Secured Claims and the Non-Participating Creditor

Secured Claims and the Non-Participating Creditor

 It is a much misunderstood truism that  a "secured creditor ‘with a loan secured by a lien on the assets of a debtor who becomes bankrupt before the loan is repaid may ignore the bankruptcy proceeding and look to the lien for satisfaction of the debt.'" In re Howard, 972 F.2d 639, 641 (5th Cir. 1992) [an enhanced version of this opinion is available to lexis.com subscribers]. Of course, the Bankruptcy Code does not say this. In the case of a chapter 11 proceeding, what the Code does say is that 

except as otherwise provided in the plan or in the order confirming the plan, after confirmation of the 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 of the debtor.

11 U.S.C. Sec. 1141(c). Unfortunately, the courts in several circuits, including the Fifth Circuit, have added a judicial gloss to this clear statutory language and have held that in order for the provision to apply, that the creditor "must participate in the reorganization." Elixir Industries v. City Bank & Trust Co. (In re Ahern Enterprises), 507 F.3d 817, 822 (5th Cir. 2007) [enhanced version]. A new decision from the Fifth Circuit illustrates the perils of this rule. Acceptance Loan Company, Incorporated v. S. White Transportation, Incorporated (Matter of S. White Transportation, Incorporated), No. 12-60648 (5th Cir. 8/5/13), which can be found here [enhanced version].

What Happened

In S. White Transportation, the creditor claimed a lien on the debtor's property and the debtor disputed the validity of the lien. They had fought over the lien in state court without resolution. When the debtor filed chapter 11, it scheduled the creditor as secured, but listed its claim as disputed. The creditor did not file a proof of claim. The confirmed plan acknowledged the lien dispute and provided for no distribution to the creditor. The creditor did not object or vote upon the plan and it was confirmed. After confirmation, the creditor requested a declaratory judgment that its lien had survived confirmation. The Bankruptcy Court said no based on the rationale that notice and opportunity to participate was sufficient. The District Court required actual participation and reversed.

The Fifth Circuit, relying on Black's Law Dictionary on rulings from other circuits, said that participation must be active to be effective. The Court held:

In light of our interpretation of the definition of the word “participate” and in accordance with the above-cited persuasive authority from our sister circuits, we hold that meeting the participation requirement in In re Ahern Enterprises requires more than mere passive receipt of effective notice.

Opinion at p. 5.

Judicial Gloss

The difficulty with this decision is that the judicial gloss overshadows the statutory language. The Code says that "property dealt with by the plan is free and clear of all claims and interests."    The Code does not that "property dealt with by a plan is free and clear of all liens and interests of parties who actively participated in the bankruptcy case."    

Espinosa and Due Process

Due process requires that a party receive 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.

United Student Aid Funds, Inc. v. Espinosa, 559 U.S. 260, 272 (2010) [enhanced version], quoting Mullane v. Central Hanover Bank & Trust Co., 339 U.S. 306, 314 (1950) [enhanced version]. Clearly the creditor here received notice which satisfied the requirements of due process.

The Fifth Circuit brushed Espinosa in a footnote, stating that it was a case about a motion for relief from judgment under Rule 60(b). However, Espinosa was about more than simply Rule 60(b)--it was about the binding effect of a plan. In Espinosa the creditor argued that the Court lacked the power to discharge its otherwise nondischargeable claim in a plan and was rebuffed. In this case, the creditor argued that the Court lacked the power to avoid its lien and was validated. Something is clearly amiss here.

Practical Problems and Reductio Ad Absurdum

The S. White decision also presents practical difficulties. If a creditor alleges a lien, no matter how spurious, and does not file a claim, does this exempt the creditor from the bankruptcy process?     The Bankruptcy Rules allow the debtor to file a claim on a creditor's behalf which the debtor could object to. However, if the creditor remains silent in response to the claims objection, then it still has not actively participated in the case. The debtor could file an adversary proceeding to determine the lien's validity. This would delay the bankruptcy and no doubt lead to criticism from the U.S. Trustee. On the other hand, if the debtor files an adversary proceeding and obtains a default judgment, then the creditor still has not actively participated. While it is true that an adversary proceeding provides the creditor with more more due process, the requirements of due process had already been met. The problem with judicial creations such as this one is that they have the prospect of taking on a life of their own. The reductio ab absurdum here is that if the active participation principle is taken to its extreme then every creditor could opt out of the chapter 11 process by not participating and a chapter 11 plan would be a worthless scrap of paper.

The Need for Rehearing En Banc

It is time for the Fifth Circuit to reconsider the active participation rule. This judicial gloss is inconsistent wit the language of the Code and is contrary to Supreme Court precedent. It encourages a creditor who knows that its lien is being challenged to remain silent and hide behind the log to the detriment of the debtor and its other creditors. In S. White, there were three other creditors who held undisputed liens upon the same property. These creditors had the right to rely upon the terms of the plan and should not be subordinated to the claim of a creditor who sought to subvert the process through its silence.

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