First Impressions: Second Circuit Rules That Lien Is Extinguished Under Chapter 11 Plan Only if Secured Creditor Participates in Case

First Impressions: Second Circuit Rules That Lien Is Extinguished Under Chapter 11 Plan Only if Secured Creditor Participates in Case

A hornbook principle of U.S. bankruptcy jurisprudence is that valid liens pass through bankruptcy unaffected. This long-standing principle, however, is at odds with section 1141(c) of the Bankruptcy Code, which provides that, under certain circumstances, "the property dealt with by [a chapter 11] plan is free and clear of all claims and interests of creditors," except as otherwise provided in the plan or the order confirming the plan. Several courts have attempted to reconcile the pass-through principle with the statute by requiring the creditor to "participate in the reorganization" as a prerequisite to the application of section 1141(c).

This judicial gloss clouds the question of whether the terms of a chapter 11 plan providing for the treatment of secured creditor claims are binding on nonparticipating secured creditors. The Second Circuit Court of Appeals recently weighed in on this issue as a matter of first impression. In City of Concord, N.H. v. Northern New England Telephone Operations LLC (In re Northern New England Telephone Operations LLC), 2015 BL 248853 (2d Cir. Aug. 4, 2015), the court ruled that a lien is extinguished by a chapter 11 plan if: (i) the text of the plan does not preserve the lien; (ii) the plan is confirmed; (iii) the property encumbered by the lien is "dealt with" by the plan; and (iv) the secured creditor participated in the bankruptcy case.

Section 1141(c)

Section 1141(c) states:

Except as provided in subsections (d)(2) [debts of individual debtors excepted from discharge under section 523] and (d)(3) [denial of discharge for, among others, liquidating corporations] of this section and except as otherwise provided in the plan or in the order confirming the plan, after confirmation of a plan, the property dealt with by the plan is free and clear of all claims and interests of creditors, equity security holders, and of general partners in the debtor.

With respect to liens and security interests, section 1141(c) means that "unless the plan of reorganization, or the order confirming the plan, says that a lien is preserved, it is extinguished by the confirmation." In re Penrod, 50 F.3d 459, 463 (7th Cir. 1995); accord JCB, Inc. v. Union Planters Bank, NA, 539 F.3d 862 (8th Cir. 2008); but see Bowen v. United States (In re Bowen), 174 B.R. 840 (S.D. Ga. 1994) (holding that a "lien" is not an "interest" within the meaning of section 1141(c); any release of a lien must rely on section 506(d)). A concern regarding the impact of lien stripping has led a number of (principally appellate) courts to add a judicial gloss to section 1141(c) requiring the secured creditor to have "participated in the reorganization" before its lien will be deemed extinguished.

In Penrod—apparently, the first decision to add the participation gloss to section 1141(c)—the debtor's chapter 11 plan made provision for payment of a secured claim, but neither the plan nor the order confirming it stated whether the lien would be extinguished. The Seventh Circuit, acknowledging the "old saw" that liens pass through bankruptcy unaffected, nevertheless concluded that "when lienholders participate in a bankruptcy proceeding, and especially in a reorganization, they know that their liens are likely to be affected, and indeed altered." It ruled that liens are "interests" covered by section 1141(c) and that "unless the plan of reorganization, or the order confirming the plan, says that a lien is preserved, it is extinguished by the confirmation . . . provided, we emphasize, that the holder of the lien participated in the reorganization."

In Elixir Indus., Inc. v. City Bank & Trust Co. (In re Ahern Enters., Inc.), 507 F.3d 817 (5th Cir. 2007), the Fifth Circuit held that four conditions must be met for a lien to be voided under section 1141(c): (i) the plan must be confirmed; (ii) the collateral must be dealt with by the plan; (iii) the lienholder must participate in the reorganization; and (iv) the lien must not be preserved under the plan. Other courts have similarly required secured creditor participation in the case as a condition to lien extinguishment under section 1141(c). See, e.g., Airadigm Communications, Inc. v. FCC (In re Airadigm Communications, Inc.), 519 F.3d 640 (7th Cir. 2008); FDIC v. Union Entities (In re Be-Mac Transport Co.), 83 F.3d 1020 (8th Cir. 1996); Penrod, 50 F.3d at 463; In re Omega Optical, Inc., 476 B.R. 157 (Bankr. E.D. Pa. 2012).

Although the four-part Ahern test has been adopted in one form or another by many other courts, relatively few have examined what constitutes "participation" for purposes of the test. See, e.g., Ahern, 507 F.3d at 823 (filing a proof of claim as an unsecured priority creditor constitutes participation); In re Regional Bldg. Systems, Inc., 254 F.3d 528 (4th Cir. 2001) (participation is found where the creditor sat on the unsecured creditors' committee and filed a proof of unsecured claim, yet failed to object to confirmation of the plan after the realization of settlement proceeds that would have rendered its claim partially secured); Greater Am. Land Res., Inc. v. Town of Brick, 2012 BL 122346 (D.N.J. May 17, 2012) (no participation where the creditor taxing authority did not file a proof of claim and the plan neither listed nor treated the tax claim); Omega Optical, 467 B.R. at 165 (to the extent participation is required by section 1141(c), filing a proof of claim, then entering a notice of appearance of counsel, constitutes participation); In re WorldCom, Inc., 382 B.R. 610 (Bankr. S.D.N.Y. 2008) (the secured creditor participated by filing a proof of claim).

The unsettled question regarding what constitutes participation was addressed again by the Fifth Circuit in Acceptance Loan Co., Inc. v. S. White Transp., Inc. (In re S. White Transp., Inc.), 725 F.3d 494 (5th Cir. 2013). The court ruled that the level of participation necessary to trigger extinguishment of a lien under section 1141(c) "requires more than mere passive receipt of effective notice" of the chapter 11 case. In that case, the secured creditor never filed a proof of claim or otherwise became involved in the bankruptcy case, although it did receive notice of the chapter 11 plan, which provided for no recovery with respect to the secured creditor's claim. The court framed the issue as whether the secured creditor's "passive receipt of notice constitutes participation within the meaning of the test" stated in Ahern. It ruled that passive receipt of notice does not constitute participation. "Participation," the Fifth Circuit explained, "connotes activity, and not mere nonfeasance," consistent with the definition contained in Black's Law Dictionary as well as the U.S. Supreme Court's ruling in Nat'l Fed'n of Indep. Bus. v. Sebelius, 132 S. Ct. 2566, 2587 (2012), where the court distinguished between "activity" and a "deci[sion] not to do something" or a "fail[ure] to do it."

New England Telephone

Northern New England Telephone Operations LLC ("NNET") and its parent company, FairPoint Communications, Inc. ("FairPoint"), filed for chapter 11 protection on October 26, 2009, in the Southern District of New York. NNET owned several properties in Concord, New Hampshire. The City of Concord ("Concord") billed NNET for property taxes on a quarterly basis. When NNET filed its bankruptcy petition, Concord had already issued tax bills for the first and second quarters ("Q1" and "Q2") of the 2009 tax year.

Concord filed proofs of claim in NNET's chapter 11 case for the Q1 and Q2 taxes. It billed NNET on November 20, 2009, for the third- and fourth-quarter ("Q3" and "Q4") taxes—prior to the April 26, 2010, bar date for the filing of claims against NNET by governmental units—but did not timely file proofs of claim for the Q3 and Q4 taxes.

The bankruptcy court confirmed a joint chapter 11 plan for NNET and FairPoint on January 13, 2011. The plan provided, among other things, that "[a]s of the Effective Date, all property of FairPoint [, NNET] and Reorganized FairPoint shall be free and clear of all Claims, Liens and interests, except as specifically provided in the Plan, the Confirmation Order, or the New Credit Agreement."

Nine months after confirmation of the plan, Concord asked the bankruptcy court to allow its claims for the Q3 and Q4 taxes, arguing that the tax claim was secured by a lien and was not discharged by the plan.

The bankruptcy court denied Concord's motion, citing the "free and clear" plan provision quoted above and holding that the lien securing the Q3 and Q4 taxes was extinguished. The district court affirmed the ruling.

The Second Circuit's Ruling

Noting that "[w]e have not previously considered the circumstances under which a plan extinguishes a lien," a three-judge panel of the Second Circuit affirmed.

The court explained that section 1141(c) provides a caveat to the long-standing "background" rule that "liens pass through bankruptcy unaffected" (citing Dewsnup v. Timm, 502 U.S. 410, 417 (1992), and Penrod, 50 F.3d at 461). The court also noted that the phrase "interests of creditors" in section 1141(c) includes liens and that, despite the absence of any express reference to lien extinguishment in section 1141(c), courts have uniformly held that confirmation of a chapter 11 plan can act to extinguish liens (citing In re Chrysler LLC, 576 F.3d 108, 126 (2d Cir.) (citing cases), vacated as moot sub nom. Ind. State Police Pension Tr. v. Chrysler LLC, 558 U.S. 1087 (2009)).

The Second Circuit reasoned that "whether a plan extinguishes a lien depends on the requirements embedded in § 1141(c)." The court concluded that a requirement of lienholder participation "is located squarely within" the provision. According to the Second Circuit, "The text of the Code allows a plan to extinguish a lien only if the underlying property is 'dealt with,' and that condition cannot be fairly satisfied in the absence of the interested parties, including the security holder."

According to the Second Circuit, this conclusion is reinforced by the interaction between section 1141(c), which permits certain liens to be extinguished, and section 506(d), which preserves certain liens. Section 506(d) provides in relevant part:

To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void unless . . . (2) such claim is not an allowed secured claim due only to the failure of any entity to file a proof of such claim under section 501 of this title.

Thus, the Second Circuit observed:

Section 506(d)(2) . . . preserves liens of non-participating lienholders whose liens would otherwise be extinguished solely as a result of their non-participation. If extinguishment under § 1141(c) is consistent with this provision (as we must and do assume), then § 1141(c) must apply only to liens located outside of § 506(d)(2)'s safe harbor. Reading the "dealt with" limitation in § 1141(c) to include only participating lienholders harmonizes these provisions (citing 8 Collier on Bankruptcy ¶ 1141.04[1] (16th ed. 2013)).

Accordingly, the Second Circuit ruled that a lien is extinguished by a plan pursuant to section 1141(c) only if: (i) the text of the plan does not preserve the lien; (ii) the plan is confirmed; (iii) the property subject to the plan is "dealt with" under the terms of the plan; and (iv) the lienholder has participated in the bankruptcy case.

The court found that these requirements were satisfied. The Second Circuit concluded, among other things, that: (a) the plan clearly provided that all property of NNET and FairPoint was "free and clear" of liens, unless the plan specified otherwise, which, in this case, it did not; and (b) Concord participated in the bankruptcy case by filing proofs of claim for the Q1 and Q2 taxes due on the same six properties for which it sought payment of Q3 and Q4 taxes. According to the court, "[A]n inference of sufficient participation follows the fact that a single lien secured payment of tax bills as to which [Concord] participated and tax bills as to which [Concord] stayed silent."

The court deflected Concord's argument that, even if section 1141(c) applied, extinguishment of its lien "is so inequitable a result that the lien should survive nonetheless." Acknowledging that it had not previously decided whether equitable principles may rescue a lien which would otherwise be extinguished by a plan, the Second Circuit wrote that "[w]e need not decide that question on appeal, because the equities in this case would not support an exception."

Finally, the Second Circuit rejected Concord's argument that the bankruptcy court should have allowed Concord to file its proofs of claim for the Q3 and Q4 taxes more than two years after confirmation of the plan under the doctrine of "excusable neglect."

Outlook and Related Developments

The Second Circuit's approach to section 1141(c) is more nuanced than those taken by most of the other courts that have adopted the participation requirement as a condition to lien extinguishment. According to the Second Circuit, encumbered property is "dealt with" under a plan only if the secured creditor participates in the case. It reached this conclusion on the basis of its view that section 1141(c) must be harmonized with section 506(d)(2), which does not require a secured creditor to file a proof of claim to preserve its lien. Because it construes the language of section 1141(c) in this way, rather than simply requiring participation as a judicial gloss that is arguably found nowhere in the express language of the provision, New England Telephone may be less objectionable to statutory constructionists.

Regardless of the rationale supporting it, the participation requirement means that a secured creditor cannot be stripped of its lien under section 1141(c), even if it receives notice of the chapter 11 plan and deliberately ignores it, unless the creditor actively participates in the case by, among other things, filing a proof of claim. Thus, absent active participation by the secured creditor, a plan proponent may not be permitted to modify or avoid the creditor's lien solely through the plan confirmation process, but instead may be required to affirmatively object to the secured claim or initiate an adversary proceeding to challenge the lien. Given this, some have criticized the participation requirement because it means that a secured creditor can opt to wait in the wings during the bankruptcy case and then proceed to exercise its remedies in a more favorable forum after confirmation of a plan, without regard for the plan's terms.

Like the Second Circuit, the Seventh Circuit in In re Pajian, 785 F.3d 1161 (7th Cir. 2015), which involved a chapter 13 case, acknowledged that a secured creditor's lien is not extinguished merely because it failed to file a proof of claim. In Pajian, a secured mortgage lender filed a proof of claim more than three months after the expiration of the deadline established in Rule 3002(c) of the Federal Rules of Bankruptcy Procedure (the "Bankruptcy Rules") for filing proofs of claim in an individual debtor's chapter 13 case—generally, 90 days after the date first set for the section 341 meeting of creditors. The lender's claims consisted of a claim secured by a mortgage on a commercial property and an unsecured claim for a deficiency judgment resulting from a state foreclosure proceeding on a residential property.

The debtor objected to the claims, arguing that they were barred from inclusion in his chapter 13 plan because the lender had missed the deadline imposed by Bankruptcy Rule 3002(c). The lender countered that: (i) a secured creditor need not file a proof of claim in order to secure distributions under a chapter 13 plan; (ii) a pleading the lender previously filed in the case prior to the deadline amounted to an "informal" proof of claim; and (iii) Bankruptcy Rule 3002(c)'s deadline is inapplicable to secured claims.

The bankruptcy court rejected the first two arguments. However, persuaded by the third argument, it ruled that a secured creditor seeking distributions under a chapter 13 plan need only file a proof of claim prior to confirmation of the plan. The court accordingly sustained the debtor's objection with respect to the unsecured claim, but overruled the objection as to the secured claim. The debtor appealed the ruling directly to the Seventh Circuit.

Initially, the Seventh Circuit noted that "[t]he appeal raises a legal question that requires this court to break new ground and resolve conflicting decisions among bankruptcy courts." The court then explained that, pursuant to Bankruptcy Rule 3021 and section 502(a) of the Bankruptcy Code, a creditor must file a proof of claim in order to participate in distributions under a plan (under any chapter). However, the Seventh Circuit emphasized, "while all creditors—secured and unsecured—must file a proof of claim in order to receive distributions, a secured creditor who fails to do so can still enforce its lien through a foreclosure action, even after the debtor receives a discharge" (citing Penrod, 50 F.3d at 461–62). "In other words," the court wrote, "a secured creditor's lien is largely unaffected by the bankruptcy discharge, regardless of whether the creditor filed a proof of claim."

The Seventh Circuit noted that bankruptcy courts have reached conflicting conclusions regarding whether the language of Bankruptcy Rule 3002(c), which does not expressly refer to "secured creditors," applies to unsecured creditors only. The Seventh Circuit ruled that "[w]e think the better interpretation is that all creditors—unsecured and secured alike—are bound by the Rule 3002(c) deadline." According to the court, this conclusion is supported by principles of sound judicial administration:

Requiring all creditors to file claims by the same date allows the debtor to craft and finalize a Chapter 13 plan without the concern that other creditors might swoop in at the last minute and upend a carefully constructed repayment schedule. If we held otherwise, secured creditors could wreak havoc on the ability of the debtor and the bankruptcy court to assemble and approve an effective plan. Each tardy filing from a secured creditor would likely require the debtor to file a modified plan, which would have to be served on all interested parties and considered by the court. All this would often lead to disruptive delays in plan confirmation hearings and would ultimately hinder the bankruptcy court's ability to manage its docket.

Finally, the court noted that its conclusion is bolstered by a recent proposal of the U.S. Judicial Conference's Advisory Committee on Bankruptcy Rules to amend Bankruptcy Rule 3002 to clarify that secured creditors as well as unsecured creditors must file a proof of claim for their claims to be allowed.

However, the Seventh Circuit held, a secured creditor's failure to file a proof of claim "does not void the creditor's lien." Rather, a secured creditor whose claim is disallowed because it fails to file a proof of claim prior to the deadline stated in Bankruptcy Rule 3002(c) is simply not entitled to any distributions under a chapter 13 plan.

Interestingly, amending section 1141(c) to clarify whether secured creditor participation in a chapter 11 case is a condition to lien extinguishment under a plan was not among the more than 260 recommendations contained in the final report issued on December 8, 2014, by the American Bankruptcy Institute Commission to Study the Reform of Chapter 11. Thus, uncertainty is likely to continue regarding the effect of plan confirmation on liens.

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