Government Working Group
Proposal #2: Section 724(b)

Section 724(b) represents a fundamental collision at the intersection of bankruptcy and tax policy. The statute governs the order of distribution of both real and personal property subject to valid, nonavoidable federal, state and local tax liens in a chapter 7 case. Section 724(b)(2) departs from the general rule that unsecured priority claims are junior in priority to perfected secured claims. Under section 724(b)(2), the trustee is required to subordinate valid tax liens below the costs of administration and a large number of other priority claims. The provision effectively enables unsecured priority claimants occupying the first through seventh rungs on the section 507(a) priority ladder to step into the position of the taxing authority and receive distributions from property of the estate despite the fact that the tax claim is properly allowed and secured. A number of courts interpreting section 724(b) have held that a trustee is under no obligation to marshal unencumbered assets of the estate as a prerequisite to subordinating prior and otherwise valid tax liens. [ FN: See, e.g., Wurst v. City of New York (In re Packard Properties, Ltd.), 112 B.R. 154, 158-59 (Bankr. N.D. Tex. 1990).]

As originally enacted, section 724(b) was designed to reflect a policy choice that those who toil on behalf of the chapter 7 estate should receive remuneration for the benefit conferred. Thus, Congress sought to guarantee the payment of "only" the costs of administration in a chapter 7 case and small wage claims by allowing a limited class of claimants to prime tax liens on "personal" property. Indeed, the legislative history to the Code, as buttressed by the Report of the Commission on the Bankruptcy Laws of the United States, reveals that the drafters intended to limit the reach ofthe statute and exempt ad valorem taxes on real property from subordination. [ FN: See H.R. Rep. No . 595, 95th Cong., 1st Sess. 382 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6338; S. Rep. No. 989, 95th Cong., 2d Sess. 96 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5882; H.R. Doc. No. 137, 93d Cong., 1st Sess. 212 (1973), reprinted in A & P Legislative History, at 476.] The statute has since been significantly expanded beyond its original scope to allow a substantial number of unsecured priority claimants to invade valid and properly perfected liens on both personal and real property. Additionally, some courts have permitted administrative claimants in a superseded chapter 11 case to subordinate tax liens upon an ensuing conversion to chapter 7. [ FN: See, e.g., Morgan v. K.C. Machine & Tool Co. (In re K.C. Machine & Tool Co.), 816 F.2d 238 (6th Cir. 1987).]

Recently, Congress has recognized the importance of tax revenues to local governments and the impact that bankruptcy has on their ability to protect their interests. In the wake of a number of circuit court decisions which held that the automatic stay prevented statutory liens from attaching to property for taxes accruing after the bankruptcy filing, Congress amended section 362 in 1994 in order to allow local governments to utilize their lien attachment authority to secure the payment of property taxes. The protection afforded by Congress in the Bankruptcy Reform Act of 1994 can, however, be rendered completely nugatory in many cases by section 724(b).

The Working Group on Government has had a number of meetings and discussions regarding issues arising under section 724(b) and the appropriate scope of the statute. A number of governmental units have appeared before the Commission and submitted comments regarding the statute. The governments have argued that the statute, as presently constituted, undermines the ability of governments to provide essential public services and should be amended.

The Working Group has developed alternative proposals aimed at remedying perceived problems and inequities. Absent majority support for any one of the three alternatives, or for another Proposal, no change to the current statute will be recommended.

Alternative Proposals

Section 724(b) be amended as follows:

(1) Bankruptcy Code section 724(b) should be repealed;

(2) Bankruptcy Code section 724(b) should be amended to exempt from subordination under the statute properly perfected, nonavoidable liens on real or personal property of the estate arising in connection with an ad valorem tax. Section 724(b) should be further amended to permit only (i) section 507(a)(1) administrative expense claims arising in connection with the chapter 7 case; and (ii) section 507(a)(3) and (a)(4) priority wage claims to prime any other properly perfected, nonavoidable tax lien on real or personal property. Section 724(b) should also require the trustee to marshal unencumbered assets of the bankruptcy estate and surcharge secured claims, if warranted by the circumstances, under section 506(c) prior to subordinating any tax liens under thestatute; or

(3) Bankruptcy Code section 724(b) should be amended to permit only (i) section 507(a)(1) claims in connection with the administration of the chapter 7 case; and (ii) section 507(a)(3) and (a)(4) priority wage claims, to prime any properly perfected, nonavoidable tax lien on real and personal property. Section 724(b) should be further amended to require the trustee to marshal unencumbered assets of the bankruptcy estate and surcharge secured claims, if warranted by the circumstances, under section 506(c) prior to subordinating any tax liens under the statute.

Discussion

A comprehensive analysis of section 724(b) has been embodied in memoranda previously circulated to the Commission. The memoranda set forth the policy justifications and rationale for amendment and should be referred to in conjunction with this Proposal. The Proposal sets forth "alternative" recommendations for reform.

Alternative (1) recommends a complete repeal of the statute. The subordination of any valid and properly perfected tax liens on real or personal property to priority claims under section 507(a)(1)-(7) would be precluded under Alternative (1). The Tax Advisory Committee of the National Bankruptcy Review Commission has recommended that the Commission adopt this alternative by a vote of five to four.

Alternative (2) recommends an amendment to section 724(b) that would completely exempt from subordination nonavoidable and properly perfected ad valorem property tax liens on real and personal property. The exemption would recognize the impact that section 724(b) has on governmental units and shelter nonavoidable and properly perfected ad valorem tax liens from subordination. Alternative (2) would permit the expenses of administering the chapter 7 estate and all wage claims entitled to priority under section 507(a)(3) and (a)(4) to prime all other tax liens. Section 724(b) would not, however, be available as a mechanism to subordinate tax liens to any other claim entitled to priority under section 507(a) or to administrative claimants in a superseded chapter 11 case.

Alternative (2) would also impose a requirement that the trustee first marshal and exhaust assets of the bankruptcy estate prior to resorting to subordination under section 724(b). Section 724(b) does not impose a marshaling requirement and some courts have permitted the invasion of the lien claim of taxing authorities without requiring the trustee to first administer other estate assets. As a component of the marshaling requirement, Alternative (2) would also direct the trustee to utilize section 506(c) in instances in which it is the secured creditor that is driving an orderly liquidation under chapter 11 and deriving the benefit from the disposition of assets prior to an ensuing conversion of the case.

Alternative (3) is similar to Alternative (2) with one important difference. Alternative (3) would not completely exempt ad valorem property tax liens from subordination under section 724(b). Rather, Alternative (3) would permit chapter 7 administrative expense claims entitled to priority under section 507(a)(1) and all wage claims entitled to priority under section 507(a)(3) and (a)(4) to prime all tax liens. Alternative (3) would also impose the marshaling requirement whichwould include a directive to resort to section 506(c) in appropriate circumstances.

Alternative (3) would essentially reflect a policy choice that the payment of priority wage claims and the costs of administering the chapter 7 estate should trump all tax liens, including those which secure the payment of an ad valorem tax.

Summary of Positions

Section 724(b) has been discussed during the plenary and Working Group sessions of a number of Commission meetings. The Commission has heard testimony and received a number of submissions with respect to the Working Group’s proposals. The views of particular commentators and constituencies can be summarized as follows:

*Tax Advisory Committee of NBRC -- The Chair of the Tax Advisory Committee to the National Bankruptcy Review Commission recently reported that while the Committee believed that a proposal aimed addressing issues arising under section 724(b) is "very important," the resolution of the issues is "highly controversial." The Committee voted in favor of a complete repeal of the statute by a vote of five to four. The Committee has also noted that section 724(b) represents fertile ground for challenge by states under the Eleventh Amendment to the Constitution in the wake of the Supreme Court’s decision in Seminole Tribe.

*National Association of Attorneys General -- NAAG supports a repeal of section 724(b). If not repealed or otherwise restricted, NAAG contends that the statute should, at a minimum, be amended to require administrative and other priority claims to be satisfied from unencumbered funds prior to permitting the resort to subordination.

*American College of Bankruptcy -- The ACB submitted a questionnaire and received responses from approximately one-third of the Fellows, which the ACB believes to be a representative group of its membership. Forty-three respondents (70%) were against a complete repeal of section 724(b), while eighteen (30%) respondents were in favor of its repeal.

*Commercial Law League of America -- The CLLA does not support a complete repeal of section 724(b). However, in position papers presented to the Commission in connection with the Commission’s meetings in February and May, the CLLA appears to support restricting the reach of section 724(b), especially with respect to ad valorem taxes. The CLLA appears to favor a proposal that would allow the subordination of tax liens to only administrative and wage claims as long as pre-conversion administrative and wage claims of the superseded chapter 11 case would be protected as well. The CLLA would also favor amending section 506(c) to lessen the impact of section 724(b).

*National Bankruptcy Conference -- The NBC does not support a repeal of section 724(b). The NBC has taken the position that a repeal of the statute would unfairly advance the priority of government tax claims through liberal tax lien laws and would encourage the proliferation of such laws.

*Department of Justice -- In a Report of the Bankruptcy Working Group, the DOJ hasadvocated a complete repeal of the statute and contends that, especially with respect to liens on real estate, no justification exists for discriminating against tax liens. The DOJ has further opined that secured creditors should not be allowed to gain a windfall by having administrative costs incurred in connection with the preservation and sale of collateral shifted to the taxing authority by virtue of section 724(b).

*National Association of County Treasurers & Finance Officers -- The NACTFO supports a complete repeal of section 724(b).

*ABA Tax Section Task Force -- In a report of the ABA Tax Section Task Force on Tax Recommendations of the NBRC, the Task Force recommends an amendment, such as to section 506(c), which would prevent the subordination of ad valorem real property tax liens to the claims of secured creditors. The Task Force is of the view that such consensual lienholders expect to have their liens primed by ad valorem property tax claims and the Code should not afford them with a windfall at the expense of local governments.

Association of the Bar of the City of New York -- The Association does not support a complete repeal of section 724(b).

*General Submissions as Reflected in Database -- The Commission has received a substantial number of written, individual submissions commenting on the Working Group’s proposals with respect to section 724(b). An overwhelming majority of those commentators support either a complete repeal of the statute or a substantial curtailment of its reach. It is, however, significant to note that virtually all of those who have submitted written submissions in favor of the Working Group’s proposals represent the interests of governmental units. Those in support of an amendment to section 724(b) are predominantly concerned with the statute’s impact on ad valorem tax liens.