United States: Staying On The Sidelines – Fifth Circuit Ruling Protects Secured Creditors Who Opt Not To Participate In Bankruptcy Proceedings

Can a secured creditor decide not to participate in a bankruptcy proceeding and thereby avoid any impact the bankruptcy may have on its lien? According to a recent decision by the United States Court of Appeals for the Fifth Circuit in S. White Transp., Inc. v. Acceptance Loan Co., 2013 WL 3983343 (5th Cir. Aug. 5, 2013), the answer appears to be that at least in the Fifth Circuit, the secured creditor can avoid the impact a bankruptcy plan has on its lien by simply declining to participate in the bankruptcy proceeding.

As a general matter, courts have observed that liens pass through bankruptcy unaffected. This general rule is based upon the lien as a property right which at least theoretically cannot be altered in the bankruptcy without the secured creditor's participation, if not its consent. Indeed, the Supreme Court's opinion in Long v. Bullard, 117 U.S. 617 (1886), is routinely cited for this proposition and is referred to as the "Bullard Rule." The Supreme Court cited the Bullard Rule without much discussion in its 1992 opinion in Dewsnup v. Timm, 502 U.S. 410 (1992), in support of its ruling that a Chapter 7 debtor could not strip down a lien. The Bullard Rule is generally understood to mean that so long as the secured creditor opts not to enforce its rights to an unsecured deficiency claim against the debtor's estate, it may choose not to participate in any way in the bankruptcy case, and may then enforce its rights against the collateral after the bankruptcy case is over. While the secured creditor will lose its in personam claim against the debtor for any possible deficiency, which will be discharged, it will retain its in rem claim against the debtor's property.

Prior to the enactment of the Bankruptcy Code, the Bullard Rule was a judge-made rule. However, when the Bankruptcy Code was enacted in 1978, the Bullard Rule was codified in section 506(d) of the Bankruptcy Code, which provides that a secured creditor need not file a proof of claim to have an allowed claim against the debtor's estate. In some circuits, however, ignoring the bankruptcy proceeding may place a secured creditor's lien at risk, because of section 1141(c) of the Bankruptcy Code. Notwithstanding the conflict with section 506(d) of the Bankruptcy Code, section 1141(c) of the bankruptcy code, and its related provisions in Chapters 12 and 13, provide that upon confirmation of a plan, all liens on property "dealt with" in the plan are extinguished.

The federal courts of appeals are sharply split on the question of the procedures necessary in bankruptcy reorganizations to modify the rights of creditors with security interests in property of the estate. One line of cases suggests that liens on estate property are automatically extinguished upon confirmation of a plan of reorganization, unless the plan expressly preserves them. Another line of cases holds that lien rights cannot be modified through the confirmation process alone, even if the plan explicitly provides for such modification. According to these cases, a plan proponent seeking to modify a creditor's lien rights must first invoke the claims allowance process by objecting to the secured claim and possibly filing a separate adversary proceeding to challenge the creditor's lien before attempting to modify the lien through a plan. The S. White decision falls in this second category. Notwithstanding the circuit split, the Supreme Court's 2010 opinion in United Student Aid Funds, Inc. v. Espinosa, 130 S.Ct. 1367 (2010), appears to have resolved the split in favor of the cases suggesting that liens on estate property are automatically extinguished upon confirmation of a plan of reorganization, unless the plan expressly preserves them. The Espinosa opinion, which focused on whether the creditor's constitutional due process rights were afforded to it, holds that failure to comply with a procedural rule does not deprive a party of due process so long as the broader constitutional notice standard is satisfied. Although S. White distinguishes Espinosa in a footnote, it appears that its basis for distinguishing the opinion misinterprets the scope and holding of Espinosa, and in doing so, adds further confusion with respect to the case law that addresses the procedures necessary in bankruptcy reorganizations to modify the rights of creditors with security interests in property of the estate.

The S. White Opnion

In S. White, Acceptance Loan Co. (Acceptance) perfected a security interest in S. White Transportation, Inc.'s (SWT) principal asset, an office building in Mississippi in 2004. SWT contested the validity of this lien in the Mississippi state courts and while the litigation was ongoing, three other entities perfected security interests in the same office building. In May 2010, SWT filed a Chapter 11 petition and in its accompanying schedules acknowledged the three later security interests but listed Acceptance's lien as "disputed." Acceptance received notice of the bankruptcy proceeding but decided not to file a proof of claim or otherwise participate in the bankruptcy proceeding. In connection with the bankruptcy, SWT filed a plan of reorganization that contested the validity of Acceptance's lien and provided no recovery for Acceptance. The bankruptcy court entered a confirmation order approving the plan and Acceptance emerged from bankruptcy protection.

After confirmation of the plan, Acceptance requested that the bankruptcy court enter a declaratory judgment that its lien survived confirmation of the plan or, alternatively, that the bankruptcy court amend the confirmation order to provide for Acceptance's lien. The bankruptcy court denied the relief requested by Acceptance holding that confirmation of the debtor's plan voided any lien Acceptance held and otherwise refused to modify the confirmation order. The bankruptcy court based its decision on section 114(c) of the Bankruptcy Code, which as noted above, provides that property settled by a confirmed plan is held "free and clear of all claims and interests." Although there was Fifth Circuit precedent¹ that provided that section a "lien holder [who] participate[s] in the reorganization," the bankruptcy court held that Acceptance participated within the meaning of this standard by having received notice of the bankruptcy. On appeal, the United States District Court for the Southern District of Mississippi reversed, holding that mere notice does not constitute participation within the meaning of applicable Fifth Circuit precedent. 1141(c) of the Bankruptcy Code only voids liens held by a "lien holder [who] participate[s] in the reorganization," the bankruptcy court held that Acceptance participated within the meaning of this standard by having received notice of the bankruptcy. On appeal, the United States District Court for the Southern District of Mississippi reversed, holding that mere notice does not constitute participation within the meaning of applicable Fifth Circuit precedent.

At the beginning of its analysis, the Fifth Circuit cited two of its prior decisions which appear to generally follow the Bullard Rule - - In re Howard, 972 F.2d 639, 641 (5th Cir. 1992) ("A secured creditor is therefore not bound by a plan which purports to reduce its claim where no objection has been filed. . . . Strict adherence to the requirement that an objection be filed to challenge a secured claim is necessary. . . . [T]he secured creditor [has an interest] in being confident that its lien is secure unless a party . . . objects to it.") citing In re Simmons, 765 F.2d 547, 552, 556 (5th Cir. 1985) (holding that a plan may not substitute for an objection to a secured creditor's claim; once a creditor files a claim, "Code and . . . Rules clearly impose the burden of placing the claim in dispute on any party in interest desiring to do so by means of filing an objection").

After citing these two prior opinions, the Fifth Circuit next cited its prior decision in Ahern Enterprises, wherein the Fifth Circuit held that four conditions must be met for a lien to be voided under section 1141(c) of the Bankruptcy Code: (1) the plan must be confirmed; (2) the property that is subject to the lien must be settled by the plan; (3) the lien holder must participate in the reorganization; and (4) the plan must not preserve the lien. According to the court, the only dispute in the case surrounded the third condition, whether Acceptance's passive receipt of notice constitutes participation within the meaning of the Ahern test. Citing Black's Law Dictionary 1229 (9th ed. 2009) as well as relying on precedent from other circuit courts of appeal, the Fifth Circuit concluded that the word participation connotes activity, and not mere nonfeasance. Due to the fact that Acceptance had only received notice of the bankruptcy and had not otherwise participated in the case, the Fifth Circuit held that its lien would not be affected by the plan.

The S. White decision, as well as the decisions in Simmons and Howard, places the burden on the debtor to contest the claims of the secured creditor either by filing an objection to the claim or by commencing an adversary proceeding to determine the validity, priority or extent of due process rights afforded to the secured creditor, the "participation" requirement contained in the test set forth by Ahern Enterprises appears to be intended to address due process concerns. In 2010, the Supreme Court addressed what due process rights must be afforded to creditors in order for a confirmed plan to be binding on such creditors. the lien. Although these decisions do not focus on the due process rights afforded to the secured creditor, the "participation" requirement contained in the test set forth by Ahern Enterprises appears to be intended to address due process concerns. In 2010, the Supreme Court addressed what due process rights must be afforded to creditors in order for a confirmed plan to be binding on such creditors.

Espinosa

In Espinosa, the debtor, Espinosa, filed for Chapter 13 bankruptcy protection in 1992. In his plan, he proposed to pay only the principal amount of his student loan due to United Student Aid Funds (United) and thus discharge the accrued interest. United received a copy of the plan, and in response, filed a proof of claim for the principal and interest due on the loan. The bankruptcy court confirmed the plan without an adversary proceeding to determine undue hardship, in contravention of the Bankruptcy Code's confirmation requirements. After confirmation, the Chapter 13 trustee mailed a notice informing United that the amount claimed in its proof of claim differed from the amount listed for payment in the plan. That notice also informed United that if it wanted to dispute the treatment of its claim, it had the responsibility to notify the trustee within 30 days. United did nothing after receiving this notice. After Espinosa completed his plan, United attempted to collect the remaining debt. After Espinosa filed a motion in the bankruptcy court to enforce its discharge order by directing United to stop collection efforts, United filed a cross-motion under rule 60(b)(4) of the Federal Rules of Civil Procedure to set aside as void the order confirming the plan. This cross-motion was filed in 2003, 10 years after Espinosa's plan was confirmed. The question before the Supreme Court was whether the bankruptcy court's order confirming the debtor's plan was void for the purpose of Federal Rule of Civil Procedure 60(b) (4). Rule 60(b)(4) permits a court to relieve a party from a final order or judgment if that order or judgment is void. United argued that the order confirming the plan was void for two reasons. First, United claimed it was denied due process because it had not been served with a summons and complaint in an adversary proceeding to determine undue hardship. Second, United argued that the confirmation order was void because the bankruptcy court lacked statutory authority to confirm Espinosa's plan absent a finding of undue hardship.

In response to United's arguments, the Supreme Court held that rule 60(b)(4) does not contemplate voiding a judgment simply because it is erroneous in lieu of a timely appeal. The Supreme Court held that statutory and procedural requirements, such as the requirement that a bankruptcy court find undue hardship before discharging a student loan under Bankruptcy Code section 523(a) (8), and the requirement that the bankruptcy court make this finding in an adversary proceeding under Bankruptcy Rule 7001(6), are not jurisdictional defects that void a judgment under rule 60(b)(4).

While due process requires notice "reasonably calculated, under all the circumstances, to apprise interested parties of the pendency of the action and afford them an opportunity to present their objections," Espinosa holds that failure to comply with a procedural rule does not deprive a party of due process so long as the broader constitutional notice standard is satisfied. After receiving actual notice of the filing of the plan, its contents and the bankruptcy court's confirmation of the plan, Espinosa's lender lost its arguments regarding the validity of service or adequacy of procedures by failing to raise a timely objection or appeal. The Supreme Court concluded that actual notice of the plan "more than satisfied [the lender's] due process rights." The bankruptcy court's failure to make the undue hardship finding before confirming Espinosa's plan was a legal error but the order remained enforceable and binding because the creditor had notice of the error and failed to object or timely appeal.

Espinosa is particularly significant because it unequivocally holds that the failure to serve a summons and complaint required under the bankruptcy rules merely deprives a creditor of a right granted by a procedural rule but does not violate its constitutional right to due process, which would warrant voiding the judgment pursuant to rule 60(b)(4). Prior to Espinosa, a number of circuit courts had held that the failure to commence an adversary proceeding and serve notice through a summons and complaint deprived a creditor of adequate notice and constitutional due process. Espinosa abrogated this line of precedent by ruling that the lack of an adversary proceeding, and its related summons and notice, do not per se give rise to a violation of the creditor's constitutional right to due process. A creditor must object to its treatment under a plan and raise any procedural arguments after receiving adequate constitutional notice, even if such notice is procedurally deficient. Accordingly, in Espinosa, the Supreme Court has recognized that the parties need to be able to rely on the finality of a confirmation order and that it trumps any right to attack confirmation orders that may contain provisions or did not follow procedures that do not comport with the Bankruptcy Code.

The Simmons, Howard and S. White Opinion in Light of Espinosa

In light of Espinosa, the S. White opinion which was recently decided, as well as the Simmons and Howard opinions in which the Fifth Circuit appears to be primarily concerned with upholding the traditionally preferred position of secured creditors under the Bankruptcy Code, rather than with issues of constitutional due process, appears to be flawed. The Howard decision, which reiterated that strict adherence to the requirement that an objection be filed to challenge a secured claim, clearly runs afoul of Espinosa. In contrast to Simmons, however, which emphasized what it saw as a requirement to modify a lien that an adversary proceeding be commenced, the Howard court directed its attention to the lack of adequate notice given to the creditor, pointing out that the creditor had not received a copy of the proposed plan and did not have actual notice that its claim would be reduced and its lien extinguished. Under these circumstances, a due process analysis like the one employed in Espinosa would have produced the same result-- because the notice of potential lien avoidance was constitutionally insufficient, the creditor's liens would have remained in effect. Although the S. White opinion attempts to distinguish Espinosa, the reason for distinguishing the opinion appears to be dubious. In a footnote, the Fifth Circuit stated that Espinosa was a case addressing a rule 60(b) motion for relief from a final judgment. According to the Fifth Circuit, the S. White case does not implicate due process under rule 60(b), and Espinosa is therefore wholly inapposite.

When Acceptance petitioned the bankruptcy for a declaration that its lien survive the bankruptcy or, alternatively, to amend the confirmation order to provide for Acceptance's lien, Acceptance was essentially requesting rule 60(b) relief. Because Acceptance and SWT were not arguing that the confirmation order should be given preclusive effect in another case, but were seeking relief from the very court that confirmed SWT's plan, the Supreme Court's analytical framework in Espinosa in analyzing relief from the confirmation order under rule 60(b) should have been employed in the case. Further, although section 1141(c) does not contain any "participation" requirement for it to apply, when viewing the entire body of case law concerning when a secured creditor's rights can be modified in a bankruptcy proceeding, it becomes clear that the "participation" requirement contained in the test set forth by Ahern Enterprises is intended to address due process concerns. In concluding that the facts of S. White do not implicate due process concerns under rule 60(b), the Fifth Circuit fails to appreciate the origins or intended purpose behind its "participation" requirement.

Conclusion

The S. White decision runs counter to the Bankruptcy Code's goal that concerned creditors will take an active role in protecting their claims and that if a party has any doubt about the treatment of its claim, it is the responsibility of that party to raise its objection by timely filing an objection to the plan. Further, the decision is at odds with the need to respect the finality of confirmed plans. While the S. White decision is a favorable opinion for secured creditors since it places the onus on the debtor to actively litigate against or object to the claims of the secured creditor, it is unclear whether the reasoning of the decision will be followed by courts outside the Fifth Circuit since Espinosa makes clear that where constitutional due process is satisfied with respect to the terms of the plan, such plan is binding on the creditors. So long as a secured creditor receives actual notice of the plan, which was the case in S. White, secured creditors in cases should remain vigilant, carefully review the terms of any proposed plan and consult with counsel prior to an order confirming a plan becoming final and non-appealable.

Footnote

1 See Elixir Indus., Inc. v. City Bank & Trust Co. (In re Ahern Enters., Inc.), 507 F.3d 817, 822 (5th Cir. 2007).

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