Secured Claims: What Does it Take to Extinguish a Lien Through a Plan?

In re Omega Optical, Inc., 476 B.R. 157 (Bankr. E.D.Pa. 2012) –

A bank filed a proof of claim in a bankruptcy that erroneously identified its claim as unsecured.  After confirmation of a chapter 11 plan of reorganization that treated the claim as unsecured, the bank filed a motion to allow it to amend its proof of claim to reflect the fact that the claim was secured.  Omega focused on the question of what it takes to extinguish a lien through a plan.

The debtor listed Sovereign Bank in its bankruptcy schedules as a secured creditor with a disputed claim, valuing the collateral at $10,000.  The debtor’s proposed plan of reorganization asserted that the bank’s claim was not properly perfected, and accordingly its secured claim was reclassified as an unsecured claim under the plan – with the bank required to terminate the UCC financing statement and release all other liens upon the effective date of the plan.  A confirmation hearing was held, and the bank did not object to the plan.

A couple of months after confirmation, the bank filed a motion to amend its proof of claim, contending that the designation as an unsecured claim was “an obvious oversight.”  In reviewing the motion to amend the claim, the court considered whether the amendment would be futile.

Under the Federal Rules of Bankruptcy Procedure, a creditor generally must file a proof of claim in order for its claim to be allowed if the claim is not scheduled by the debtor or is scheduled as disputed, contingent, or unliquidated.  However, the court emphasized that the penalty for failure to file a proof of claim is not loss of the creditor’s lien since Section 506(d)(2) of the Bankruptcy Code specifically states that failure to file a proof of claim is not a basis for voiding the lien.  Thus, although a secured creditor that fails to file a required proof of claim might not be entitled to vote or to receive any distributions under a plan, that does not cause its lien to be extinguished.

Notwithstanding this point, the confirmation process itself can affect a lien since Section 1114(c) of the Bankruptcy Code generally provides that property dealt with under a plan will be free and clear of interests.  The bankruptcy court noted that some courts have applied a four-part test to determine whether a lien is extinguished through a plan:

(1)        the plan must be confirmed;

(2)        the property that is subject to the lien must be dealt with by the plan;

(3)        the lienholder must participate in the reorganization; and

(4)        the plan must not preserve the lien.

In this case, all four elements were clearly met, including “participation” by the bank.  (The bank filed a proof of claim, and its attorney entered an appearance in the bankruptcy case on behalf of the bank.)

Although it was not necessary for a decision in this case, the bankruptcy court included an extended discussion of the participation requirement in a long footnote.  The court noted that the U.S. Supreme Court has determined that serving a creditor who had notice of the bankruptcy with a copy of a chapter 13 plan that expressly addressed its claim was sufficient for purposes of constitutional due process.

The bankruptcy court goes on to speculate that if there is a further requirement for creditor participation as a condition for extinguishing a lien, this may be to provide the foundation for personal jurisdiction over the creditor.  Simply providing notice of the bankruptcy and the terms of a plan may not be sufficient for that purpose, while a creditor’s participation by filing a proof of claim constitutes submitting to the court’s jurisdiction with respect to the claim.

On the other hand, if extinguishing the lien under a plan pursuant to Section 1141(c) does not involve a challenge to the validity, priority or extent of the lien (i.e. does not potentially trigger the need for an adversary proceeding), then creditor participation may not be necessary.  The exclusive jurisdiction that a bankruptcy court has over estate property may be sufficient to provide jurisdiction over those asserting an interest in the property.

As noted in a prior blog post (Treatment Under Plan of Reorganization: What Does It Take To Discharge A Mortgage?), the approach of requiring “participation” by a creditor raises the possibility that a plan by itself may not be effective to extinguish a lien even though the creditor has received notice sufficient to satisfy due process.  This in turn undermines the plan process.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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