Lien Priority Battle: Federal Appeals Court Says Bank's Later-Created, Unrecorded $1 Million Security Interest In Real Estate Trumps IRS' Earlier-Created, Recorded $60K Tax Lien

A case that was recently addressed by a federal appeals court provides an intriguing example of a situation where, in applying Maryland state law (ie. Maryland's doctrine of equitable conversion), an earlier-created, recorded lien on real estate was found to be inferior in priority to a later-created, unrecorded security interest. It is interesting to note that:

• the recorded lien found to be inferior was an IRS tax lien, and
• there was an absence of any bad faith on the IRS' part (bad faith being a typical factor disqualifying a party in a real estate transaction seeking the protection of the recording statutes),
• while the bank's security interest, unrecorded at the time the IRS recorded its tax lien, was ultimately recorded, the court stated that the bank's said security interest would have been protected anyway, regardless of its compliance with the recording statutes,
• the key in this case is that the bank's security interest, while not recorded until after the IRS recorded its lien, was created prior to the IRS' lien recordation (by six days).

The basic facts of the case, abstracted from the appeals court ruling, follow:

1. Restivo Auto Body failed to pay certain employment taxes relating to the calendar years 2002 and 2003, and the first and second quarters of 2004,
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2. The IRS issued notice and demand for payment of these deficiencies on or before September 20, 2004, giving rise to a tax lien on all property owned by Restivo Auto Body at that point (See 26 U.S. Code § 6322, stating that this type of lien "shall arise at the time the assessment is made and shall continue until the liability for the amount so assessed (or a judgment against the taxpayer arising out of such liability) is satisfied or becomes unenforceable by reason of lapse of time.").
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3. On January 10, 2005 [after dragging its feet in recording its tax lien for almost four (4) months], the IRS filed notice of its federal tax lien for the relevant quarters in the appropriate county land records.
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4. On January 4, 2005, six days before the IRS filed notice of its federal tax lien, Restivo Auto Body borrowed $1 million from Susquehanna Bank, giving the Bank a note and a deed of trust on two adjacent parcels of real property to secure repayment of the loan.
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5. The deed of trust, however, was not recorded until February 11, 2005, more than a month after the IRS filed notice of its tax lien.
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6. In April, 2011, Restivo Auto Body filed for Chapter 11 bankruptcy protection and, in connection therewith, the IRS filed a proof of claim, stating that Restivo Auto Body owed it $62,438.99 in taxes, interest, and penalties (the lien was originally for $147,392.84, according to the lower court ruling) for the relevant quarters.
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7. Susquehanna Bank thereupon commenced an adversary proceeding against the IRS, seeking a declaratory judgment as to the relative priorities of the parties' secured interests.

The bankruptcy court ruled in favor of Susquehanna Bank, saying its lien, despite being unrecorded at the time the IRS recorded its lien, had priority over the IRS lien. On initial appeal to the U.S. District Court affirmed the bankruptcy court ruling. The district court's affirmance was based on its appluication of the existing statute, and as an alternative basis for affirmance, it applied Maryland's doctrine of equitable conversion, stating that Susquehanna Bank's security interest would have taken priority under Maryland law even if the lien had never been recorded.

The appeals court, despite rejecting the reasoning of the district court based on the reading of the applicable statute, nevertheless affirmed the lower court's ruling, accepting its alternative basis for affirmance in applying Maryland's doctrine of equitable conversion.

In this regard, the court stated:

• Apart from its application of Md. Code Ann., Real Prop. § 3-201, the district court also concluded that Susquehanna Bank had a prior security interest under § 6323(h)(1)(A), based on the Maryland doctrine of equitable conversion. The court explained that under Maryland law, "the holder of an equitable title or interest in property, by virtue of an unrecorded contract of sale, has a claim superior to that of a creditor obtaining a judgment subsequent to the execution of the contract." Susquehanna Bank, 2013 WL 4067624, at *7 (quoting Stebbins-Anderson Co. v. Bolton, 117 A.2d 908, 910 (Md. 1955)) (internal quotation marks omitted). And it pointed out that the doctrine applies to lenders whose interests are secured by mortgages or deeds of trust. Construing § 6323(h)(1)(A), the court concluded that "an IRS tax lien is entitled only to the protection due under state law to `a subsequent judgment lien arising out of an unsecured obligation'" id. (quoting § 6323(h)(1)(A)), and that, under Maryland law, as made applicable by § 6323(h)(1)(A), judgment liens are "subject to prior, undisclosed equities," id. (quoting Wash. Mut. Bank v. Homan, 974 A.2d 376, 389 (Md. Ct. Spec. App. 2009)) (internal quotation marks omitted).
  
  We agree with the district court that § 6323(h)(1)(A) incorporates Maryland law insofar as it protects equitable security interests against subsequent judgment-creditor liens.
  
  The Maryland doctrine of equitable conversion "emanates from the maxim that `equity treats that as being done which should be done.'" Noor v. Centreville Bank, 996 A.2d 928, 932 (Md. Ct. Spec. App. 2010) (quoting Himmighoefer v. Medallion Indus., Inc., 487 A.2d 282, 286 (Md. 1985)).
  
  Pursuant to that doctrine, upon contracting to buy land, "in equity the vendee becomes the owner of the land, the vendor of the purchase money." Id. (quoting Himmighoefer, 487 A.2d at 286). Although the seller retains legal title during the executory period, he has "no beneficial interest in the property" apart from his "right to the balance of the purchase money." Watson v. Watson, 497 A.2d 794, 800 (Md. 1985). Rather, he holds his legal title "in trust for the purchaser." Wolf Org., Inc. v. Oles, 705 A.2d 40, 45 (Md. Ct. Spec. App. 1998).
  
  By contrast, a holder of equitable title "retains a significant interest in the enforcement of a land sales contract." Wash. Mut. Bank, 974 A.2d at 388. Consistent with these principles, Maryland courts have repeatedly held that a land purchaser's equitable title is superior to any judgment lien subsequently obtained against the seller. See, e.g., Watson, 497 A.2d at 800; Wolf Org., 705 A.2d at 46-47. As Maryland's Court of Appeals explained in Himmighoefer:
  
  
  It is a general rule that the holder of an equitable title or interest in property, by virtue of an unrecorded contract of sale, has a claim superior to that of a creditor obtaining judgment subsequent to the execution of the contract. . . . The right of the vendee to have the title conveyed upon full compliance with the contract of purchase is not impaired by the fact that the vendor, subsequently to the execution of the contract, incurred a debt upon which judgment was recovered. A judgment creditor stands in the place of his debtor, and he can only take the property of his debtor subject to the equitable charges to which it is liable in the hands of the debtor at the time of the rendition of the judgment. 
  
  487 A.2d at 287 (quoting Stebbins-Anderson Co., 117 A.2d at 910) (internal quotation marks and citations omitted). A judgment creditor's lien cannot attach to a seller's bare legal title in the property after the seller has conveyed equitable title, because the seller's legal title is a mere "technicality." Wolf Org., 705 A.2d at 46. Nor can the judgment creditor's lien attach to the seller's equitable interest in the property, because that interest has already become "vested in another." Id.
  
  Moreover, the Maryland doctrine of equitable conversion protects the security interest of a purchaser regardless of the purchaser's compliance with the recordation statutes. The recordation statutes protect only bona fide purchasers. See Lewis v. Rippons, 383 A.2d 676, 680 (Md. 1978) (holding that because a party was not a bona fide purchaser, "the recording statute avail[ed] him not"); see also Greenpoint Mortg. Funding, Inc. v. Schlossberg, 888 A.2d 297, 308 (Md. 2005); In re Careful Laundry, 104 A.2d 813, 818 (Md. 1954).
  
  And Maryland law is clear that "a judgment creditor is not in the position of a bona fide purchaser." Kolker v. Gorn, 67 A.2d 258, 261 (Md. 1949); see also, e.g., Himmighoefer, 487 A.2d at 287; Stebbins-Anderson Co., 117 A.2d at 910; Chi. Title Ins., 988 A.2d at 1050; Wash. Mut. Bank, 974 A.2d at 389; Chambers v. Cardinal, 935 A.2d 502, 511 (Md. Ct. Spec. App. 2007). Thus, a judgment creditor's claim "is subject to prior, undisclosed equities" and "must stand or fall by the real, and not the apparent rights of the defendant in the judgment." Kolker, 67 A.2d at 261 (quoting Ahern v. White, 39 Md. 409, 421 (1874)) (internal quotation marks omitted).
  
  This traditional scheme of real property law and equity does not render Md. Code Ann., Real Prop. § 3-201's recordation requirement a nullity, as the district court recognized. Bona fide purchasers remain incentivized to record their interests to achieve priority against other bona fide purchasers. See Md. Code Ann., Real Prop. § 3-203.
  
  While Susquehanna Bank did not sign a contract to purchase Restivo Auto Body's real property, it did receive a conditional deed to secure repayment of its loan. And Maryland principles in equity "treat lenders who secure their interests with a mortgage or deed of trust as entitled to the protections available to bona fide purchasers for value," so long as those lenders act in good faith. Wash. Mut. Bank, 974 A.2d at 396; see also Silver v. Benson, 177 A.2d 898, 902 (Md. 1962) ("It is well settled that in circumstances where a deed is set aside for fraud, a mortgagee not a party to the fraud is entitled to the protection afforded a bona fide purchaser by a court of equity, to the extent of his interest"). Consequently, a lender's equitable interest in secured property is superior to the interest of subsequent judgment lienholders. Taylor Elec. Co., Inc. v. First Mariner Bank, 992 A.2d 490, 502 (Md. Ct. Spec. App. 2010) ("The overwhelming weight of authority is that once a bona fide purchaser or lender for value acquires title by way of execution of a contract for sale or valid mortgage, the purchaser or mortgagee takes title free and clear of any subsequent lien" (emphasis added and omitted)).
  
  These principles are not unique to Maryland, which applies traditional equitable principles to traditional real property law. See Hellmann v. Circle C Props. I, Ltd., No. 04-03-00217-CV, 2003 WL 22897220, at *2-3 (Tex. Ct. App. Dec. 10, 2003) (holding that a lender who held a deed of trust had priority over a debtor's subsequent judgment creditor); Suffolk Cnty. Fed. Sav. & Loan Ass'n v. Geiger, 57 Misc. 2d 184, 186 (N.Y. Sup. Ct. 1968) (holding that a mortgagee had priority over a subsequent judgment lienholder).
  
  Applying these principles in this case, Susquehanna Bank took equitable title to Lots 17 and 39 when Restivo Auto Body executed a deed of trust and delivered it to the Bank on January 4, 2005. That equitable title gave Susquehanna Bank priority over all of Restivo Auto Body's subsequent judgment-creditor lienholders. And because federal tax law subordinates a federal tax lien to a deed of trust that has become protected "against a subsequent judgment lien arising out of an unsecured obligation," 26 U.S.C. § 6323(h)(1)(A), Susquehanna Bank's equitable security interest, which had become protected on January 4, 2005, had priority over the IRS's lien under § 6323(a).[*]

For the ruling, see In re Restivo Auto Body (Susquehanna Bank v. U.S.)  No. 13-2249 (4th Cir. October 31, 2014).

See also, In Re: Restivo Auto Body, Inc.: 4th Circuit Rules Executed But Unrecorded Security Interest Has Priority Over IRS Tax Lien.