Do Pre-existing Liens Really Pass Through Bankruptcy Unaffected
Do Pre-existing Liens Really Pass Through Bankruptcy Unaffected
While the Supreme Court has not directly addressed the issue since Dewsnup, three recent circuit court cases—In re Penrod, 50 F.3d 459 (7th Cir. 1995); Cen-Pen Corporation v. Hanson, 58 F. 3d 89 (4th Cir. 1995); and In re Dutchman, 1999 WL 734687 (4th Cir., Sept. 21, 1999)—have specifically dealt with this issue. The Seventh Circuit in Penrod held that where a creditor holding a lien participates in a chapter 11 case, §1141(c) will extinguish that lien on confirmation unless the plan or confirmation order provides otherwise. In comparison, the Fourth Circuit in Cen-Pen and Dutchman affirmed the general rule that liens pass through bankruptcy unaffected and held that liens may only be affected by the debtor taking some affirmative step toward that end, such as instituting an adversary proceeding against the lienholder.
The issue before the Seventh Circuit in Penrod was whether a secured creditor's lien is extinguished upon plan confirmation if that secured creditor actively participated in the bankruptcy case and the confirmed plan of reorganization makes provision for the payment of the secured claim. In Penrod, the creditor filed a proof of claim to which the debtors did not object. The reorganization plan classified the secured creditor as the only Class 3 creditor and provided that the claim would be paid in full with interest on a monthly basis. The debtors subsequently sold the property on which the lien was secured, and the creditor brought suit in state court to enforce its lien in the proceeds. The Bankruptcy Court for the Northern District of Indiana agreed with the debtors that the lien was extinguished. The District Court for the Northern District of Indiana affirmed.
The Seventh Circuit stated that, pursuant to §1141(c), liens do pass through bankruptcy unaffected "unless they are brought into the bankruptcy case and dealt with there." Id. at 463. The court held that unless the plan of reorganization or order confirming the plan specifically states that the lien is preserved, the lien is extinguished upon confirmation where the holder of that lien participated in the reorganization. Id. Because the creditor participated in the bankruptcy case by filing a proof of claim, the lien became "property dealt with by the plan" and was extinguished upon confirmation. The court further concluded that if a creditor does not participate in the bankruptcy case, e.g., does not file a proof of claim, then his lien is not "property dealt with by the plan" and §1141(c) does not apply. Id.
The Fourth Circuit dealt with this same issue somewhat differently in Cen-Pen Corp. v. Hanson. From 1969 through 1985, the debtors executed four promissory notes secured by deeds of trust on their residence. In 1985, to forestall foreclosure, the debtors entered into a financing agreement with the creditor, which provided that the creditor succeeded to the rights and remedies under the second and third deeds of trust. Subsequently, the debtors filed separate chapter 7 bankruptcy petitions in 1985 and 1986 and ultimately received discharges. As the result of a suit filed by the debtors against the creditor alleging violations of the Truth in Lending Act, the parties entered into a settlement agreement in April 1987 whereby the debtors were to refinance their outstanding indebtedness to the creditor within 90 days. The creditor subsequently filed a state court action alleging that the debtors never obtained alternative financing nor did they execute any documents to refinance the debt. Thereafter, the debtors filed chapter 13 bankruptcy petitions in September 1992, which stayed the state court action. Based on the language of the releases contained in the settlement agreement, the debtors' chapter 13 plan treated the creditor's claim as unsecured, which entitled the creditor to a distribution equaling 25 percent of its claim. The plan also provided that it would be automatically confirmed if there were no objections and that "all claims to be allowed must be filed." Finally, the plan provided that "to the extent that the holder of a secured claim does not file a proof of claim, the lien of such creditor shall be voided upon entry of the Order of Discharge." Cen-Pen, 58 F.3d at 91. The creditor did not file a proof of claim and did not object to the plan. The debtors received their discharge in December 1993.
On Feb. 2, 1994, the creditor filed a complaint in the bankruptcy court to determine the validity of its lien on the debtors' residence. The bankruptcy court declined to address the effect of the settlement agreement on the creditor's security interest. Rather, the court held that even if the creditor possessed a valid lien as of the date of the debtors' petitions, confirmation of the plan vested the residence in the debtors free and clear of the liens. The District Court for the Eastern District of Virginia disagreed and held that confirmation of the plan simply vested in the debtors the same interest in the residence that they had before filing the bankruptcy petition—the residence subject to the creditor's lien. Id. at 92.
The debtors appealed. They argued that, under the terms of §1327, confirmation of their plan voided the liens held by the creditor. Because the chapter 13 plan failed to address the creditor's liens or make any provision for payment or satisfaction of such liens and only stated that the creditor's claims were unsecured, the Fourth Circuit held that the liens passed through the bankruptcy case intact. Id. at 94. The court further held that a bankruptcy discharge extinguishes only in personam claims against debtors, but generally has no effect on in rem claims against the debtors' property. Id., citing Johnson v. Home State Bank, 501 U.S. 78, 84, 111 S.Ct. 2150, 2154, 115 L.Ed.2d 66 (1991). The Fourth Circuit concluded that where a plan does not "provide for" a creditor's lien, that lien passes through bankruptcy intact, absent the initiation of an adversary proceeding to determine the validity, priority or extent of the liens. Id. at 93. According to the Fourth Circuit, "a plan 'provides for' a claim or interest when it acknowledges the claim or interest and makes explicit provision for its treatment." Id. at 94.
In response to the debtors' argument that the creditor failed to file a proof of claim or otherwise object to the plan, the Fourth Circuit opined that, based on §506(d)(2), failure to file a proof of claim is not the basis for avoiding the lien of a secured creditor. Furthermore, the court concluded that it was unnecessary for the creditor to participate in the bankruptcy case because unchallenged liens survive the discharge. The secured creditor need only look to the liens for satisfaction of the debt. Id. at 94, citing In re Tarnow, 749 F.2d 464, 465 (7th Cir. 1984).
Most recently, the Fourth Circuit reaffirmed its commitment to, if not expanded its holding in, the Cen-Pen decision in In re Dutchman. In Dutchman, the chapter 13 debtor sought a declaratory judgment that the IRS's liens would be extinguished upon completion of the payments specified to be paid to the IRS under its confirmed plan of reorganization (the payments amounted to substantially less than the amount of the IRS's asserted secured claim).3 That confirmed plan, however, listed the majority of the IRS' secured claim as a "Class II Priority Claim." The plan also provided that the liens of the Class II creditors "shall be considered released and of no effect" upon the payment of all "allowed claims" due them. Notwithstanding the substantially reduced amounts called for in the plan to be paid to the IRS, the debtor argued that the plan was binding on the IRS and thus the property subject to the IRS's liens will vest in him free and clear of the liens upon payment of the requisite amounts set forth in the plan.
The Fourth Circuit acknowledged that the IRS participated in the bankruptcy case by filing a secured proof of claim. The court further acknowledged that the debtor's plan provided for payment of the IRS's claims and that the IRS did not object to the plan, a copy of which it had received, or attend the confirmation hearing. However, the court held that because the debtor failed to commence an adversary proceeding to extinguish the IRS's lien, object to the proof of claim filed by the IRS or in any way attempt to modify the IRS's lien, the debtor would not then be allowed to avoid the lien on the grounds that its plan had "provided for" the IRS's claims. According to the Fourth Circuit, simply attempting to "provide for" liens, and thereby obtaining a favorable result by "camouflaging" the treatment of a secured creditor's liens, is insufficient. Id. at 189. An "appropriate affirmative step" must be taken by the debtor to avoid a lien. Id. "In order to 'provide for' a creditor for purposes of §1327(c), the plan must, at a minimum, clearly and accurately characterize the creditor's claim throughout the plan." Id. at 10. In this case, the plan improperly characterized all of the IRS's claims as priority claims and failed to give specific notice to the IRS of the debtor's intent to accord the liens less than full protection. As a result, the Fourth Circuit held that the IRS's liens passed through the bankruptcy case.
Survey of Other Cases
The District Court for the Eastern District of Pennsylvania held, in the case of Coffin v. Malvern Federal Savings Bank, 189 B.R. 323 (E.D. Pa. 1995), that the liens held by a creditor survived the chapter 13 bankruptcy case. The district court found that, although the proof of claim and confirmed plan addressed the arrearage amounts, they both failed to address the entire debt secured by the liens. Thus, the liens were not "property dealt with by the plan" under §1141, and therefore were not extinguished. Coffin at 327. Similarly, the Bankruptcy Court for the Eastern District of Pennsylvania held that the IRS' secured claims passed through the bankruptcy case unaffected where the chapter 13 plan failed to provide for the claims. In re Vandy Inc., 189 B.R. 342, 349 (Bankr. E.D. Pa. 1995). The confirmed plan referenced priority tax claims; however, the IRS's claim was not a priority claim. Moreover, the confirmed plan failed to reference the IRS in the class of secured creditors. Therefore, the claims were not "property dealt with by the plan."
In Green Tree Financial Servicing Corp. v. Smithwick, the District Court for the Southern District of Texas adopted the Penrod decision by holding that Green Tree was put on notice that the confirmed chapter 13 plan might alter the terms of the payment underlying the lien when it chose to participate in the bankruptcy case. 202 B.R. 420, 424 (S.D. Texas 1996). Consequently, Green Tree had to abide by the confirmed plan, which altered the interest rate at which the debtors would repay the secured claim.4
The District Court for the Eastern District of Arkansas concluded that the secured claim of the IRS passed through the bankruptcy case unaffected where the chapter 13 plan failed to address it. Kuebler v. United States of America, et al., 172 B.R. 95 (E.D. Ark. 1994). The court discharged the personal liability of the debtors as to the IRS; however, the lien remained enforceable.
In the case of Federal Deposit Insurance Corp. v. Union Entities (In re Be-Mac Transportation Co.), 83 F.3d 1020 (8th Cir. 1996), the Eighth Circuit held that the FDIC's lien was not property dealt with by the plan nor was it extinguished upon confirmation because the FDIC did not participate in the bankruptcy case. The court concluded that, because the bankruptcy court ruled that the FDIC's second amended claim clarifying the status of the amended claim was untimely, the FDIC did not participate in the case as a secured creditor and its lien was never brought into the case. Id. at 1026. The Penrod decision was also followed in the case of Harmon v. United States, 101 F.3d 574 (8th Cir. 1996), which held that confirmation of a chapter 12 plan operates to avoid the liens of all participating secured creditors that are provided for by the plan unless the terms of the plan provide otherwise. And in In re Burton Securities, 202 B.R. 411, 420 (S.D. Texas 1996), the court followed Penrod and Be-Mac when it held that because the creditor had participated in the debtors' chapter 11 bankruptcy and the plan did not expressly preserve its lien, the lien was extinguished upon confirmation.
Bankruptcy courts in Iowa, Minnesota and Alabama all followed the Penrod decision in their rulings in In re Harnish, 224 B.R. 91 (Bankr. N.D. Iowa 1998); In re Siemers, 205 B.R. 583 (Bankr. D. Minn. 1997); and Roper v. American Health & Life Insurance Co., 203 B.R. 326 (Bankr. N.D. Ala. 1996), respectively, by holding that confirmation of the chapter 13 plan of reorganization operates to avoid liens of all participating secured creditors who are provided for in the plan. Similarly, in In re CIS Corp., 1997 WL 666265, *3-*4 (S.D.N.Y. Oct. 24, 1997), the District Court for the Southern District of New York held that because the creditor neither filed a proof of claim nor had its claim provided for by the debtors' chapter 11 plan, the creditor's pre-petition lien would survive bankruptcy.
The Bankruptcy Court for the District of Massachusetts held in In re Winchell, 200 B.R. 734 (Bankr. D. Mass. 1996), that the creditor's lien was extinguished upon confirmation of the debtor's plan pursuant to the express terms of the plan, even though the creditor failed to file a proof of claim. The bankruptcy court reasoned that the circumstances of that case differed from Penrod in that Penrod was governed by the general rule, while this case was governed by the exception set forth in §1141(c) ("Except as otherwise provided in the plan or in the order confirming the plan..."). Winchell, 200 B.R. at 737. Therefore, the plan and confirmation order displaced the general rule. The bankruptcy court concluded that the estate property vested in the debtor free and clear of any claims pursuant to the plan and confirmation order, regardless of whether the creditor filed a proof of claim. The court noted that the creditor did not dispute that the property at issue belonged to the debtor at the commencement of the case and that the property became an asset of the bankruptcy estate.
Conclusion
The majority of the cases on the issue of whether pre-existing liens pass through bankruptcy support the Penrod decision that a lien may be avoided or modified during the bankruptcy case without an adversary proceeding, thus providing exceptions to the general rule. However, the creditor must have participated in the proceeding or been provided adequate notice of the debtor's intent to modify the lien, and the plan of reorganization or confirmation order must specifically "deal with" the lien. It is the debtor's obligation to state expressly that the secured creditor's liens are not passing through the plan unaffected and specify how the secured creditor's claims are being treated.
Footnotes
1 Section 1141(c) of the Bankruptcy Code provides:
Except as provided in subsections (d)(2) and (d)(3) of this section and 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 general partners in the debtor. 11 U.S.C. §1141(c). Return to article
2 Similarly, §1327(c) of the Bankruptcy Code provides:
Except as otherwise provided in the plan or in the order confirming the plan, the property vesting in the debtor under subsection (b) of this section is free and clear of any claim or interest of any creditor provided for by the plan. 11 U.S.C. §1327(c). Return to article
3 The parties stipulated that, following the designated plan payments, the remaining amount of the IRS' secured claim would be $139,750.89. Return to article
4 Reversed and remanded by the U.S. Court of Appeals for the Fifth Circuit to permit the bankruptcy court to apply a rebuttable presumption that the contract rate was the appropriate post-confirmation interest rate to apply to the creditor's claim. 121 F.3d 211 (5th Cir. 1997). Return to article
Journal Date: Monday, November 1, 1999 |