Chicago Mercantile Exchange v. United States of America, and Gnp Commodities, Inc.

840 F.2d 1352, 61 A.F.T.R.2d (RIA) 781, 1988 U.S. App. LEXIS 2534

• Court: Court of Appeals for the Seventh Circuit
• Decided: February 22, 1988
• Docket: 87-1316
• Status: Published

Opinions

CUDAHY, Circuit Judge.

Chicago Mercantile Exchange (“CME”) brought this interpleader action under 28 U.S.C. § 1335 (1982), naming as defendants the United States and GNP Commodities, Inc. (“GNP”). Bruce Yermack, a CME member, owed more than $274,000 in federal income taxes; he also owed GNP over $93,000 in CME exchange-related debt. CME holds $166,361.57 in proceeds from the involuntary sale of Yermack’s seat on the exchange. CME instituted this action to resolve conflicting claims to the proceeds. The district court found for GNP, in an opinion reported at 650 F.Supp. 141 (N.D.I11.1986). The government appeals. We affirm.

I.

The relevant facts are not in dispute. The Internal Revenue Service (the “IRS”), on October 9,1985, served a Notice of Levy on CME, levying on all property or money in CME’s possession belonging to Yermack. The IRS claimed a tax lien on Yermack’s property up to $274,672.29, under 26 U.S.C. § 6321 (1982).¹

In addition to his federal tax liability, Yermack incurred a substantial debt to GNP. GNP was the clearing member of the exchange responsible for Yermack’s trades. Among other responsibilities, “[i]n the event that an original party to a contract defaults on his obligation to answer margin calls or to make or take delivery, it is the duty of the clearing member to satisfy its customer’s obligations.” I P.M. Johnson, Commodities Regulation § 1.31 (1982) (emphasis . in original). Yermack owed GNP $93,670.57 in exchange-related debts.

GNP claims that CME rules grant it priority to the proceeds from the seat’s sale. Yermack’s property interest in the CME seat is determined by CME rules, approved by the Commodity Futures Trading Commission under the Commodity Exchange Act, 7 U.S.C. §§ 1-24 (1982 & Supp.1986). CME Rule 100 states:

Membership in the Exchange is a personal privilege subject to purchase, sale, and transfer only as authorized and on the conditions prescribed herein. A member shall have no rights in or to the membership or the proceeds of the sale of such membership except as specifically granted herein.

Brief for Appellant at 6a. The exchange rules contain an elaborate transfer mechanism by which CME sells the membership and distributes the proceeds. See CME Rules 103-110, Brief for Appellant at 6a-16a. To begin voluntary or involuntary transfer of membership, the exchange first locates a prospective buyer, who must forward a check payable to the exchange. CME Rule 105, Brief for Appellant at 7a. The exchange must approve the transfer. See CME Rules 107-108, Brief for Appellant at 13a. If the transfer is approved, the exchange distributes the proceeds under CME Rule 110, Brief for Appellant at 14a-15a.

Rule 110 sets up a priority scheme for internal exchange claims.² The seller is entitled only to the remainder, if any, of the proceeds after the internal claims are paid. Under CME rules, this remainder is the full extent of his property interest in the seat.

Thus, we are presented with a classic confrontation: two parties claim an interest in the same limited pot. GNP argues that Yermack had no interest in the proceeds to which the tax lien could attach until after Rule 110 claims were satisfied. The IRS, on the other hand, argues that since Yermack had some interest in the seat, the lien could attach to the entire proceeds and Rule 110 claimants are simply unperfected secured creditors whose claims are subordinate to the tax lien under 26 U.S.C. § 6323 (1982). According to this argument, in order to prevail over a tax lien, Rule 110 creditors would have to file financing statements to perfect their “security interests” under local law. Further, the IRS argues that even if CME Rule 110 gives GNP’s claim priority, that rule must give way to the paramount federal interest in collecting taxes. This argument is based on the premise that Rule 110 conflicts with the language or purposes of federal tax lien law.

The district court rejected the government’s arguments, finding that Yermack’s interest in the property was limited to the net proceeds after payment of Rule 110 claims and holding that the government’s lien attached only to that remainder.

II.

The government’s argument in this case has great surface appeal. It is axiomatic that section 6321 reaches “every interest in property that a taxpayer might have.” United States v. National Bank of Commerce, 472 U.S. 713, 720, 105 S.Ct. 2919, 2924, 86 L.Ed.2d 565 (1985). It is also clear from the statute’s face that a perfected tax lien has priority over a prior unperfected security interest. See 26 U.S. C. § 6323 (1982); see also infra p. 1357 n. 5. We do not dispute these statements of the applicable law; however, they do not in themselves compel judgment for the government.

The government’s position requires us to accept two propositions. First, we must find that the tax lien attached to the entire membership proceeds. Second, we must find that GNP’s interest was an unperfect-ed security interest in the seat. Careful analysis shows that neither proposition is true.

The initial question in this case is not whether an unperfected security interest prevails over a properly filed tax lien; rather the issue is whether Yermack, the taxpayer, had any interest in the proceeds. Section 6321 states that a tax lien attaches to “all property and rights to property, whether real or personal, belonging to [the taxpayer].” 26 U.S.C. § 6321 (1982); see also supra p. 1353 n. 1. The lien attaches only to property “belonging to” the taxpayer.

The nature and extent of the taxpayer’s property interest is a matter of state law. See National Bank of Commerce, 472 U.S. at 722, 105 S.Ct. at 2925; United States v. Rodgers, 461 U.S. 677, 683, 103 S.Ct. 2132, 2137, 76 L.Ed.2d 236 (1983); United States v. Bess, 357 U.S. 51, 55, 78 S.Ct. 1054, 1057, 2 L.Ed.2d 1135 (1958); see also Avco Delta Corp. Canada Ltd. v. United States, 459 F.2d 436, 440 (7th Cir.1972) (“a federal court must look to state law to determine the nature of the legal interest which the taxpayer had in the property sought to be reached”). As the Supreme Court explained in Bess, section 6321 creates no property rights but merely attaches consequences, federally defined, to rights created under state law.” Bess, 357 U.S. at 55, 78 S.Ct. at 1057; see also Rodgers, 461 U.S. at 683, 103 S.Ct. at 2137. In the case before us, we must look to the CME rules creating the property right to determine the attributes of that property.

The government urges us to hold that, because Yermack has an interest in some of the proceeds, a tax lien can attach to the entire amount. We reject that contention as inconsistent with the plain language of the statute and the Supreme Court’s statements on the subject. Indeed, the Court has stated that “if [the statute] allowed for the gratuitous confiscation of one person’s property interests in order to satisfy another person’s tax indebtedness, such a provision might pose significant difficulties under the Due Process Clause of the Fifth Amendment.” Rodgers, 461 U.S. at 697, 103 S.Ct. at 2144. The tax lien can attach to Yermack’s interest in the membership proceeds, but to nothing beyond that interest.

III.

A more plausible government argument is that Yermack had an interest in the entire proceeds, so the tax lien could attach to the whole. Unfortunately for the IRS, the Supreme Court has consistently held that the seller of an exchange seat has only an interest in property subject to the exchange rules, including exchange priority rules. See Board of Trade v. Johnson, 264 U.S. 1, 12, 44 S.Ct. 232, 234, 68 L.Ed. 533 (1924); Hyde v. Woods, 94 U.S. (4 Otto) 523, 525, 24 L.Ed. 264 (1877); see also In re Sorkin, No. 86 B 1905, slip op. at 10 (Bankr.N.D.Ill. Nov. 26, 1986) (facts identical to this case).

The Hyde case is especially apposite and essentially controls the case before us. In Hyde, a trustee in bankruptcy tried to override an exchange rule identical in effect to CME Rule 110.³ The Court upheld the rule, explaining that the debtor’s rights in the seat were defined by the exchange rules:

A seat in this Board is not a matter of absolute purchase. Though we have said it is property, it is encumbered with conditions when purchased, without which it could not be obtained_ The rule entered into and became an incident of the property when it was created, and remains a part of it into whose hands soever it may come. As the creators of this right — this property — took nothing from any man’s creditors when they created it, no wrong was done to any creditor by the imposition of this condition.

Hyde, 94 U.S. at 525. The rules of the exchange create the property and they govern its attributes. The Court reiterated this holding in the landmark Johnson case. See 264 U.S. at 12, 44 S.Ct. at 235 (“By operation of the bankruptcy law, the membership passes, subject to rules of the Exchange, to the trustee.”) (emphasis added).

Both Hyde and Johnson arose in the bankruptcy context. Their property analysis is, however, in no way limited to that context and must apply with equal force in a tax lien context.⁴ Both Hyde and Johnson found that the holder of an exchange seat holds that seat subject to the exchange rules, which define and limit his property interest. If he has no property right beyond that granted by the exchange rules, then he has no further property right to which a tax lien can attach. See In re Sorkin, slip op. at 10.

This conclusion is reinforced by analysis of the rules at issue here. Specifically, CME Rule 100 states: “A member shall have no rights in or to the membership or the proceeds of the sale of such membership except as specifically granted herein.” Brief for Appellant at 6a. This rule puts the world on notice. Before purchasing his seat, Yermack undoubtedly checked the exchange rules to determine what he was buying. Likewise, any lender taking the seat as security would check the rules to determine the value of that security. On so doing, he or she would find that the conjunction of Rules 100 and 110 limits Yermack’s property right to an interest in those proceeds remaining after satisfaction of Rule 110 claims. That is the only interest Yermack had in the seat; so it is the only interest on which the IRS could levy.

IV.

This conclusion finds further support in several Supreme Court tax lien decisions. In United States v. Bess, 357 U.S. 51, 78 S.Ct. 1054, the taxpayer was insured under a life insurance policy. A tax lien attached prior to his death and the IRS brought suit against the policy beneficiary for the entire proceeds. Id. at 52, 78 S.Ct. at 1056. The Court held that the taxpayer’s interest in the policy was defined by the policy terms as enforced by state law. Id. at 55, 78 S.Ct. at 1057. Since, under the policy, the insured could only force the insurer to pay him the policy’s “cash surrender value,” that was the only property interest to which the tax lien could attach. Id. at 56, 78 S.Ct. at 1058.

Bess is analogous to this case. Yermack could request CME to sell his seat. When the exchange did so, however, he would receive only the net proceeds after Rule 110 claims were paid. The exchange rules here are like the insurance policy in Bess. They create the property right and define its attributes. In Bess, to ignore those limits would have been to redefine the property so as to take it from its owner, the policy beneficiary, and give it to the IRS. That would raise great constitutional difficulties. See Rodgers, 461 U.S. at 697, 103 S.Ct. at 2144. Those difficulties are also inherent in the government’s position here.

Another analogous case is United States v. Durham Lumber Co., 363 U.S. 522, 80 S.Ct. 1282, 4 L.Ed.2d 1371 (1960). Under the North Carolina law at issue in Durham Lumber, any money owed by a building owner under a construction contract had to be used first to satisfy subcontractors’ claims of which the owner had notice, up to the amount owed the subcontractors by the general contractor. Id. at 525, 80 S.Ct. at 1283. The Court held that, based on this statute, a tax lien against the general contractor’s property did not extend to the full face amount of a building contract, but only to the net proceeds after subcontractor claims were paid. Id. As with Bess, the analogy to the present case is clear and powerful. The position of the subcontractors in Durham Lumber is identical to GNP’s position here. The tax lien attaches only to those proceeds remaining after satisfaction of GNP’s Rule 110 claim.

This conclusion also answers the government’s preemption argument. The IRS contends that Rule 110 must give way to the paramount federal interest in collecting taxes. This might be true if Rule 110 conflicted with the tax lien statute; however, as shown above, there is no conflict. Rule 110 is simply part of the property definition and the statute only reaches Yer-mack’s interest in the property. Cf. Hyde, 94 U.S. at 525.

Y.

Two other government contentions deserve brief comment. First, the IRS argues that GNP’s interest is nothing more than a run-of-the-mill unperfected security interest in the proceeds. If so, the tax lien takes priority because, under section 6323, a filed tax lien prevails over a security interest unless that interest is choate and perfected. 26 U.S.C. § 6323 (1982).⁵

The government's argument here misses the mark once again. As recognized in Hyde, 94 U.S. at 525-26, the Rule 110 creditor is not a secured creditor. The Supreme Court distinguished exchange priority rules on the ground that those rules are attributes of the property at its creation. Id. This is not a case “where a man has done this with property which was his own, property on which he himself imposed the direction or the incumbrance, which impeded creditors.” Id. Instead, the rule was an incident of the seat when Yermack bought the membership; it preexisted his interest and will survive so long as the seat exists. It is an incident of the property, not a lien on that property.⁶

Turning to less formalistic concerns, the government’s final argument is that upholding the district court’s decision will create a giant loophole in the statute, allowing creditors to evade its grasp by disguising security interests as property attributes. There are several answers to this contention. First, our holding is very narrow. We only reiterate the Supreme Court’s holding that property rights in an exchange membership are determined by the exchange rules. In this case, that translates to a holding that the tax lien attaches only to those proceeds remaining after all Rule 110 claims are settled.

Second, this has been the law in the bankruptcy context for over one hundred years, at least since the Hyde decision. Bess and Durham Lumber, analogous tax lien cases, did not result in a torrent of deceptive activity.⁷ If they had, Congress would have amended the statute to correct the problem. Indeed, apparently the IRS did not decide to challenge exchange priority rules in the tax lien context until recently. The only other case directly to decide the point before us is In re Sorkin, decided in 1986.

Third, and most important, the statute compels the result we reach today. If Congress wished the statute to reach property not “belonging to” the taxpayer, it could have worded the statute to achieve that result. Perhaps recognizing the dubious constitutionality of such a statute, Congress enacted a more limited proposal. The Supreme Court has construed the statute to respect state law property definitions, and we do likewise.

VI.

We once again emphasize the narrow scope of our holding. The Supreme Court, in Hyde and Johnson, held that exchange priority rules are incidents of the membership interest at its inception. In Bess, the Court held that the tax lien statute does not alter property interests; therefore, the lien in this case attached only to Yermack’s interest in the property, which consisted of the net proceeds after satisfaction of Rule 110 claims. We therefore affirm the district court’s judgment.

Affirmed.

1 . Section 6321 reads:

If any person liable to pay any tax neglects or refuses to pay the same after demand, the amount (including any interest, additional amount, addition to tax, or assessible penalty, together with any costs that may accrue in addition thereto) shall be a lien in favor of the United States upon all property and rights to property, whether real or personal, belonging to such person.

26 U.S.C. § 6321 (1982).

2 . In pertinent part, Rule 110 states:

The proceeds of the sale of a membership shall be applied to the following purposes and in the following order of priority:

b. Payment of any indebtedness to the clearing member who last qualified the selling member arising out of a pledge of such membership as collateral security on such indebtedness, or a deficit which the President determines to have arisen directly out of futures transactions on the Exchange;

c. Payments of amounts due to members and other clearing members on claims filed which the President determines to have arisen directly out of futures transactions on the Exchange;

e. No other claims against the proceeds of the sale of a membership shall be recognized and administered by the Exchange, but the creditors of the seller of a membership not falling in the foregoing categories may pursue other legal means of securing payment of their obligations.

Distribution of proceeds shall be made by the payment of claims in the categories listed in this rule to the extent the proceeds from the sale are sufficient to meet those obligations.

The surplus, if any, shall be paid to the person whose membership was sold or his legal representative upon the execution of a satisfactory release. The President’s determination and allowance of claims hereunder shall be final.

CME Rule 110, Brief for Appellant at 14a-16a.

3 . The exchange rule at issue in Hyde stated:

In sales of seats for accounts of delinquent members, the proceeds shall be applied to the benefit of the members of this Board exclusive of outside creditors, unless there shall be a balance after payment of the claims of members in full.

Hyde, 94 U.S. at 524.

4 . Indeed, at oral argument the government admitted it was unable to distinguish the property analysis in Hyde and Johnson from this case.

5 . The pertinent part of § 6323 reads:

(a) The lien imposed by section 6321 shall not be valid as against any purchaser, holder of a security interest, mechanic's lienor, or judgment lien creditor until notice thereof which meets the requirements of subsection (f) has been filed by the Secretary.

(b) Definitions. — For purposes of this section

(1) Security interest. — The term "security interest” means any interest in property acquired by contract for the purpose of securing payment or performance of an obligation or indemnifying against loss or liability. A security interest exists at any time (A) if, at such time, the property is in existence and the interest has become protected under local law against a subsequent judgment lien arising out of an unsecured obligation, and (B) to the extent that, at such time, the holder has parted with money or money’s worth.

26 U.S.C. § 6323 (1982).

The import of this section, in plain language, is that a prior perfected, choate security interest has priority over a tax lien.

6 . The government cites language from Johnson that purportedly shows that the Supreme Court considered the creditor member's interest a “lien". The Johnson Court does state that the creditor’s interest is "in some respects similar to the typical lien of the common law.” 264 U.S. at 11, 44 S.Ct. at 234. Still, the very next sentence states that the right "differs, however, from the common law lien.” Id. Later, the distinction is made clear: "The lien, if it can be called such, is inherent in the property at its creation, and it can be asserted at any time before actual transfer." Id. at 15, 44 S.Ct. at 236. Thus, Johnson supports Hyde and our decision in this case.

7 . Indeed, when asked at oral argument for an example of how the district court’s decision could be abused in other contexts, the government failed to come up with any plausible example. The one hypothetical proposed was that a condominium association could draft rules stating that no member could sell his or her unit without paying off debts to other members. This example actually lends credibility to our decision: such a rule would not have priority over a tax lien on the condominium unit, since the rule is not an attribute of the unit under state law. It is merely a consensual security interest created later, and would therefore not prevail over a filed tax lien. Cf. Rodgers, 461 U.S. at 683, 103 S.Ct. at 2137.