Seventh Circuit: Secured Creditor That Participated In Chapter 11 Case Bound By Terms Of Confirmed Plan That Extinguished Lien

• Published date: 30 September 2022
• Subject Matter: Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy
• Law Firm: Jones Day
• Author: Mr Dan Prieto and Mark Douglas

A hornbook principle of U.S. bankruptcy jurisprudence is that valid liens pass through bankruptcy unaffected. This long-standing principle, however, arguably conflicts with section 1141(c) of the Bankruptcy Code, which provides that, under certain circumstances, "the property dealt with by [a chapter 11] plan is free and clear of all claims and interests of creditors," except as otherwise provided in the plan or the order confirming the plan. Several courts have attempted to reconcile the pass-through principle with the statute by requiring the creditor to "participate in the reorganization" as a prerequisite to the application of section 1141(c). This judicial gloss raises the question of whether the terms of a chapter 11 plan providing for the treatment of secured creditor claims are binding on nonparticipating secured creditors.

The U.S. Court of Appeals for the Seventh Circuit recently addressed the participation question in In re Aguirre, 37 F.4th 427 (7th Cir. 2022). The court affirmed a lower court ruling that, because a tax lien creditor was "a party in the bankruptcy case," the creditor's tax lien did not pass through bankruptcy unaffected by the terms of a confirmed chapter 11 plan that extinguished the lien in exchange for an agreement to pay the creditor's secured claim in full in cash. The court also vacated an order directing a state court to vacate a tax deed issued to the creditor.

Section 1141(c)

Section 1141(c) states:

Except as provided in subsections (d)(2) [debts of individual debtors that are excepted from discharge under section 523] and (d)(3) [denial of discharge for, among others, liquidating corporations] of this section and 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.

With respect to liens and security interests, section 1141(c) means that "unless the plan of reorganization, or the order confirming the plan, says that a lien is preserved, it is extinguished by the confirmation." In re Penrod, 50 F.3d 459, 463 (7th Cir. 1995); accord JCB, Inc. v. Union Planters Bank, NA, 539 F.3d 862 (8th Cir. 2008). But see Bowen v. United States (In re Bowen), 174 B.R. 840 (S.D. Ga. 1994) (holding that a "lien" is not an "interest" within the meaning of section 1141(c); any release of a lien must rely on section 506(d)).

Concern regarding the impact of lien-stripping has led a number of (principally appellate) courts to add a judicial gloss to section 1141(c) requiring the secured creditor to have "participated in the reorganization" before its lien will be deemed extinguished. See generally Collier on Bankruptcy ' 1141.04[1] (16th ed. 2022) (discussing cases).

In Penrod'apparently, the first decision to add the participation gloss to section 1141(c)'the debtor's chapter 11 plan made provision for payment of a secured claim, but neither the plan nor the order confirming it stated whether the lien would be extinguished. The Seventh Circuit, acknowledging the "old saw" that liens pass through bankruptcy unaffected, nevertheless concluded that "when lienholders participate in a bankruptcy proceeding, and especially in a reorganization, they know that their liens are likely to be affected, and indeed altered." Penrod, 50 F.3d at 462. It ruled that liens are "interests" covered by section 1141(c) and that "unless the plan of reorganization, or the order confirming the plan, says that a lien is preserved, it is extinguished by the confirmation ... provided, we emphasize, that the holder of the lien participated in the reorganization." Id. at 463.

In Elixir Indus., Inc. v. City Bank & Trust Co. (In re Ahern Enters., Inc.), 507 F.3d 817 (5th Cir. 2007), the Fifth Circuit held that four conditions must be met for a lien to be voided under section 1141(c): (i) the plan must be confirmed; (ii) the collateral must be dealt with by the plan; (iii) the lienholder must participate in the reorganization; and (iv) the lien must not be preserved under the plan.

In City of Concord, N.H. v. Northern New England Telephone Operations LLC (In re Northern New England Telephone Operations LLC), 795 F.3d 343 (2d Cir. 2015), cert. denied, 577 U.S. 1009 (Nov...