Treatment Under Plan of Reorganization: Mortgage Discharge May Take More Than You Might Expect

Acceptance Loan Co. v. S. White Transp., Inc. (In re S. White Transp., Inc.), 725 F.3d 494 (5th Cir. 2013) –

The 5th Circuit upheld the district court decision with the result that notwithstanding the debtor’s attempt to discharge a mortgage through a plan of reorganization, a mortgagee was able to retain its lien by remaining silent until after confirmation.

As discussed in more detail in the blog post on the district court decision (Treatment Under Plan of Reorganization: What Does It Take To Discharge A Mortgage?):

  • Although the debtor identified the mortgagee’s claim in its bankruptcy schedules, it designated the claim as disputed.
  • The mortgagee did not file a proof of claim or otherwise get involved in the bankruptcy.
  • The debtor filed a plan of reorganization that noted that the mortgage was contested and provided for no recovery on the claim.
  • The mortgagee received notice of the plan giving it an opportunity to object.
  • Shortly after the bankruptcy court confirmed the plan, the mortgagee moved for a declaratory judgment that its lien had survived confirmation.

In response to the mortgagee’s request, the bankruptcy court held that the lien was voided based on Section 1141(c) of the Bankruptcy Code, which provides that property dealt with in a plan of reorganization generally is free and clear of all claims and interests except as provided in the plan.  To the extent that a lien holder must “participate” for its lien to be avoided, the bankruptcy court concluded that the mortgagee’s receipt of notice of the plan was sufficient.  The district court reversed on the grounds that mere notice was not participation.

According to the 5th Circuit:

It is a long standing rule in bankruptcy that “[a] secured creditor ‘with a loan secured by a lien on the assets of a debtor who becomes bankrupt before the loan is repaid may ignore the bankruptcy proceeding and look to the lien for satisfaction of the debt.’”…  However, this default rule only applies so long as the lien is not “invalidated by some provision of the Code.”

Under 5th Circuit precedent, for a lien to be voided under a plan of reorganization: (1) the plan must be confirmed, (2) the property subject to the lien must be dealt with in the plan, (3) the lien holder must participate, and (4) the plan must not preserve the lien.

In this case the only issue was whether the mortgagee’s receipt of notice of the plan constituted participation for purposes of the test.  The 5th Circuit concluded that it did not.  Consequently, the debtor could not avoid the mortgagee’s lien through its plan.

The court acknowledged that courts are split on whether active participation is required.  In some courts, it is sufficient if the creditor receives notice of the plan and has an opportunity to object.  However, the 5th Circuit reiterated that it requires “activity, and not mere nonfeasance.”  (It noted that the 7th Circuit and 8th Circuit also require more than notice.)

This analysis can create significant practical issues for a debtor attempting to resolve liens in connection with a plan of reorganization.  Many would expect that if the secured creditor is given notice of the treatment of its lien and fails to object, then the lien can be avoided.  However, that is clearly not the case in those jurisdictions that require “active” participation.

Going beyond notice, it seems likely that filing a proof of claim will be sufficient participation.  However, there is no guarantee that all courts will agree.  It appears that a debtor’s only recourse to resolve with certainty the lien of a mortgagee that lies in wait until the plan is confirmed is to bring an adversary proceeding to resolve the claim.  Perhaps this will work if a debtor is concerned about only one or two large lien claims and has the time to litigate.  However, if a number of liens are at issue, this approach does not appear to be practical.

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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