim of priority to Prudential's progress payment depends upon the date of Prudential's default. If Prudential defaulted before the IRS filed its notices of tax lien, then International Fidelity has priority to the funds over the government. On the other hand, if Prudential defaulted after the IRS filed the tax liens, the IRS was free to seize the funds to satisfy Prudential's outstanding tax debt. As we have noted earlier, the District Court relied on the relation-back doctrine and therefore did not address the issue of Prudential's default date.

Despite the significance of Prudential's default date, we need not pinpoint it exactly in order to decide which party has priority to the funds in this case. The government is entitled to the funds it seized pursuant to the first tax levy. The IRS filed its first notice of tax lien on March 22, 1988 , and served the corresponding tax levy on the Housing Authority on June 7, 1988 , for $38,616.23 in unpaid payroll taxes. Since Prudential began its full-time work on the Housing Authority project on June 13, 1988 , and originally promised to complete its work by the end of July, it could not have been in default as of March 22. The IRS is therefore entitled to the $31,067.00 seized pursuant to the first tax levy.

International Fidelity, however, is entitled to the funds seized pursuant to the second tax levy. Although the IRS served the second tax levy for three assessments of deficiency on August 30, 1988 , it never filed a tax lien with respect to one of the assessments, and did not file tax liens for the other two until November 28 and December 16, 1988 . The crucial date for deciding whether a claim is protected under local law pursuant to §6323(c) is "the time of tax lien filing[.]" For purposes of §6323 , "tax lien filing" means "the filing of notice . . . of the lien imposed by [the assessment of taxes]." 26 U.S.C. §6323(h)(5) . The government claims that its tax levy of August 30, 1988 , is equivalent to a tax-lien filing under §6323 . Our response to the government's argument is the same response we earlier gave to International Fidelity: we decline to ignore the plain language of the statute. ³ The statute speaks of the date of tax-lien filing, not the date of a tax levy. Even under the government's theory of the case, Prudential had defaulted by November 28, 1988 . Therefore, at the time of tax-lien filing, International Fidelity had priority to the funds under local law.

III.

To summarize: we reverse the judgment of the District Court with respect to the first tax levy. Accordingly, judgment for the government shall be entered in the amount of $31,067.00. We affirm the judgment of the District Court with respect to the second tax levy. International Fidelity is entitled to these funds as the completing surety. The cause is remanded to the District Court with directions to enter judgment in accordance with this opinion.

It is so ordered.

¹ Despite the presence of general language in support of its position, we find International Fidelity's reliance on Housing Authority of Mexico, Missouri v. General Insurance Co. of America [75-2 USTC ¶9631 ], 392 F.Supp. 65 (E.D. Mo. 1974), misplaced. General Insurance involved priority to a retainage, not progress payments. Moreover, the opinion did not cite any Missouri law on the issue.

² It is true that in United States v. Trigg [72-2 USTC ¶9642 ], 465 F.2d 1264, 1271 (8th Cir. 1972), cert. denied, 410 U.S. 909 (1973), we indicated that a surety would be entitled under 26 U.S.C. §6323(c) to a contractor's progress payments levied upon by the IRS prior to the contractor's default date. This language from Trigg, however, is dictum. In Trigg, the surety did not make any payments under its agreement with the contractor. Three individuals who agreed to indemnify the surety made the payments. The dispositive question was whether the individuals agreed to indemnify the surety in the ordinary course of their business as required by §6323 . The Court disposed of their claim when it answered no to this question. Moreover, the local law applicable to the dispute in Trigg was the law of Arkansas .

³ While it is true that the levy brings the funds within the constructive possession of the government, this does not mean--contrary to the government's assertion--that International Fidelity cannot later prove it had a superior right to the funds at the time of the levy. If we were to hold otherwise, we would eliminate the ability of claimants to bring wrongful-levy actions against the government.