The holding in the recent case of SE Prop. Holdings, LLC v. Unified Recovery Grp., LLC, No. from the Federal District Court for Eastern District of Louisiana illustrates how security interests can be wiped out by subsequent tax liens. The District Court held that an IRS tax lien had priority over a security interest in accounts taken and perfected years before the tax lien arose, based on the judicially created “choateness” doctrine.

Under the choatness doctrine, an otherwise perfected security interest loses its priority to a subsequently filed tax lien in respect of property to which the debtor has not acquired rights at the time of filing of the tax lien, notwithstanding the inclusion of an after acquired property clause.

The existence and precise nature of an interest is determined according to state law. However, the issue of priority between conflicting interests is settled according to federal law. Under state law, a security interest in an account does not require performance of the obligation giving rise to the account. Instead, an account is defined in the Commercial Code as “a right to payment of a monetary obligation, whether or not earned by performance…for services rendered or to be rendered.” However, Under the definitions section of the Code of Federal Regulations (“CFR”) relating to tax liens and their effect on security interests, “[a]n account receivable is in existence when, and to the extent, a right to payment is earned by performance.”

Under the choateness doctrine, a security interest that has otherwise attached and been perfected under state law prior to the filing of the tax lien only “attaches” relative to that tax lien when it becomes choate. To become choate, three elements must be established: (i) the identity of the secured party, (ii) the property subject to the lien, and (iii) the amount of the lien. A security interest in an account does not become choate until the account comes into existence, and this is not until the services giving rise to the account are performed.

In SE Holdings the account at issue was in existence – the applicable services giving rise to the account had been performed – before the filing of the tax lien. Beginning in 2005, St. Bernard Parish entered into three debris removal contracts with United Recovery Group (“URG). In August 2008, Unified Recovery Group (URG) granted SE Property Holdings, LLC (“SEPH”) a security interest in its accounts. SEPH perfected its security interest by filing a financing statement and subsequently filed a continuation statement. By the end of 2012, URG completed the work contemplated under the St. Bernard Parisj contracts. On January 29, 2013, the IRS filed its tax lien. Saint Bernard Parish filed an interpleader as to FEMA funds it held for the contracts. SEPH and the IRS each filed summary judgment motions claiming those funds.

The SE Holdings Court held that, although URG performed the debris removal work required under the contracts well before the IRS filed the tax lien, URG had not fully discharged its duties under such contract because URG also had the “contractual responsibility” to “assist in preparation of documentation for claims submitted for reimbursement.” The SE Holdings Court reasoned that the accounts receivable were not “acquired”, according to the choateness doctrine, until URG completely performed its obligation.” It further held Saint Bernard Parish’s invoice approval, a matter out of URG’s control, was the triggering event marking completion of URG’s performance.

SE Holdings may have been able to avoid losing its security interest if it had given greater consideration in drafting and litigating of its security interests. There was no mention of any kind of a substantial performance argument or exception in the application of the choateness doctrine in SE Holdings, yet the Court admitted that there was a fair argument that the funds were proceeds of contract rights, that came into existence when the contracts were made. However, the Court did not rule on these issues because the secured party failed to raise them.

SE Holdings demonstrates that an otherwise valid and perfected security interest in accounts can lose priority to a subsequently filed tax lien if some arguably minor performance obligation remains. It therefore behooves secured parties to retain attorneys that can carefully draft and litigate their security interests.

The information presented is not intended to be, and does not constitute, “legal advice.” Because each situation varies, and only brief summary information is provided here, you should not use this information as a basis for action unless you have independently verified with your own counsel that it applies to your particular situation.