Secret Liens: Can They Really Have Super-Priority Status?

There are two possible characteristics of statutory liens that should concern bankruptcy practitioners and their clients. The first possibility is super-priority, such that the statutory liens must be satisfied before other secured creditors are entitled to receive property of the estate. The second possibility is the notice requirements (or lack thereof) for attaching the lien to the debtor's assets. Under certain state laws, the statutory lienholder does not have to give public notice of the lien in order to perfect, hence the notion of a “secret lien.” As a result, a senior lender may later discover that its interests are subordinate to the interests of the secret lien holder. This result could surprise the debtor, committee and the court. This article provides several examples of super-priority secret liens.

Wage Lien Statutes

Perhaps the most interesting example is a wage lien statute from Wisconsin. See 2003-2004 Wis. Legis. Serv. 63 (2003 A.B. 2) (West). While a former version of this particular statute has existed for some time, legislators recently debated whether to grant workers super-priority over the liens of commercial lenders. See Paul Gores, Senate Passes Bankruptcy Compromise, 10/1/03 Milwaukee J. & Sentinel 1D (2003). The old statute created a wage lien in favor of the department of workforce development or the employee, but the lien was subordinate to the liens of commercial lenders that originated before the wage lien. See Wis. Stat. ' 109.09(c) (2002). Nevertheless, the wage lien took effect when the department or the employee filed notice with the state court. The Wisconsin legislature recently amended Wis. Stat. ' 109.09 and thereby granted workers super-priority over commercial lenders. Gores, supra. The super-priority lien is limited to the first $3000 of unpaid wages that were earned in the preceding 6 months. See 2003-2004 Wis. Legis. Serv. 63. The wage lien is superior to commercial lenders' liens even if the commercial lender received no notice of the unpaid wages prior to extending its loan.

Similar statutes can be found in other states. For example, in Kentucky a statute exists that grants employees a lien when the “business is transferred, suspended or attached.” See Ky. Rev. Stat. '' 376.150, 376.180 (Banks-Baldwin 2003). Like the Wisconsin statute, there is no requirement of public notice to trigger the lien. Unlike the recent Wisconsin statute, the Kentucky statute does not explicitly provide for super-priority. See Id. Whether the statutory lien is superior to security interests created under Article 9 of the U.C.C. and mortgage interests is not clear. See Richard H. Nowka & Jeff S. Taylor, Kentucky Employees' Wage Liens: A Sneak Attach on Creditors, But Beware of the Bankruptcy Trustee, 84 Ky. L. J. 317, 324-334 (arguing that Article 9 is inapplicable to the wage lien because it is a non-possessory statutory lien). By the same token, the Indiana legislature has enacted a statute that confers a preferred status upon employees when the employer's business is suspended or transferred to an assignee, a receiver, or a trustee. See Ind. Code ' 22-2-10-1 (2003). The Indiana statute establishes employees as preferred creditors for up to $600 in unpaid wages that were earned in the 3 months prior to the triggering event. Id.

Condominium Fee Liens

Some states have enacted statutes that confer super-priority secret liens to condo associations for unpaid condo fees. See Grahame K. Wells, The Use of Super-Liens to Promote Cooperation Between Condominium Associations and Lenders, 13 Ann. Rev. Banking L. 477, 483-485 (1994) (citing statutes from Alaska, Colorado, Connecticut, Massachusetts, Nevada, Pennsylvania, Rhode Island, Washington, West Virginia, and the District of Columbia). In fact, the Uniform Condominium Act and the Uniform Common Interest Ownership Act have both adopted super-priority lien provisions. Id. For example, in Massachusetts, a condo association will receive a super-priority lien for unpaid condo fees after the condo association brings an action to enforce the lien. See Trustees of MacIntosh Condominium Ass'n v. F.D.I.C., 908 F. Supp. 58, 64 (D. Mass 1995) (citing Mass. Gen. Laws. ch. 183A, ' 6). This lien is limited, however, to unpaid fees “during the 6 months immediately preceding institution of an action to enforce the lien.” See Mass. Gen Laws, ch. 183A, ' 6(c) (2003).

Public Utility Lien

One must be wary of public utility liens, as well. For example, the City of Northfield, in Minnesota, imposes a statutory lien for unpaid sewer and water service charges. See In re Sheldahl, Inc., 298 B.R. 874, 875 (Bankr. D. Minn. 2003) (citing Northfield City Code '' 82-35 & 82-109). This lien does not have to be recorded and, therefore, constitutes a secret lien. Id. at 877. Furthermore, Minnesota law stipulates that this lien is treated like a lien for property taxes. Id. Accordingly, the lien is enforceable against a bona fide purchaser. Id.

Respecting State Law: Recent Federal Decisions Enforcing Secret Liens

As a baseline, the Code defers to state law with respect to property rights. To this end, property rights outside of bankruptcy are respected inside of bankruptcy. See Douglas G. Baird, Elements of Bankruptcy, 5, 79 (3rd ed. 2001) (citing Butner v. U.S., 440 U.S. 48, 55 (1979) and Chicago Bd. of Trade v. Johnson, 264 U.S. 1 (1924)). However, various provisions of the Code allow trustees and debtors-in-possession to alter property rights under certain circumstances. See, e.g., 11 U.S.C. '' 544, 545, 547, & 548. Furthermore, the Code grants certain claims priority over other claims. See, e.g., 11 U.S.C. ' 507.

Section 545 of the Code governs the bankruptcy treatment of statutory liens. That section provides the trustee or debtor-in-possession with the authority to avoid various statutory liens, including those that become effective upon insolvency or a bankruptcy filing, and liens that are not enforceable against a bona fide purchaser at the time of the bankruptcy filing. Because of section 545, some bankruptcy practitioners may ignore statutory liens not in existence prior to the bankruptcy filing. Recent decisions counsel otherwise. These decisions reaffirm the notion that bankruptcy courts should respect state property rights when they do not expressly conflict with the Code. See In re AR Accessories Group, Inc., 345 F.3d 454 (7th Cir. 2003); Sheldahl, 298 B.R. 874.

In AR Accessories, the Wisconsin Department of Workforce Development (the Department) filed a petition to obtain a wage lien in accordance with Wis. Stat. ' 109.09(2). 345 F.3d at 456-457 (as noted above, the Wisconsin statute was amended after this decision). A creditor and the trustee (plaintiffs) filed an adversarial proceeding against the Department, alleging that the Department's actions with respect to the wage lien violated the automatic stay. Id. The Department asserted that sections 362(b)(3) and 546(b)(1)(A) allow creditors to perfect liens in accordance with underlying state law. Id. Section 546 of the Code contains limitations on the trustee's and debtor-in-possession's avoiding powers. Section 546(b)(1)(A) permits a lien holder to perfect an interest in the debtor's property after the bankruptcy filing in accordance with applicable state law. To facilitate such perfection, the Code also contains an exception to the automatic stay with respect to the lienholder's attempts to perfect its statutory lien. See 11 U.S.C. ' 362(b)(3). The Code does not require that there be a time-limit with respect to postpetition perfection of the lien. Vanderbilt Mortgage and Fin. v. Griggs (In re Griggs), 965 F.2d 54, 57 (6th Cir. 1992); see also 5-546 Collier on Bankruptcy ' 546.03[c][ii] (15th ed. rev. 2003). Accordingly, unperfected statutory liens may survive avoidance proceedings provided the lien is properly perfected after the bankruptcy filing. See Id.

The plaintiffs responded with two attacks on the applicability of section 546(b)(1)(A). Id. at 457-458. First, the plaintiffs noted that the Wisconsin statute did not contain any language “providing for retroactive perfection of the lien interest.” Id. The Seventh Circuit held that state statutes do not have to contain express “relation back” language. Id.; see also Klein v. Civale & Trovato, Inc. (In re Lionel Corp.), 29 F.3d 88, 93 (2nd Cir. 1994) (holding that the section 546(b)(1)(A) exception applies where applicable law allows “perfection after another party has acquired interests in the property”). But see Matter of Peter J. Schmitt Co., Inc., 154 B.R. 47 (Bankr. D. Del. 1993) (holding that the exception did not apply where the state statute did not contain express “relation back” language). Second, the plaintiffs alleged that the Department had no prepetition lien interest as is required for the section 546(b)(1)(A) exception. Id. The Seventh Circuit found that the Department's lien interest arose “when the last services were performed for which wages are unpaid and owing;” therefore, the Department held a prepetition lien interest that could be perfected postpetition. Id. at 458-459.

In Sheldahl, a city filed a proof of claim for sewer and water services against a debtor's estate. Id. at 875. In addition, the city alleged that its claim was secured by a statutory lien. Id. The debtor objected to the city's claim under section 545 of the Code asserting that the city's lien was not effective against a bona fide purchaser who purchased the property at the commencement of the bankruptcy proceeding. Id. The bankruptcy court emphasized that the city's lien was not unenforceable simply because it was an unrecorded secret lien. Id. at 877. Instead, the court looked to the applicable state law to determine whether the lien was enforceable against a bona fide purchaser. Id. Minnesota law allows cities to collect unpaid charges for sewer and water services “in the manner provided for the enforcement and collection of real property taxes.” Id. (citing Minn. Stat. ' 444.075 subd. 2b) (emphasis omitted). Ultimately, the court held that the city's lien could not be avoided under section 545 because property tax claims are enforceable against a bona fide purchaser. Id. The secret lien prevailed.

Implications for Bankruptcy Practitioners

The decisions discussed above should alert bankruptcy practitioners to the hidden dangers of statutory liens. The courts have reaffirmed the principle that property rights outside of bankruptcy are the same as property rights inside of bankruptcy where those rights do not explicitly conflict with the Code (although such secret liens may violate the priority scheme established in section 507). Accordingly, bankruptcy practitioners must be alert to changes in the applicable state law.

This heightened awareness is not just for Chapter 7 practitioners. This issue should surface in Chapter 11 liquidation analyses under section 1129(a)(7) and evidence of feasibility under section 1129(a)(11).

In the restructuring world certain constants exist: The Bankruptcy Code (Code) has not dramatically changed since 1978, a Chapter 7 corporate debtor cannot receive a discharge, and exemptions are defined to the penny. But be wary ' there are unknown pitfalls out there. State governments, to appear responsive to local issues caused by distressed businesses, have increasingly enacted laws that spring “secret liens” or other penalties on debtors. Although bankruptcy practitioners may instinctively deride such laws as subordinate to the federal Code, recent federal opinions disagree.

Super-Priority Secret Liens: The Secrets Revealed

Commentators on Article 9 of the Uniform Commercial Code (Article 9) recognized the problems associated with statutory liens. See, e.g., Meredith S. Jackson & Jennifer L. Kercher, Report of the ABA Business Law Section Uniform Commercial Code Committee, Subcommittee on Relation to Other Law, Re: Inclusion of Nonpossessory Statutory Liens in Article 9, 51 Consumer Fin. L.Q. Rep. 108 (Spring 1997). Statutory liens often benefit individuals who have little or no education regarding commercial transactions. These liens exist in many forms, including health care liens, tax liens, mechanics' liens, warehousemens' liens, wage liens, landlords' liens, and artisans' liens. Consequently, these liens are governed by little-publicized, non-uniform state laws. See Id. While the Article 9 drafters ultimately elected to apply Revised Article 9 to certain types of agricultural liens, the commission explicitly excluded other statutory liens from Article 9. See U.C.C. ' 9-109 (2002).

There are two possible characteristics of statutory liens that should concern bankruptcy practitioners and their clients. The first possibility is super-priority, such that the statutory liens must be satisfied before other secured creditors are entitled to receive property of the estate. The second possibility is the notice requirements (or lack thereof) for attaching the lien to the debtor's assets. Under certain state laws, the statutory lienholder does not have to give public notice of the lien in order to perfect, hence the notion of a “secret lien.” As a result, a senior lender may later discover that its interests are subordinate to the interests of the secret lien holder. This result could surprise the debtor, committee and the court. This article provides several examples of super-priority secret liens.

Wage Lien Statutes

Perhaps the most interesting example is a wage lien statute from Wisconsin. See 2003-2004 Wis. Legis. Serv. 63 (2003 A.B. 2) (West). While a former version of this particular statute has existed for some time, legislators recently debated whether to grant workers super-priority over the liens of commercial lenders. See Paul Gores, Senate Passes Bankruptcy Compromise, 10/1/03 Milwaukee J. & Sentinel 1D (2003). The old statute created a wage lien in favor of the department of workforce development or the employee, but the lien was subordinate to the liens of commercial lenders that originated before the wage lien. See Wis. Stat. ' 109.09(c) (2002). Nevertheless, the wage lien took effect when the department or the employee filed notice with the state court. The Wisconsin legislature recently amended Wis. Stat. ' 109.09 and thereby granted workers super-priority over commercial lenders. Gores, supra. The super-priority lien is limited to the first $3000 of unpaid wages that were earned in the preceding 6 months. See 2003-2004 Wis. Legis. Serv. 63. The wage lien is superior to commercial lenders' liens even if the commercial lender received no notice of the unpaid wages prior to extending its loan.

Similar statutes can be found in other states. For example, in Kentucky a statute exists that grants employees a lien when the “business is transferred, suspended or attached.” See Ky. Rev. Stat. '' 376.150, 376.180 (Banks-Baldwin 2003). Like the Wisconsin statute, there is no requirement of public notice to trigger the lien. Unlike the recent Wisconsin statute, the Kentucky statute does not explicitly provide for super-priority. See Id. Whether the statutory lien is superior to security interests created under Article 9 of the U.C.C. and mortgage interests is not clear. See Richard H. Nowka & Jeff S. Taylor, Kentucky Employees' Wage Liens: A Sneak Attach on Creditors, But Beware of the Bankruptcy Trustee, 84 Ky. L. J. 317, 324-334 (arguing that Article 9 is inapplicable to the wage lien because it is a non-possessory statutory lien). By the same token, the Indiana legislature has enacted a statute that confers a preferred status upon employees when the employer's business is suspended or transferred to an assignee, a receiver, or a trustee. See Ind. Code ' 22-2-10-1 (2003). The Indiana statute establishes employees as preferred creditors for up to $600 in unpaid wages that were earned in the 3 months prior to the triggering event. Id.

Condominium Fee Liens

Some states have enacted statutes that confer super-priority secret liens to condo associations for unpaid condo fees. See Grahame K. Wells, The Use of Super-Liens to Promote Cooperation Between Condominium Associations and Lenders, 13 Ann. Rev. Banking L. 477, 483-485 (1994) (citing statutes from Alaska, Colorado, Connecticut, Massachusetts, Nevada, Pennsylvania, Rhode Island, Washington, West Virginia, and the District of Columbia). In fact, the Uniform Condominium Act and the Uniform Common Interest Ownership Act have both adopted super-priority lien provisions. Id. For example, in Massachusetts, a condo association will receive a super-priority lien for unpaid condo fees after the condo association brings an action to enforce the lien. See Trustees of MacIntosh Condominium Ass'n v. F.D.I.C. , 908 F. Supp. 58, 64 (D. Mass 1995) (citing Mass. Gen. Laws. ch. 183A, ' 6). This lien is limited, however, to unpaid fees “during the 6 months immediately preceding institution of an action to enforce the lien.” See Mass. Gen Laws, ch. 183A, ' 6(c) (2003).

Public Utility Lien

One must be wary of public utility liens, as well. For example, the City of Northfield, in Minnesota, imposes a statutory lien for unpaid sewer and water service charges. See In re Sheldahl, Inc., 298 B.R. 874, 875 (Bankr. D. Minn. 2003) (citing Northfield City Code '' 82-35 & 82-109). This lien does not have to be recorded and, therefore, constitutes a secret lien. Id. at 877. Furthermore, Minnesota law stipulates that this lien is treated like a lien for property taxes. Id. Accordingly, the lien is enforceable against a bona fide purchaser. Id.

Respecting State Law: Recent Federal Decisions Enforcing Secret Liens

As a baseline, the Code defers to state law with respect to property rights. To this end, property rights outside of bankruptcy are respected inside of bankruptcy. See Douglas G. Baird, Elements of Bankruptcy, 5, 79 (3rd ed. 2001) (citing Butner v. U.S. , 440 U.S. 48, 55 (1979) and Chicago Bd. of Trade v. Johnson , 264 U.S. 1 (1924)). However, various provisions of the Code allow trustees and debtors-in-possession to alter property rights under certain circumstances. See, e.g., 11 U.S.C. '' 544, 545, 547, & 548. Furthermore, the Code grants certain claims priority over other claims. See, e.g., 11 U.S.C. ' 507.

Section 545 of the Code governs the bankruptcy treatment of statutory liens. That section provides the trustee or debtor-in-possession with the authority to avoid various statutory liens, including those that become effective upon insolvency or a bankruptcy filing, and liens that are not enforceable against a bona fide purchaser at the time of the bankruptcy filing. Because of section 545, some bankruptcy practitioners may ignore statutory liens not in existence prior to the bankruptcy filing. Recent decisions counsel otherwise. These decisions reaffirm the notion that bankruptcy courts should respect state property rights when they do not expressly conflict with the Code. See In re AR Accessories Group, Inc., 345 F.3d 454 (7th Cir. 2003); Sheldahl, 298 B.R. 874.

In AR Accessories, the Wisconsin Department of Workforce Development (the Department) filed a petition to obtain a wage lien in accordance with Wis. Stat. ' 109.09(2). 345 F.3d at 456-457 (as noted above, the Wisconsin statute was amended after this decision). A creditor and the trustee (plaintiffs) filed an adversarial proceeding against the Department, alleging that the Department's actions with respect to the wage lien violated the automatic stay. Id. The Department asserted that sections 362(b)(3) and 546(b)(1)(A) allow creditors to perfect liens in accordance with underlying state law. Id. Section 546 of the Code contains limitations on the trustee's and debtor-in-possession's avoiding powers. Section 546(b)(1)(A) permits a lien holder to perfect an interest in the debtor's property after the bankruptcy filing in accordance with applicable state law. To facilitate such perfection, the Code also contains an exception to the automatic stay with respect to the lienholder's attempts to perfect its statutory lien. See 11 U.S.C. ' 362(b)(3). The Code does not require that there be a time-limit with respect to postpetition perfection of the lien. Vanderbilt Mortgage and Fin. v. Griggs (In re Griggs), 965 F.2d 54, 57 (6th Cir. 1992); see also 5-546 Collier on Bankruptcy ' 546.03[c][ii] (15th ed. rev. 2003). Accordingly, unperfected statutory liens may survive avoidance proceedings provided the lien is properly perfected after the bankruptcy filing. See Id.

The plaintiffs responded with two attacks on the applicability of section 546(b)(1)(A). Id. at 457-458. First, the plaintiffs noted that the Wisconsin statute did not contain any language “providing for retroactive perfection of the lien interest.” Id. The Seventh Circuit held that state statutes do not have to contain express “relation back” language. Id.; see also Klein v. Civale & Trovato, Inc. (In re Lionel Corp.), 29 F.3d 88, 93 (2nd Cir. 1994) (holding that the section 546(b)(1)(A) exception applies where applicable law allows “perfection after another party has acquired interests in the property”). But see Matter of Peter J. Schmitt Co., Inc., 154 B.R. 47 (Bankr. D. Del. 1993) (holding that the exception did not apply where the state statute did not contain express “relation back” language). Second, the plaintiffs alleged that the Department had no prepetition lien interest as is required for the section 546(b)(1)(A) exception. Id. The Seventh Circuit found that the Department's lien interest arose “when the last services were performed for which wages are unpaid and owing;” therefore, the Department held a prepetition lien interest that could be perfected postpetition. Id. at 458-459.

In Sheldahl, a city filed a proof of claim for sewer and water services against a debtor's estate. Id. at 875. In addition, the city alleged that its claim was secured by a statutory lien. Id. The debtor objected to the city's claim under section 545 of the Code asserting that the city's lien was not effective against a bona fide purchaser who purchased the property at the commencement of the bankruptcy proceeding. Id. The bankruptcy court emphasized that the city's lien was not unenforceable simply because it was an unrecorded secret lien. Id. at 877. Instead, the court looked to the applicable state law to determine whether the lien was enforceable against a bona fide purchaser. Id. Minnesota law allows cities to collect unpaid charges for sewer and water services “in the manner provided for the enforcement and collection of real property taxes.” Id. (citing Minn. Stat. ' 444.075 subd. 2b) (emphasis omitted). Ultimately, the court held that the city's lien could not be avoided under section 545 because property tax claims are enforceable against a bona fide purchaser. Id. The secret lien prevailed.

Implications for Bankruptcy Practitioners

The decisions discussed above should alert bankruptcy practitioners to the hidden dangers of statutory liens. The courts have reaffirmed the principle that property rights outside of bankruptcy are the same as property rights inside of bankruptcy where those rights do not explicitly conflict with the Code (although such secret liens may violate the priority scheme established in section 507). Accordingly, bankruptcy practitioners must be alert to changes in the applicable state law.

This heightened awareness is not just for Chapter 7 practitioners. This issue should surface in Chapter 11 liquidation analyses under section 1129(a)(7) and evidence of feasibility under section 1129(a)(11).