Sovereign Immunity Doesn’t Insulate States from Lien Stripping

Bankruptcy Judge Gregory L. Taddonio of Pittsburgh likened the Pennsylvania state taxing authority to Achilles, the Greek hero who thought himself invincible. According to the judge, the agency believed it was “cloaked with immunity of such magnitude that its tax liens are invulnerable to modification by the bankruptcy court.”

“But just as Achilles fatefully discovered,” Judge Taddonio identified three independent reasons why states are not immune from having tax liens stripped down or stripped off in chapter 13.

The Strip Down and Strip Off Cases

In his March 29 opinion, Judge Taddonio ruled on two cases. In one, the tax lien was behind a mortgage for more than the real property was worth. In the other, there was enough value in the real estate to cover only a portion of the state’s subordinate tax lien.

The state had filed secured proofs of claim in both cases.

The chapter 13 debtors were asking Judge Taddonio to strip off the tax lien where the state’s interest was completely under water and to strip down the tax lien where the property’s value covered only a portion of the state’s interest in the estate’s property.

The state filed motions to dismiss for lack of subject matter jurisdiction and failure to state a claim under Rules 12(b)(1) and 12(b)(6). Both prongs of the motion were based on the notion that Eleventh Amendment sovereign immunity precluded that bankruptcy court from impairing the state’s tax liens.

The Bankruptcy Court’s Power in Chapter 13

Judge Taddonio ultimately found three reasons why the state had no sovereign immunity when a debtor seeks to strip down or strip off a tax lien. But first, he laid out the distinctions between a court’s power in chapter 13 versus chapter 7.

By virtue of the Supreme Court’s Dewsnup and Caulkett decisions, courts lack power to either strip down or strip off liens in chapter 7. See Dewsnup v. Timm, 502 U.S. 410 (1992); and Bank of America N.A. v. Caulkett, 135 S. Ct. 1995 (2015).

Although the high court arguably ignored the statutory language in both cases, the Supreme Court nonetheless ruled that Section 506(d) does not permit impairment of liens in chapter 7.

Judge Taddonio pointed out that the power of the court in chapter 13 is not derived from Section 506(d), but rather from Sections 506(a) and 1322(b).

Section 506(a)(1) bifurcates a lien into a secured claim equal to the creditor’s interest in the collateral and an unsecured claim for the deficiency. Then, Section 506(d) declares that a lien is void to the extent it does not represent a secured claim.

Significantly, Section 1322(b)(2), not available to chapter 7 debtors, allows chapter 13 plans to modify the rights of secured creditors, with exceptions. And of course, Section 1327(a) binds creditors to the terms of a plan, even if the creditor has not voted for the plan.

The Statutory Waiver of Immunity by Filing a Claim

Judge Taddonio began with the assumption that the Eleventh Amendment protected the state from lien stripping. He then analyzed whether the abrogation of sovereign immunity in Section 106(b) nonetheless exposed the state to lien stripping.

When a governmental unit has filed a proof of claim, Section 106(b) waives “sovereign immunity with respect to a claim against such governmental unit that is property of the estate and that arose out of the same transaction or occurrence out of which the claim of such governmental unit arose.”

Because the state had filed claims in both cases, the issue boiled down to whether the tax lien and the debtor’s stab at lien stripping arose from the “same transaction or occurrence.”

Judge Taddonio cited the Third Circuit for ruling that the existence of a “logical relationship” determines whether the claim and the debtor’s action arose from the same transaction or occurrence. Unlike in the Sixth Circuit, where the rule is more strict, he said that the logical relationship test must be construed liberally in the Third Circuit.

Judge Taddonio found the required relationship arising from the taxing authority’s proofs of claim, which invoked the jurisdiction of the bankruptcy court and initiated the claims allowance process. He said that the proofs of claim and the debtor’s adversary proceedings to impair the liens were devices by which both parties sought to declare their rights in the debtors’ properties.

Because the state’s claims could not be allowed without fixing the secured status of the claims, Judge Taddonio found waivers of immunity, since “assessing the creditor-debtor relationship” arose “out of the same aggregate core of facts.” Therefore, the filing of state’s claims waived sovereign immunity for lien stripping.

Waiver via Section 106(a)

Section 106(a) abrogates sovereign immunity “as to a governmental unit” with respect to 59 enumerated sections of the Bankruptcy Code, including Sections 502, 506 and 1327, but not Section 1322.

The state argued, among other things, that there was no waiver because the chapter 13 plans were impairing the liens under Section 1322, which is not listed in Section 106(a). The state also contended that the debtors were impairing liens under Section 506(d), which the Supreme Court had declared impermissible in Dewsnup and Caulkett.

The Third Circuit, Judge Taddonio said, has ruled that lien impairment in chapter 13 is accomplished by a combination of Sections 1322(b)(2) and 506(a), not via Section 506(d).

Section 1322, not listed in Section 106(a), only prescribes the contents of a plan. Given that Sections 522 and 1327 are included in Section 106(a), Judge Taddonio found a waiver of immunity because Section 1327 subsumes Section 1322. Otherwise, he said, “the inclusion of Section 1327 within the abrogation sections of Section 106(a) would be impotent.”

Was There Ever Any Sovereign Immunity?

Finally, Judge Taddonio ruled that the state never had sovereign immunity to begin with because the lien stripping proceeding was in rem.

The Constitution grants Congress the authority to enact uniform laws on the subject of bankruptcies. In turn, the Supreme Court has ruled that the states’ adoption of the Constitution represented a blanker waiver of immunity to the federal bankruptcy power. The Court has also ruled that discharge only affects a creditor’s rights in the res and does not affect the personal rights of the creditor.

In ruling that there was no sovereign immunity defense to a preference suit, the Supreme Court went on to say that actions “ancillary to” the exercise of in rem jurisdiction are covered by the blanket waiver emanating from the adoption of the Constitution.

Judge Taddonio concluded there was no sovereign immunity in the first place because “[l]ien stripping is nothing more than a determination of the rights in a debtor’s res,” as to which there is a constitutional waiver.