Bankruptcy

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Judge Follows Legal Priority While Acknowledging "Moral Priority" Of Losing Parties

By Steve Sather (index)

San Antonio Bankruptcy Judge Leif Clark is known as the master of the footnote. Thus, when faced with a relatively straightforward case requiring him to construe a confirmed chapter 11 plan, he held his nose and applied the law. In re Texas Pig Stands, Inc., No. 05-52336 (Bankr. W.D. Texas 1/10/08). However, he used his written opinion to let the disappointed parties know that they had "moral priority" and told them where to complain.

Texas Pig Stands is a case, like many, that didn't work out quite as well as it should have. The Debtor confirmed a liquidating plan. The Liquidation Trustee sold the Debtor's property. After the first lienholder and the property taxes were paid at closing, there was a balance of $62,655.35 left over. The parties acknowledged that some of these funds would have to go to pay the lienholder's attorney and a mechanic's lien creditor. The question was what to do with the remaining balance.

The Liquidation Trustee requested permission to pay the employees and vendors who had incurred post-confirmation claims. The State of Texas asserted that the balance should go to pay its tax claim, which had accrued pre-petition, pre-confirmation and post-confirmation. Interestingly enough, the State's claim had not been a secured claim prior to bankruptcy. However, the default language in the plan allowed the State to exercise "all right and remedies under applicable non-bankruptcy law." Of course, one of these remedies is to file a tax lien. When the Liquidation Trustee failed to pay the State under the terms of the confirmed plan, the State gave notice of default and then filed a post-confirmation tax lien. When it came time to distribute the sales proceeds, the State contended that its lien covered all taxes, whether incurred pre-petition, pre-confirmation or post-confirmation.

Judge Clark methodically worked through the issues, concluding that he had post-confirmation jurisdiction to hear the dispute, that the default language of the plan allowed the filing of the tax lien and that the tax lien secured all of the taxes. As a result, the Judge concluded that:

"(T)he Comptroller is entitled to distribution from the sales proceeds to the extent that the proceeds are available to satisfy the Comptroller's tax lien, subject to the payment of prior liens and claims. Unfortunately, the sale proceeds will not satisfy the Comptroller's tax lien in full. The employees, trade vendors aand all other general unsecured creditors therefore will remain unpaid."

Order Granting Authority for Liquidation Trustee to Distribute Sales Proceeds, p. 7.

However, the Court did not stop there. In a footnote, the Judge told the parties where to complain.

"This is, no doubt, an unfortunate result, but one which is mandated by the Texas Tax Code itself. The court can only refer these unpaid employees and trade vendors to Governor Rick Perry's office and to the office of the Texas Comptroller for a fuller explanation for why the state elected to deprive them of their honest, hard-earned compensation. The unpaid employees have a clear moral priority over the claims of the Comptroller for unpaid sales taxes. But for the employees' willingness to work at the restaurant and the trade vendor's willingness to extend credit to the Liquidation Trustee, there would not have been any money to pay the Comptroller. The state clearly is receiving an economic windfall, and further expects these employees to work for free to confer that windfall. Despite the employees' and vendors' moral priority, the Comptroller nonetheless holds legal priority under the Texas Tax Code and the confirmed plan. This court is bound by the latter."

Order, n. 5 (emphasis added).

With all respect to His Honor's good intentions, what else could the State have done? Under Texas law, monies collected for sales taxes are trust funds required to be held for the benefit of the State. The State apparently acquiesced in allowing the Debtor and later the Liquidation Trustee to continue to operate the business despite the fact that tax monies were being collected and not remitted to the State. When the Liquidation Trustee defaulted under the plan, over a year before the sale took place, the State could have closed the restaurant down, in which case the employees would have been unemployed and uncompensated much sooner. Instead, the State, like all the other parties in the case, waited to see whether a brighter future lay ahead. When that prospect did not fully materialize, the State insisted on its legal rights. Had the State passed on its right to get paid ahead of those with lower priorities, the elected officials who are the public face of the State would have opened themselves up to a firestorm of criticism from the public for giving away the State's money.

The Liquidation Trustee was faced with a terrible choice here. He was tasked with paying creditors under a plan and maximizing the value of the Debtor's assets. When the Debtor's business could not pay for current operations, the Trustee had a choice. He could either close the business and likely lose it to foreclosure, or he keep cross his fingers and hope that things got better. While closing the business and not incurring further post-confirmation debt was the correct legal answer (first, do no harm), all of the parties--the Liquidation Trustee, the employees, the vendors, the first lienholder, the State--apparently thought it was better to keep going. In a perfect world, the parties drafting the plan could have created a carve-out for payment of post-confirmation expenses. However, who goes into a plan anticipating that the Debtor won't be able to pay operating expenses? Also, who anticipates that the boilerplate default language contained within a plan will allow a seventh priority unsecured creditor to become a secured creditor?

While the result in this case is unfortunate for the employees who did not get paid, it is not all that unusual. To draw an analogy from George Orwell's Animal Farm, some creditors are more equal than others. Employees, vendors and customers will always rank below lienholders. When businesses fail, there are always winners and losers and those without liens are always the losers. If the Judge wanted to drop a bomb onto someone's lap, he could have directed the unpaid employees to contact their state legislators and demand to know why there is not a floating lien for unpaid wages, much like the floating lien for perishable agricultural commodities. While such a proposal would be politically infeasible, it would at least raise the issue of whether legal priorities should be more closely aligned with moral priorities.

Full post as published by A Texas Bankruptcy Lawyer's Blog on January 16, 2008 (boomark / email).