"I'll Sit This One Out" - Fifth Circuit Permits Secured Creditor to Disregard Chapter 11 Case

 A few weeks ago in In re S. White Transportation [an enhanced version of this opinion is available to lexis.com subscribers], the U.S. Court of Appeals for the Fifth Circuit permitted a secured creditor that had indisputably received notice of the debtor’s chapter 11 case, but took no steps to protect its interests until after the confirmation of the debtor’s plan, to continue to assert a lien against the debtor’s property post-confirmation. 

In S. White Transportation, the debtor contested the lien of Acceptance Loan Co. It listed Acceptance’s lien as “disputed” in its schedules. The court noted that “Acceptance received effective notice of the pendency of SWT’s bankruptcy on at least several occasions”, but Acceptance never appeared in the case and never filed a proof of claim. Acceptance also failed to object to the debtor’s plan of reorganization, which provided no recovery for Acceptance. Shortly after the debtor’s plan was confirmed by the bankruptcy court, Acceptance filed a motion seeking a declaration that its lien had nevertheless survived. 

The bankruptcy court denied by motion, citing the unambiguous language of Section 1141(c) [an annotated version of this statute is available to lexis.com subscribers] of the Bankruptcy Code, which states that, unless the plan itself provides otherwise, “after confirmation of a plan, property dealt with by the plan is free and clear of all claims and interests”. The district court reversed, however, and the Fifth Circuit upheld the reversal. 

The Fifth Circuit referred to a general principle that liens are unaffected by bankruptcy, but acknowledged that the maxim is at odds with Section 1141(c). A previous Fifth Circuit decision, Ahern Enterprises, had added a judicial gloss to Section 1141(c) that a secured creditor whose lien is voided thereunder must have in some way “participated” in the chapter 11 case, but did not elucidate what “participation” meant in this context. The bankruptcy court in S. White Transportation broadly interpreted the “participation” requirement of Ahern Enterprises to encompass a creditor who received notice and failed to take any steps to protect its interests. The Fifth Circuit, however, ruled that “’participation’ connotes activity, and not mere nonfeasance”, and refused to find Section 1141(c) satisfied here.                        

Notice to creditors and interested parties is the life blood of bankruptcy practice, particularly in large chapter 11 cases where thousands of claims must be definitively resolved in order for a debtor to reorganize successfully. The Supreme Court has held that creditors’ rights may be affected in bankruptcy so long as notice is given that is sufficient to comport with the requirements of due process.   

Large debtors often have numerous junior encumbrances on property, such as mechanics liens, which are disputed or completely underwater. It is often vital to a debtor’s ability to reorganize that it be able to extinguish such encumbrances upon emergence, particularly where it needs to attract fresh debt capital in order to complete its reorganization. A requirement that the mere provision of notice to such creditors can no longer suffice to address such liens would place a huge and costly burden on chapter 11 debtors to effectuate the “participation” of passive creditors in their cases, such as by utilizing Section 501(c) of the Bankruptcy Code to file proofs of claim on such creditors’ behalf.       

Chances are, however, that S. White Transportation will prove to be an outlier. Recent judicial trends have emphasized the “plain meaning” mode of statutory interpretation, even in instances, such as the recent controversy over credit bidding by secured lenders, where the results are demonstrably at odds with long standing commercial practice. Here, conversely, it is the Fifth Circuit’s embellishment of Section 1141(c) that has led to a departure from what most bankruptcy practitioners would view as an established norm, i.e., that the rights of a party who has indisputably received notice, but chooses not to participate in a chapter 11 case, can be materially and negatively affected.     

Nonetheless, if the Fifth Circuit’s rationale in S. White Transportation were to be adopted by other circuits or upheld by the Supreme Court, it clearly would have a significant impact on large chapter 11 cases.

Read more articles at Kelley Drye & Warren LLP’s Bankruptcy Law Insights blog.

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