A secured junior lender who purchased property at a senior lender’s foreclosure sale paid $100,000 to the Internal Revenue Service to induce it to release a right of redemption in connection with its tax liens on the property. After a bankruptcy court held that the junior lender had priority over the IRS but would not address the settlement payment, the junior lender sued the IRS in the U.S. Court of Federal Claims. It sought return of its $100,000 settlement payment, arguing that the settlement was void for lack of consideration.
- The debtor, originally named Crystal Cascades, LLC, changed its name to Crystal Cascades Civil, LLC in May 2001 after it acquired a taxpayer identification number from the IRS.
- July 2004 a bank made loans to Crystal Cascades secured by deeds of trust on its property.
- August 2004 and January 2005 the IRS filed notices of tax liens using the correct taxpayer identification number, but using the outdated name of “Crystal Cascades, LLC.”
- February 2005 deeds of trust were recorded against the property to secure loans made to Crystal Cascades by the junior lender, Road and Highway Builders, LLC (RHB).
- After the bank initiated foreclosure proceedings in June 2005, Crystal Cascades filed a chapter 11 bankruptcy.
RHB filed an adversary proceeding in the bankruptcy against the IRS to establish that its liens had priority over the IRS tax liens. Contemporaneously RHB purchased the property at the bank’s foreclosure sale for $1.4 million. Shortly after the foreclosure sale, RHB and the IRS negotiated a settlement in which RHB paid $100,000 for a release of the IRS right of redemption.
More than a year later, the bankruptcy court found that the IRS notices did not provide constructive notice since they contained an incorrect name. Thus, RHB’s liens had priority. The bankruptcy court awarded surplus foreclosure sale proceeds to RHB, but declined to address the $100,000 settlement payment.
A year or so later RHB sued the IRS in the Court of Federal Claims. It sought recovery of its $100,000 payment, asserting that the settlement agreement was void for lack of consideration based on an argument that the right of redemption was illusory because it was later held to be invalid. After losing in the Court of Federal Claims, RHB appealed to the Federal Circuit Court.
Finding that the case turned on whether the IRS acted in bad faith, the Circuit Court cited the Restatement (Second) of Contracts for the proposition that:
Forbearance of a right can represent consideration to support an agreement, provided that the forbearing party believes in good faith that its claim or defense may be fairly determined to be valid.
The court combined this rule with a presumption that government officials act in good faith that can be overcome only by clear and convincing evidence. Further, RHB was required to show a “specific intent to injure the plaintiff” as part of this showing.
RBH argued that the IRS could not have believed in good faith that is had a valid right of redemption because:
- The IRS did not investigate whether the debtor was using any other names.
- It had already decided it would not exercise its right of redemption before negotiating with RHB.
- The IRS lost at trial and on appeal in the bankruptcy proceedings.
- An IRS expert witness testified in the bankruptcy proceedings that a person searching for liens on the property would not have found the tax liens.
Not surprisingly, this was not sufficient to provide clear and convincing evidence that the IRS acted in bad faith with an intent to injure RHB:
- Standard IRS practice is to limit verification efforts to confirming that the name on a lien matches the name in the agency’s collections system.
- It is also standard IRS practice “to ‘realize value’ from the release of a right of redemption in cases where actual redemption may not be feasible.” The court did not view this as an improper motive.
- The bankruptcy ruling was subsequent to the settlement. At the time of the negotiations, there was an open question about the standard for searching public records.
- While the IRS expert’s testimony that the “average reasonably diligent user” looking for liens would not have found the tax liens “could indicate that the IRS acted unreasonably,” the court did not view this as suggesting bad faith.
Consequently the court agreed that RHB did not rebut the presumption of good faith by clear and convincing evidence.
On the one hand, it is difficult to envision any evidence that would have satisfied the test set by the court, and it seems vaguely troubling that there is no redress even if the IRS was acting unreasonably. On the other hand, this was a settlement after all. RHB bought the ability to remove the cloud of the IRS claims and move forward immediately with its plans for the property even though those claims were not finally resolved for another three years.
Vicki R. Harding, Esq.