Opinion ID: 199934
Heading Depth: 2
Heading Rank: 4

Heading: Priority of Fleet's lien

Text: 66 The bankruptcy court reasoned that the government's right of setoff was junior to Fleet's lien as a matter of law because that court had authorized on June 28, 1995, and periodically renewed a borrowing order under the three subsections of 11 U.S.C. § 364(c). The order granted a secured lien on all of Calore's pre- and postpetition assets, including accounts receivable, to Fleet's predecessor Shawmut. It also granted priority over all other administrative claims. The district court did not reach this ground of the bankruptcy court's judgment. 67 Only one of the bankruptcy court's three sources of statutory authority, 11 U.S.C. § 364(c)(2), provides Fleet with a colorable claim to priority. The borrowing order gave Shawmut a senior lien on Calore's previously unencumbered assets under § 364(c)(2). It also gave Shawmut a junior lien on Calore's previously encumbered assets, certain vehicles and equipment, under § 364(c)(3). Because accounts receivable were not in this category, the § 364(c)(3) lien is not relevant here. In case Shawmut's claim turned out to be undersecured by the assets subject to lien, the court gave Shawmut a superpriority administrative claim under § 364(c)(1). That superpriority is also irrelevant here because any unsecured claim, even an administrative one, is junior to a secured claim; and the government's setoff claim qualifies as a secured claim under 11 U.S.C. § 506(a). Therefore, Fleet's sole possible argument for priority rests on the § 364(c)(2) lien.
68 The bankruptcy court applied Article Nine of the Uniform Commercial Code to determine the relative priority of Fleet's lien and the government's setoff rights. We initially determine the proper source of law for the priority dispute in this case. As a general matter, 11 U.S.C. § 553 does not create a scheme of priority for the setoff rights it preserves, any more than it creates those rights themselves, see Sisk v. Saugus Bank & Trust Co. ( In re Saugus Gen. Hosp., Inc. ), 698 F.2d 42, 44 (1st Cir.1983). Setoff is a creature of the common law, and therefore in most cases a question of state law under Erie Railroad Co. v. Tompkins, 304 U.S. 64, 58 S.Ct. 817, 82 L.Ed. 1188 (1938). Federal law, however, determines the rights and liabilities of the United States, as the Supreme Court held in Clearfield Trust Co. v. United States, 318 U.S. 363, 63 S.Ct. 573, 87 L.Ed. 838 (1943). If Congress enacts a statute, that statute governs. If Congress does not, the federal courts apply federal common law. The United States's general right of setoff, like its other rights in commercial disputes, is a matter of federal common law, as is the priority of that right as against the rights of other creditors. 69 We address first, if briefly, the government's contention that this case falls within a federal statute. The government invokes the Assignment of Claims Act, 31 U.S.C. § 3727 (1994), which provides certain requirements for the assignment of claims against the federal government, none of which Fleet has met. Fleet responds correctly that the Act applies only to the voluntary assignment of claims, and not to assignments by operation of law, including those in the context of bankruptcy. United States v. Aetna Cas. & Sur. Co., 338 U.S. 366, 373-74, 70 S.Ct. 207, 94 L.Ed. 171 (1949). The government also makes some passing references to the Judgment Setoff Act, 31 U.S.C. § 3728 (1994 & Supp. II 1996), but does not press the point; there is no judgment at stake in this case and so the Act by its terms does not apply. Therefore, the question of the priority of the government's setoff rights is a question of federal common law. 70 That said, a federal court applying federal common law will often simply incorporate the law of the appropriate state if there is no relevant federal interest to justify a distinct federal rule. In United States v. Kimbell Foods, Inc., 440 U.S. 715, 99 S.Ct. 1448, 59 L.Ed.2d 711 (1979), the Supreme Court considered whether to rely on any federal interest in generating federal common law to determine the priority of a lien that the government acquired as a party to a contract. The Court held that state law should apply, and reasoned that there was no sufficiently compelling federal interest at stake. Id. at 740, 99 S.Ct. 1448. It noted that the expectations of parties to commercial transactions tend to be based on state law, and that the federal courts should not disrupt those expectations without good reason. Id. at 739-40, 99 S.Ct. 1448. The Court distinguished the problem of commercial liens held by the federal government from that of federal tax liens. Tax collection is uniquely important to the proper functioning of the government, and in tax cases the government is an involuntary creditor. Id. at 734-36, 99 S.Ct. 1448. 71 The present case involves both of the situations the Court discussed in Kimbell Foods. As to Calore's unpaid taxes, the government is an involuntary creditor facing the problem of enforcement: if the government's allegations are true, Calore was engaged in a continuing process of misappropriating funds supposedly held in trust for employee taxes both before and after filing its Chapter 11 petition. As to the GSA's contract debts, by contrast, the government was purchasing services on the market and should not necessarily expect treatment different from that of any other participant in commerce. 72 When the federal courts make new federal common law, it is to protect strong federal interests — for example, the interest of the government as tax creditor. Happily for federalism purposes, state law adequately protects that interest here. We read the Uniform Commercial Code, at least as interpreted by Massachusetts, 10 differently than did the bankruptcy court, and for present purposes we incorporate state law into federal. 11 Our analysis of the Code follows.
73 Initially, we note that the bankruptcy court correctly concluded that Article Nine of the Uniform Commercial Code applied to the relative priority of setoffs and security interests despite the language of section 9-104(i), which states that the Article does not apply to any right of setoff. Mass. Gen. Laws ch. 106, § 9-104(i) (2000) (repealed 2001); see 5 Collier, supra, ¶ 533.12[1] (The majority of jurisdictions construe section 9-104(i) to mean that, although a creditor may claim and enforce a right of setoff without complying with the requirements of Article Nine, nevertheless Article Nine governs the priority of any setoff right in conflict with an Article Nine security interest.). The Supreme Judicial Court of Massachusetts has applied Article Nine to determine the validity of a setoff right after an assignment of accounts receivable as security. See Graves Equip., Inc. v. M. DeMatteo Constr. Co., 397 Mass. 110, 489 N.E.2d 1010, 1011 (1986); Fall River Trust Co. v. B.G. Browdy, Inc., 346 Mass. 614, 195 N.E.2d 63, 64 (1964). 74 The bankruptcy court then proceeded to apply section 9-312(5) of that Article. Section 9-312(5) accords priority between conflicting security interests in the same collateral to that secured party who first files or perfects according to the requirements of Article Nine; or, if neither of the contesting parties has filed or perfected, to that party whose interest first attached. 12 Fleet defends the bankruptcy court's choice of that provision. The government argues that, instead, the court should have applied section 9-318, which applies to the assignment of accounts receivable. Under section 9-318, an account debtor may assert against an assignee any defense or claim that either arises from the terms of the assigned contract or accrued before the account debtor had notice of the assignment. 13 75 For three reasons, we hold that section 9-318 applies to this case and section 9-312(5) does not. First, the government's right of setoff fits within subsection 9-318(1)(b)'s description of a defense or claim of the account debtor against the assignor. In two cases we cited earlier, Graves Equipment and Fall River Trust, Massachusetts's highest court applied section 9-318 to a right of setoff asserted by an account debtor against an assignee of accounts receivable. Graves Equip., 489 N.E.2d at 1011-12; Fall River, 195 N.E.2d at 64. The only possible way to distinguish this case from Graves Equipment and Fall River Trust would rely on the fact that in this case, Fleet's predecessor Shawmut first took a lien on Calore's accounts, by a prepetition security agreement and then by the June 1995 borrowing order; only later, with the July 1996 sale of assets, did Fleet obtain permission to lift the automatic stay and to exercise its right to take an assignment of the accounts. The application of section 9-312(5) must therefore rest on the premise that in this context the rights of a creditor who holds a perfected lien on accounts receivable and subsequently becomes an assignee exceed those of one who becomes an assignee directly. 76 Neither Fleet nor the bankruptcy court, however, offer any reason grounded in policy to reach a different result in this case, which features an assignment through a lien, from that we would reach in a case of a direct assignment. It would be an odd result if parties whose agreement to assign accounts would remain subject to an account debtor's existing defenses and claims could bypass those defenses and claims with the device of a lien. Moreover, there is authority in other jurisdictions to the contrary. See Me. Farmers Exch. v. Farm Credit of Me., 789 A.2d 85, 2002 ME 18, ¶ 13 (stating that section 9-318 provides a limited right to a setoff for [an account debtor], a right that can be superior to the security interest of a secured party, and then applying section 9-318(1)(a) because the account debtor had notice); Commerce Bank, N.A. v. Chrysler Realty Corp., 244 F.3d 777, 783 (10th Cir. 2001) (applying Kansas law) (The fact that [the secured party] had a perfected security interest, and [the account debtor] did not, makes no difference because [the secured party]'s secured status comes into play only after it is shown that [the assignor] was entitled to payment of the funds.); see also Chase Manhattan Bank (N.A.) v. State, 40 N.Y.2d 590, 388 N.Y.S.2d 896, 357 N.E.2d 366, 369 (N.Y.1976) ([T]he `first to file' rule [referring to section 9-312(5)], designed to resolve situations where secured parties are competing in asserting superior rights, should not be controlling when the dispute is between a secured party and an account debtor.). In addition, in United California Bank v. Eastern Mountain Sports, Inc., 546 F.Supp. 945 (D.Mass.1982), cited in Graves Equipment, 489 N.E.2d at 1012, a case decided under Massachusetts law, the District of Massachusetts applied section 9-318 to an assignment following the conveyance of a security interest. Id. at 950, 963-64. 77 Fleet relies for its contrary argument on MNC Commercial Corp. v. Joseph T. Ryerson & Son, Inc., 882 F.2d 615 (2d Cir.1989), in which the Second Circuit applied section 9-312 to a dispute between an account debtor and the assignee of accounts receivable. Id. at 620. In that case, however, the account debtor did not actually own the claim against the assignor that it sought to assert against the assignee, and the court stated that New York law left open the question what would occur if the account debtor did own the asserted claim. Id. In this case, Fleet cannot argue that the government does not own the IRS's claim against Calore. 14 78 Second, the government's right of setoff is not clearly a security interest within the meaning of section 9-312(5). Although a claim accompanied by a right of setoff is a secured claim within the meaning of the Bankruptcy Code, 11 U.S.C. § 506(a), a secured claim within the meaning of federal bankruptcy law is not necessarily the same thing as a security interest within the meaning of Article Nine. If a right of setoff were an Article Nine security interest, it is difficult to see how it would escape the procedural requirements for priority, such as filing or perfection, imposed by that Article. That result would produce tension with the reading of section 9-104(i) discussed above, under which setoffs are not subject to Article Nine's procedural requirements. Some courts have found persuasive in this context a comment of Article Nine's reporter, Professor Grant Gilmore, that [o]f course a right of set-off is not a security interest and has never been confused with one: the statute [referring to section 9-104(i)] might as appropriately exclude fan dancing. I G. Gilmore, Security Interests in Personal Property § 10.7, at 315-16 (1965), quoted in Nat'l City Bank, Northwest v. Columbian Mut. Life Ins. Co., 282 F.3d 407, 410 (6th Cir.2002). 79 Third, section 9-312(5) by its terms applies [i]n all cases not governed by other rules stated in this section, that is, section 9-312. The first subsection of that section, 9-312(1), in turn states that [t]he rules of priority stated in other sections of this Part and in the following sections shall govern when applicable. The Part cited is Part Three of Article Nine, which includes section 9-318. This language indicates that section 9-312(5) states a default rule that courts should apply only in the absence of other governing provisions. Thus, to the extent we could properly view the dispute between Fleet and the government as either a contest of priority between conflicting security interests or a question of the validity of a defense or claim of the account debtor against the assignor, we should adopt the latter perspective. 80 Accordingly, we next apply section 9-318 to the facts of this case.
81 In this case, because Calore's debt to the IRS was unrelated to the terms of the contract between Calore and the GSA, subsection (1)(b) of section 9-318 governs the outcome. Under that provision, the crucial times are when the government received notice of the assignment of Calore's debts to Fleet, and when the IRS's claim against Calore accrued. 82 The parties contest exactly when the government received notice. The government argues that it received notice only when Fleet informed the court and the other parties of the sale of Calore's assets in August 1996. Because that date is also when Calore ceased doing business as Calore, the government's tax claims necessarily accrued before notice, and those claims take priority. Fleet argues that the government received notice at the time of the first borrowing order, in June 1995, which gave Fleet's predecessor Shawmut its security interest in all of Calore's assets. 83 The government's claims based on Calore's prepetition tax debts accrued, by definition, before Calore's Chapter 11 petition and so before the borrowing order. The government's rights based on those claims therefore take priority over Fleet's security interest even on Fleet's view of timing. The government's setoff rights based on postpetition tax claims presumably accrued, at least in part, after June 1995 but before August 1996. We must therefore decide whether the borrowing order provided the government with reasonable notice under section 9-318, so that the government cannot now assert claims accruing after the borrowing order against Fleet. 84 It did not. The borrowing order at most informed the government not of an assignment of Calore's accounts, but only of a lien placed on those accounts that could later lead to an assignment. Following the borrowing order, the government and other account debtors continued to do business with and make payments to Calore, and not to Shawmut, the lienholder. At least one court has reasoned in applying section 9-318 that notice of an assignment that precedes the assignment itself is ineffective. See Citizens State Bank of Corrigan v. J.M. Jackson Corp., 537 S.W.2d 120, 121 (Tex.Civ.App.1976) ([An account debtor can]not be put on notice of an assignment prior to the time that that assignment existed.). This is not a case in which Calore assigned accounts receivable to serve as security, with the assignment effective at the time the debt was incurred, although such assignments do occur and are sometimes called security interests. In this case, Fleet acquired its right to collect Calore's receivables only later, after the July 1996 sale of assets. 85 We need not rule out the possibility that some particularly comprehensive and express form of notice could potentially affect an account debtor's rights before an actual assignment, however. On the facts of this case, the borrowing order lacked sufficient detail to satisfy the requirements of section 9-318(3), which states that notice must reasonably identify the rights assigned. Mass. Gen. Laws ch. 106, § 9-318(3) (2000) (repealed 2001). As quoted earlier, the borrowing order refers generally to all of Calore's accounts. It does not identify any debtors, contracts, or amounts. Although there are no relevant cases under Massachusetts law, courts applying section 9-318(3) as part of the law of other states have required more detail in notices of assignment. See Progressive Design, Inc. v. Olson Bros. Mfg. Co., 200 Neb. 291, 263 N.W.2d 465, 468-69 (Neb. 1978) (rejecting as reasonable notice a letter that did not identify the contract by date, or by the type or kind of contract, nor did it refer to the product or services contracted for, nor even the amount of money involved); Bank of Salt Lake v. Corp. of the President of the Church of Jesus Christ of Latter-Day Saints, 534 P.2d 887, 891 (Utah 1975) (dictum) (stating that a letter with incorrect invoice numbers and amounts did not provide reasonable notice). Certainly, in order to prevent an account debtor from raising against an assignee defenses and claims accruing after the notice but before the assignment itself, the notice given would have to meet at least the standards set forth in these cases. 86 The reason that the order did not include such specifics is probably that no one involved — Fleet, Calore, or the bankruptcy court — intended the order to serve as notice to Calore's account debtors of an assignment of Calore's accounts receivable. Nor would the attorneys at the U.S. Attorney's Office for the District of Massachusetts, to whom the order was served, have had any reason to think that the order had such a purpose. Nothing in the order even mentioned the IRS or the GSA, whose agents might perhaps have understood the potential significance of a potential assignment. Cf. Chase Manhattan Bank, 388 N.Y.S.2d 896, 357 N.E.2d at 369 (holding that a UCC filing statement filed with New York's Secretary of State did not give reasonable notice to the state of its contents under section 9-318). Accordingly, the government received its notice of assignment no earlier than the following August; because the government's tax claims accrued prior to that date, it can exercise its right of setoff against Fleet, and the bankruptcy court's conclusion was mistaken. 87 The purpose of the rule requiring notice to foreclose an account debtor's setoff rights for claims independent of the contract out of which the account arises is presumably to permit the account debtor to protect its rights. Knowing that it will no longer be able to rely on the assigned accounts in disputes with the assignor, the account debtor may act differently in dealings with the assignor, or even cease doing business with the assignor entirely. The government in this context is, of course, unable to make such choices. Calore's tax debts would continue to accrue regardless of the government's actions. That distinction between the government and an ordinary commercial actor is one of the reasons that the federal courts have been particularly careful to guard the government's interest in tax collection. See Kimbell Foods, 440 U.S. at 735-36, 99 S.Ct. 1448 (The United States is an involuntary creditor of delinquent taxpayers, unable to control the factors that make tax collection likely.). Nevertheless, proper notice in this case might have been helpful to the United States: specifically, it might have alerted government attorneys to the need to act quickly to protect the government's rights. Thus, while we have treated the waiver and priority questions separately in this opinion, the underlying theme remains that it is not clear on the present record that the government's inaction was unreasonable or inappropriate.