Staying On The Sidelines – Fifth Circuit Ruling Protects Secured Creditors Who Opt Not To Participate In Bankruptcy Proceedings

Can a secured creditor decide not to participate in a bankruptcy proceeding and thereby avoid any impact the bankruptcy may have on its lien? According to a recent decision by the United States Court of Appeals for the Fifth Circuit in S. White Transp., Inc. v. Acceptance Loan Co., 2013 WL 3983343 (5th Cir. Aug. 5, 2013), the answer appears to be that at least in the Fifth Circuit, the secured creditor can avoid the impact a bankruptcy plan has on its lien by simply declining to participate in the bankruptcy proceeding.

As a general matter, courts have observed that liens pass through bankruptcy unaffected. This general rule is based upon the lien as a property right which at least theoretically cannot be altered in the bankruptcy without the secured creditor's participation, if not its consent. Indeed, the Supreme Court's opinion in Long v. Bullard, 117 U.S. 617 (1886), is routinely cited for this proposition and is referred to as the "Bullard Rule." The Supreme Court cited the Bullard Rule without much discussion in its 1992 opinion in Dewsnup v. Timm, 502 U.S. 410 (1992), in support of its ruling that a Chapter 7 debtor could not strip down a lien. The Bullard Rule is generally understood to mean that so long as the secured creditor opts not to enforce its rights to an unsecured deficiency claim against the debtor's estate, it may choose not to participate in any way in the bankruptcy case, and may then enforce its rights against the collateral after the bankruptcy case is over. While the secured creditor will lose its in personam claim against the debtor for any possible deficiency, which will be discharged, it will retain its in rem claim against the debtor's property.

Prior to the enactment of the Bankruptcy Code, the Bullard Rule was a judge-made rule. However, when the Bankruptcy Code was enacted in 1978, the Bullard Rule was codified in section 506(d) of the Bankruptcy Code, which provides that a secured creditor need not file a proof of claim to have an allowed claim against the debtor's estate. In some circuits, however, ignoring the bankruptcy proceeding may place a secured creditor's lien at risk, because of section 1141(c) of the Bankruptcy Code. Notwithstanding the conflict with section 506(d) of the Bankruptcy Code, section 1141(c) of the bankruptcy code, and its related provisions in Chapters 12 and 13, provide that upon confirmation of a plan, all liens on property "dealt with" in the plan are extinguished.

The federal courts of appeals are sharply split on the question of the procedures necessary in bankruptcy reorganizations to modify the rights of creditors with security interests in property of the estate. One line of cases suggests that liens on estate property are automatically extinguished upon confirmation of a plan of reorganization, unless the plan expressly preserves them. Another line of cases holds that lien rights cannot be modified through the confirmation process alone, even if the plan explicitly provides for such modification. According to these cases, a plan proponent seeking to modify a creditor's lien rights must first invoke the claims allowance process by objecting to the secured claim and possibly filing a separate adversary proceeding to challenge the creditor's lien before attempting to modify the lien through a plan. The S. White decision falls in this second category. Notwithstanding the circuit split, the Supreme Court's 2010 opinion in United Student Aid Funds, Inc. v. Espinosa, 130 S.Ct. 1367 (2010), appears to have resolved the split in favor of the cases suggesting that liens on estate property are automatically extinguished upon confirmation of a plan of reorganization, unless the plan expressly preserves them. The Espinosa opinion, which focused on whether the creditor's constitutional due process rights were afforded to it, holds that failure to comply with a procedural rule does not deprive a party of due process so long as the broader constitutional notice standard is...