Key Takeaway:  Second Circuit allows secured
creditors to opt out of chapter 11 and preserve their liens from discharge
.

We have reported in this blog about the many courts that have clung to the archaic “lien rides through” principle espoused in the U.S. Supreme Court’s Dewsnup v. Timm chapter 7 case.  This principle permits a lien to “ride through” a bankruptcy case if the creditor did not “participate” in the case.  Of course,Dewsnup, as a chapter 7 case, did not involve the effect of discharge.  Instead, Dewsnup focused strictly on the interpretation and application of section 506(d) of the Bankruptcy Code.  Moreover, in decidingDewsnup, the Supreme Court overlooked that the “lien rides through” principle harkens back to an era when the discharge only affected debts that could be “proved,” and secured debts could only be “proved” at that time for the amount of a deficiency claim.  

Nevertheless, circuit courts have simply recited the “lien rides through” mantra and applied the principle to chapter 11 and chapter 12 cases, allowing the discharge of a lien only if the secured creditor “participated” in the case.  The language regarding the effect of discharge in chapter 11 cases differs from that used for chapter 12 and 13 cases.  Both section 1227(c) and section 1327(c) of the Bankruptcy Code specify that the effect of discharge is to revest the property “free and clear of any claim or interest of any creditorprovided for by the plan.”  Section 1141(c), however, is much broader and states that “the property dealt with by the plan is free and clear of all claims and interests of creditors, equity holders, and of general partners in the debtors.”  (Of course, in all three chapters, the plan or confirmation may provide otherwise).  Unlike sections 1227(c) and 1327(c), however, section 1141(c) focuses on the debtor’s property and not on particular creditors.  Nowhere in section 1141(c) is the binding effect of discharge on a creditor predicated upon a creditor’s inclusion in a plan or participation in the chapter 11 case.

Given the express language of chapter 11, it is, therefore, not clear why courts in chapter 11 cases have focused on the participation of a secured creditor in the case to determine if property dealt with by the debtor’s plan was free and clear of the creditor’s lien after emergence from chapter 11.  When the Second Circuit decided to take up the issue in Northern New England Telephone Operations, it had the perfect opportunity to buck the trend in the other circuits, apply the literal language of section 1141(c) of the Bankruptcy Code, and at least ditch Dewsnup in the context of a chapter 11 case.  Unfortunately, the Second Circuit did not do so.  Instead, it seized upon the opportunity to state, in dicta, that the effect of a confirmed chapter 11 plan is to revest property dealt with by the plan in the reorganized debtor free and clear of all interests so long as neither the plan nor the confirmation order provides otherwise (as expressly stated in section 1141(c)) and the lienholder “participated in the bankruptcy proceedings.”

One might understand the Second Circuit’s insistence that a “participation” gloss be added to the requirements of section 1141(c) if it were couched as a matter of due process.  The Second Circuit, however, clearly states in Northern New England Telephone Operations that due process is not driving its decision.  Indeed, the court makes it quite clear that a creditor may have actual notice that a plan proposes to revest its collateral in the reorganized debtor free and clear of the creditor’s lien, and the secured creditor is free to stand by, watch, do nothing, and then enforce its lien after the debtor emerges from chapter 11.  In support of this interpretation, the Second Circuit states that it is relying “on the equitable character of bankruptcy law” and is implementing the “background rule” that allows a secured creditor, even in chapter 11, to elect to opt out of the bankruptcy process.

The Second Circuit attempts to locate the “participation” gloss in the text of section 1141(c), stating that property cannot be “dealt with” by a plan “in the absence of the interested parties.”  Other than by its vague reference to “equity” and a “background rule,” though, the court never addresses why a voluntary absence by an interested party should take property outside the scope of a discharge.

The Second Circuit relies heavily upon the importance of section 506(d) of the Bankruptcy Code, a section that deals exclusively with avoiding a lien to the extent that the lien secured a claim that is not an allowed secured claim and one that is rarely used in a chapter 11 case.  In Bank of America, N.A. v. Caulkett, the Supreme Court recently addressed the effect of section 506(d) on lien stripping in a chapter 7 case.  (As the Weil Bankruptcy Blog noted, the Supreme Court repeatedly noted in that case that no party had asked it to overturn Dewsnup.)  In Northern New England Telephone Operations, the Second Circuit focused on section 506(d)(2) – which prevents the avoidance of a lien solely because the secured creditor failed to file a proof of claim – as establishing that the Bankruptcy Code preserves liens so long as the secured creditor ignores the chapter 11 case.  The court easily could have reconciled the two provisions by applying section 506(d) to objections arising prior to the debtor’s emergence from chapter 11 or to secured claims that otherwise are protected from discharge by operation of the plan or the confirmation order.

Moreover, the Second Circuit focused on section 506(d), but ignored other provisions of the Bankruptcy Code that also allow debtors to interfere with the rights of secured creditors.  Among other things, section 363(f) of the Bankruptcy Code allows a debtor to sell property free and clear of interests, and section 364(d) allows the court to approve a priming lien.  Can a secured creditor choose not to “participate” in a case and avoid application of those provisions?  If the Second Circuit’s “participation” gloss applies to the effect of discharge – one of the fundamental goals of a chapter 11 case –where else should it apply?

We certainly have seen creative strategies employed by secured creditors in recent years.  Will Northern New England Telephone Operations provide another route?