The Federal Priority Statute Catherine E. Vance Development Specialists, Inc. What is the Federal Priority Statute? The Federal Priority Statute is a federal law mandating that when certain events relating to a person’s insolvency occur, the federal government jumps to the head of the line for payment in most cases. The statute itself is a model of brevity, stating that a claim of the United States government must be paid first when a person is insolvent and – 1) 2) 3)

the person, without enough property to pay all debts makes a voluntary assignment of property; property of the person, if absent, is attached; or an act of bankruptcy is committed. 1

The Federal Priority Statute also applies to decedents’ estates, but our concern here is the insolvent company. Some form of the Federal Priority Statute has been around since the ink on the Constitution was barely dry, with the first version having been enacted in 1797, and its roots trace back even further to old English law. As Chief Justice Burger once explained, “the Crown exercised a sovereign prerogative to require that debts owed it be paid before the debts owed to other creditors.” 2 Americans being adverse to references to the “Crown,” the policy of the Federal Priority Statute soon took a new form, albeit with similar substance and identical effect: As Mr. Justice Story wrote for the Court in 1832, the priority proceeds from “motives of public policy, in order to secure an adequate revenue to sustain the public burdens and discharge the public debts…[A]s that

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31 U.S.C. § 3713. United States v. Moore, 423 U.S. 77, 80 (1975).

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policy has mainly a reference to the public good, there is no reason for giving to [the statute] a strict and narrow interpretation. 3 Like Justice Story, most courts have found no good reason to give the Federal Priority Statute “a strict and narrow interpretation;” over the years, the statute has been applied to debts owed to any number of federal agencies and departments, including, of course, the Internal Revenue Service. What is Meant by “Priority?” The priority conferred upon federal debts is not absolute. In the first place, the statute does not create an enforceable lien on a debtor’s property, only a right to payment ahead of most of the debtor’s creditors. Prior liens, so long as they are properly perfected, will probably have to be satisfied before the federal government gets paid. It’s worth noting that the Supreme Court has never directly held that prior liens take priority over the government and there is authority to the contrary. The cases the high court has decided, however, seem to draw a line between consensual versus statutory liens, with the latter usually held subordinate to the government’s priority. Expenses incurred in administering an insolvent debtor’s estate raise a similar issue. It’s difficult to imagine that any court would allow the possibility that those who administer estates for others should await payment until after a class of beneficiaries has been satisfied. Yet, a 1993 Supreme Court case4 suggests that this result is possible, holding in an insurance case that a preference above the government for administrative expenses was permissible – but only as to policyholders. An administrative expense priority was not ruled out in other contexts, but the Court’s language does present the troublesome possibility that the government takes ahead of the administrators. 3 4

Id. at 81-82 quoting United States v. State Bank of North Carolina, 6 Pet. 29, 35 (1832). United States v. Fabe, 508 U.S. 491 (1993).

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Beyond liens and administrative expenses, the Federal Priority Statute will, however, trump just about everything. What Triggers Application of the Federal Priority Statute? Some triggering events are evident from the statute’s language, like making an assignment for the benefit of creditors, but in all events, the company must be insolvent. The Federal Priority Statute also states that “acts of bankruptcy” are triggering events, which is rather ironic given that the statute has no application at all once an actual bankruptcy case is commenced. Courts tend to rely on the old Bankruptcy Act’s definition of “acts of bankruptcy,” which includes making preferential or fraudulent transfers, or concealing assets with the purpose of hindering or delaying creditors. Just what is meant by “property of the person, if absent, is attached” is not clear, but this phrase likely has little practical application today, at least in terms of attachment. Creditors do not routinely attach their debtors’ property in modern practice, at least not all of the property. The more likely approach would be to ask the court to appoint a receiver – and if the court does so, the Federal Priority Statute kicks in. Application of the statute in the receivership context rests on the Supreme Court’s instruction that the purpose of the Federal Priority Statute “is to make those into whose hand control and possession of the debtor’s assets are placed, responsible for seeing that the Government’s priority is paid.” 5 Under this reasoning, it is difficult to imagine that the appointment of a receiver would not trigger application of the statute. But it also means that the FPS extends to a number of other proceedings, just about any collective process intended to marshal a debtor’s assets, liquidate them, and make distribution to creditors. 5

King v. United States, 379 U.S. 329, 337 (1964).

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In an interesting twist, the Federal Priority Statute does not apply to insurance receiverships or liquidations, at least not completely. Congress ceded to the states the authority to regulate “the business of insurance,” including insolvency proceedings. About ten years ago, the Supreme Court decided that this allows the states to bump federal claims down in the order of payment, but only relative to policyholders and their interests. 6 To Whom Does the Federal Priority Statute Apply? Part of this answer is easy – assignees for the benefit of creditors, court appointed receivers, and those who have attached all the property of an absent debtor, all of these must obey the command to prioritize federal debt. Bankruptcy trustees, on the other hand, need not. For the harder part of the answer, the Supreme Court’s guidance must once again be employed: the statute applies to “those into whose hand control and possession of the debtor’s assets are placed, responsible for seeing that the Government’s priority is paid.” 7 Official capacity or formal designation as the representative of an insolvent debtor’s property is not decisive; rather, the question is whether a person controls that property and is responsible for payment of the company’s debts. Defined in these terms, the Federal Priority Statute casts a very wide net. Courts have found the statute to encompass, for example, distributing agents, bulk sales purchasers, and others who control the debtor’s assets and debt payment decisions. Courts have also applied the Federal Priority Statute to the insolvent company’s officers and directors, which is probably the most troublesome aspect of the statute’s

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United States v. Fabe, supra n.4. Id.

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jurisprudence. The language of the statute would seem to require an “insolvency plus” analysis. Again, the easiest example is an insolvent company entering into an assignment for the benefit of creditors; there is insolvency plus the act of assignment. Bringing in turnaround experts also fits the “insolvency plus” framework of the statute, provided those experts also assume positions of authority, such as chief executive officer or as members of the board. Anything less makes the mere fact of insolvency a triggering event, a result plainly inconsistent with what the statute expressly provides. Unfortunately for officers and directors faced with this situation, it is the courts, not this author, who have the final word. What Happens if Debts are Wrongfully Paid Ahead of the Federal Government? A representative of a person or an estate … paying any part of a debt of the person or estate before paying a claim of the Government is liable to the extent of the payment for unpaid claims of the Government. So says the Federal Priority Statute. This means, of course, personal liability for the assignee, receiver, or whoever has control and possession of the debtor’s property and the responsibility for ensuring the government gets paid. Personal liability can attach even if the representative distributes the debtor’s property perfectly in compliance with the state law governing payment of claims because the Federal Priority Statute preempts those schemes. There is good news. The Federal Priority Statute is not a strict liability statute. The courts have long required that, in order to impose personal liability under the statute, the representative must have knowledge of the government’s debt or notice of facts that would lead a reasonably prudent person to inquire as to the existence of the debt. Some

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courts hint that some form of willful disregard of the government’s priority might be required, though no cases directly so hold. Another limitation on the representative’s personal liability goes to the amount. Note that the statute says liability is for “the extent of the payment.” If only, say, $1,000 was improperly distributed to a creditor with a lower priority than the federal government, then that is the extent of the representative’s liability even if the government is owed millions.

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