Is This What Passive-Aggressive Means? Fifth Circuit Allows Secured Creditor that Took No Action During Chapter 11 Case to Protect Its Lien to Exercise Rights Post-Emergence

Contributed by Erika del Nido
In the Fifth Circuit’s recent decision, Acceptance Loan Co., Inc. v. S. White Transportation, Inc. (In re S. White Transportation, Inc.) the United States Court of Appeals for the Fifth Circuit held that a secured creditor who received actual notice of a chapter 11 case but took no steps to preserve its claim or lien could still enforce its lien against the reorganized debtor’s property.  In so holding, the Fifth Circuit followed the unfortunate precedent that has been established in some circuits, including the Fifth, that adds a judicial gloss to section 1141(c) of the Bankruptcy Code to allow a lien to “ride through bankruptcy” if the lienholder did not “participate” in the chapter 11 case.  In S. White Transportation, the Fifth Circuit concluded that such participation requires that the creditor have taken some form of affirmative action in the chapter 11 case and that even deliberate passivity in the face of actual notice of the bankruptcy did not constitute “participation.”
Prior to the commencement of its chapter 11 case, the debtor, S. White Transportation, brought an action in state court to challenge the validity of a lender’s lien.  The state court action was still pending as of the petition date, and the debtor scheduled the lender’s lien as “disputed” in its schedules.  Although the lender received actual notice of the debtor’s chapter 11 case, including the bar date, the lender never filed a proof of claim and was not otherwise involved in the case.  The debtor’s chapter 11 plan referenced the lender’s disputed lien and failure to file a proof of claim and provided no recovery for the lender.
After the debtor’s plan was confirmed and the debtor emerged from chapter 11, the lender then decided to protect its rights.  It petitioned the bankruptcy court for a declaratory judgment that the lien survived confirmation of the plan or for an amendment of the confirmation order to allow its lien.  The bankruptcy court was bound to follow the existing precedent of Elixir Indus., Inc. v. City Bank & Trust Co. (In re Ahern Enters., Inc.), in which the Fifth Circuit held that section 1141(c) voids liens only when the “Lien holder participate[s] in the reorganization.”  The bankruptcy court, however, denied the lender’s motion because it found that the lender had “participated” in the chapter 11 case as a result of having received actual notice and declining to take action.  Accordingly, the bankruptcy court found that, pursuant to section 1141(c) of the Bankruptcy Code, the property that allegedly secured the lender’s claim revested in the reorganized debtor “free and clear of all claims and interests.”  The lender appealed to the district court, which held that “mere notice does not constitute participation within the meaning of In re Ahern Enterprises.”  The reorganized debtor then appealed to the Fifth Circuit.
The Fifth Circuit’s Analysis
The Fifth Circuit cited as a “general rule” (one found nowhere in the language of the Bankruptcy Code) that liens “ride through” a bankruptcy and are not affected.  Section 1141(c) of the Bankruptcy Code, however, provides a significant exception to this “general rule”:  “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.”  In Ahern Enterprises, the Fifth Circuit held that, in addition to satisfying the literal requirements of section 1141(c) (i.e., the plan is confirmed, the property subject to a lien is dealt with by the plan, and the plan does not preserve the lien), the reorganized debtor would have to show that the lien holder “participated” in the reorganization.
The Ahern court did not provide a clear definition of “participation,” but found sufficient participation existed where an undersecured creditor filed a proof of claim for the unsecured amount that it was owed.  The sole issue in dispute between the reorganized debtor and the lender in S. White Transportation was whether no involvement by a creditor in a chapter 11 case notwithstanding receipt of actual notice of the bankruptcy case constituted sufficient “participation” to warrant voiding a lien.
As a preliminary matter, the Fifth Circuit stated that “the word ‘participation’ connotes activity, and not mere nonfeasance.”  The Fifth Circuit then noted that other courts also have added the judicial gloss of “participation” on to section 1141(c) but have differed on the level of participation required to void a lien.  The Seventh Circuit has held that a secured creditor “participat[es] in the bankruptcy proceeding through filing a claim,”  but the Eighth Circuit has held that the filing of an untimely claim that was disallowed by the bankruptcy court meant that “the [secured creditor] was not permitted to participate as a secured creditor [because its own untimely filing meant that] its lien was never brought into the bankruptcy proceedings and could therefore not be extinguished by confirmation of the plan.”  In contrast, in In re Reg’l Bldg. Sys., Inc., the Bankruptcy Court for the District of Maryland held that “the only participation necessary is that the creditor receive notice of the plan and an opportunity to object.”
Based upon the definition of “participate” and the decisions from the Seventh and Eighth Circuits, the Fifth Circuit held that “meeting the participation requirement in In re Ahern Enterprises requires more than mere passive receipt of effective notice.”
In holding that mere notice of a bankruptcy does not constitute sufficient participation for the purposes of voiding a lien under section 1141(c), the Fifth Circuit built upon the Seventh and Eighth Circuit’s decisions.  The Fifth Circuit’s decision raises troubling issues about the efficacy of a bar date in dealing with secured claims and how a chapter 11 debtor should deal with a known disputed lien in the face of voluntary passivity by a secured creditor.  To date, the courts have seemed content to recite the old Bankruptcy Act mantra “liens ride through bankruptcy” without fully examining the consequences of that principle in the context of chapter 11 of the Bankruptcy Code.