1 October 2015
Many secured creditors wrongly believe that if they fail to participate in a bankruptcy proceeding, their lien will be extinguished on plan confirmation. In fact, the opposite may be true. There may clearly and somewhat surprisingly be a benefit to a secured creditor in not participating in a bankruptcy proceeding, at least in the context of a plan of reorganization.
The peculiar confluence of rules and exceptions that govern extinguishment of liens in bankruptcy has been the subject of a series of decisions in recent years by federal courts. A focus of these decisions has been determining what happens in the event the lienholder fails to participate in the bankruptcy proceeding. This issue was analyzed initially in this column several years ago in the context of a Mississippi federal district court ruling.1 Very recently, however, the Second Circuit weighed in as well as part of the broader analysis of a question of first impression, namely, under what circumstances does a plan of reorganization extinguish a lien.
Today we revisit, both generally and in light of the Second Circuit decision, how a confirmed reorganization plan can extinguish liens in bankruptcy, and further how a lienholder's failure to participate in a bankruptcy proceeding can affect that result.
The 'Penrod' Line of Cases
The general rule on extinguishment of liens in bankruptcy is that liens pass through unaffected.2 In theory, a secured creditor can enforce its lien outside of bankruptcy (subject to relief from the automatic stay) and foreclose in state court. However, as is the case with most general legal principles, there are exceptions to this rule. In this instance, the exception is set forth in §1141(c) of the Bankruptcy Code.
Section 1141(c) states that property "dealt with" by a plan of reorganization is "free and clear of all claims and interests of creditors, equity security holders, and of general partners in the debtor."3 The express language of §1141(c) identifies three criteria in determining whether a lien survives plan confirmation. A lien is extinguished if (1) a plan is confirmed, (2) the property subject to the lien is "dealt with" by the plan, and (3) neither the plan nor the order of confirmation preserves the lien. However, courts have added to this list a fourth requirement, described in one opinion as a "judicial gloss" on §1141(c).4 This requirement is that the lienholder must have "participated" in the bankruptcy proceeding. Although not explicit in §1141(c), some courts have viewed this condition as integral to the notion that the liened property is "dealt with" by the plan, while others have suggested it to be a freestanding requirement, but within the intent and spirit of §1141(c).5
Probably the leading case on this participation requirement is Penrod, a Seventh Circuit decision issued in 1995.6 The court in that case, while noting that "liens are property rights and the forfeiture of such rights is disfavored," warned nevertheless 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."7 It then held that a creditor who filed a proof of claim in a bankruptcy had, by virtue of such filing, sufficiently participated in the proceeding to allow extinguishment of its lien.8
What constitutes participation sufficient to satisfy the requirements of §1141(c) is a question of continuing debate. A benchmark espoused by the Fifth Circuit is that the participation must ensure "the creditor has notice of the plan and the potential effect on the creditor's lien."9 While at least one lower court ruled that mere notice and an opportunity to object should be sufficient to allow extinguishment,10 the judiciary has largely followed Penrod in concluding that at a minimum a proof of claim must be filed. However, courts have continued to grapple with even that requirement, sometimes distinguishing the ruling based on whether the proof of claim was properly filed or related to the lien to be extinguished.11
Although it has been approximately 20 years since Penrod was decided, it was only in August of this year that the Second Circuit tackled this issue in the case of City of Concord, N.H. v. Northern New England Telephone Operations (In re Northern New England Telephone Operations) (the NNET case).12 In doing so, it aligned itself firmly with its sister courts of the Fourth, Fifth, Seventh, Eighth and Tenth Circuits.
The NNET Case
The facts of the NNET case were as follows: Northern New England Telephone Operations (NNET) filed for bankruptcy in late 2009. It owned and paid quarterly real estate taxes on several properties in Concord, N.H. and, by the time of its bankruptcy filing, was in arrears for two quarters. The city of Concord filed proofs of claim for the two quarterly pre-petition invoices, but failed to do so for two post-petition ones. NNET thereafter adopted a plan of reorganization pursuant to which "all property" was to be free and clear of creditors' interests. While the city received payments on the pre-petition invoices, following confirmation of NNET's plan the city requested a court order requiring payment of the remaining two invoices. The court refused to grant such order, citing the language of the plan.13 The district court affirmed that ruling on appeal. The city then appealed to the Second Circuit.
The Second Circuit first noted that while §1141(c) does not specifically refer to the extinguishment of liens, courts have uniformly held that to be its effect. It then recited the three criteria it described as "embedded" in that section, as well as the fourth consideration "inferred" by courts: that the lienholder participate in the bankruptcy proceeding. The court rejected the notion that this last element was simply an enhancement of the mandate that the plan deal with the property. Rather, it fell "squarely within" 1141(c) as a "stand-alone requirement."14 The court emphasized that requiring participation furthered the equitable principles of bankruptcy law by assuring that the lienholder has the opportunity to decide whether to enforce its lien outside of bankruptcy court or seek to collect its debt within such proceeding. Thus, the court held that all four elements were in fact requirements of §1141(c).
The court then responded to Concord's contention that it had not participated in the bankruptcy proceeding with respect to the property subject to the lien sufficient to warrant elimination of such lien. As noted above, Concord had filed proof of claims for taxes due in respect of the first and second quarters of the 2009 tax year, but not for the third and fourth quarters of such year. Concord argued that since it had not filed proofs of claim for the unpaid post-petition tax bills, it had not participated sufficiently in the proceeding in respect of those tax bills or the lien securing their payment. The court, however, stated that all four quarterly tax bills were secured by a single, automatic statutory lien. It then ruled that an "inference of sufficient participation" followed from having a single lien on the same set of properties secure payment of tax bills for all four quarters. Accordingly, based on the requirements of §1141(c), the city had sufficiently participated in the bankruptcy, and it had so participated in respect of the property subject to the lien.
A few other observations about the court's analysis are important here. Penrod had suggested that it was the lien, and not the property, to be voided, that must be "dealt with" by the plan. The Second Circuit firmly disagreed. Rather, the court stated that "the property subject to the lien, rather than the lien itself, must be dealt with by the plan," alluding to the statutory language of §1141(c).15 Second, the court rejected the notion that references in the plan to the property at issue must be specific, finding instead that a general term such as "all property" was adequate to put creditors on notice and accordingly satisfy the statute.
In addition, the court pointedly left the door open to two additional avenues for challenging extinguishment of liens, both of which it felt were inapplicable in the case before it. As noted above, the court stated pointedly in its ruling that the city had sufficiently participated in respect of the property subject to the lien. It went on to indicate in a footnote that the city's participation was so closely related to the property and lien at issue that it need not decide whether some amount of participation may be too limited or unrelated to satisfy the "dealt with" requirement.16 By doing so, it clearly suggested there may be instances in which an insufficient nexus exists between the filed proof of claim, on the one hand, and the lien and property, on the other. It also left open the possibility that equitable principles may be invoked to preserve a claim that would otherwise be extinguished by a plan, noting that the equities in this case did not support such an exception.17
The NNET case is important for a number of reasons. The Second Circuit has finally provided needed guidance on when liens may be extinguished by a confirmed plan of reorganization. In so doing, it sided with the other circuit courts that have adjudicated this question. However, while the courts may be taking generally consistent positions, there nevertheless remain issues to be resolved. The most obvious among these is the level of participation beyond which a creditor will be deemed to have sufficiently participated in a bankruptcy proceeding to put its lien at risk. While courts are generally requiring filing of proofs of claim and not mere notice, they are liberally construing 1141(c) in making that determination, as evidenced by the ruling in the NNET case that "all property" is an adequate description of the property dealt with by the plan. But in addition to these legal issues, there remain unanswered strategic questions. The most important of these is how the NNET case and others like it will affect the decision by secured creditors as to whether and to what extent to participate in a bankruptcy proceeding, and whether courts will differentiate a creditor who intentionally fails to file a proof of claim from one who inadvertently fails to do so. The answers to those questions also remain to be seen.
1. See Alan M. Christenfeld & Barbara M. Goodstein, "To Participate or Not to Participate: A Secured Party's Question," 248 N.Y.L.J. No. 67 (Oct. 4, 2012).
2. See Dewsnup v. Timm, 502 U.S. 410, 417 (1992); Long v. Bullard, 117 U.S. 617 (1886).
3. 11 U.S.C. §1141(c). ("Interests of creditors" has been interpreted to include secured claims (see Penrod, infra note 6, at *463)).
4. Elixir Indus. v. City Bank & Tr. Co. (In re Ahern Enters.), 507 F.3d 817, 823 (5th Cir. 2007) (the Ahern case).
5. See The Ahern case, 507 F.3d at *822.
6. In re Penrod, 50 F.3d 459 (7th Cir. 1995) (the Penrod case). See also In re Pajian,785 F.3d 1161 (7th Cir. 2015).
7. Id at 461.
9. See The Ahern case, 507 F.3d at *823.
10. In re Reg' Bldg. Sys., 251 B.R. 274, 287 (Bankr. D. Md. 2000), aff'd 254 F.3d 528 (4th Cir. 2001).
11. See FDIC v. Union Entities (In re Be-Mac Transp. Co.), 83 F.3d 1020 (8th Cir. 1996); In re Reg' Bldg. Sys., 251 B.R. at *531.
12. 795 F.3d 343 (2d Cir. Aug. 4, 2015).
13. Id. at *344-45.
14. Id. at *348.
15. Id. at *347 n.1.
16. Id. at *351 n.5.
17. Id. at *351.
Reprinted with permission from the October 1, 2015 edition of New York Law Journal © 2015 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.