Second Circuit Holds That a Chapter 11 Plan May Extinguish a Lien When the Lienholder “Participates in the Bankruptcy Proceedings”

By Michael Riela

Vedder Price

New York

 In City of Concord v. Northern New England Telephone Operations LLC (In re Northern New EnglandTelephone Operations LLC), No. 14-3381, 2015 WL 4619576 (2d Cir. Aug. 4, 2015), the Second Circuit considered the circumstances under which a Chapter 11 plan extinguishes a lien.  Notably, although the general rule is that liens may pass through a bankruptcy unaffected, the Second Circuit held that a Chapter 11 plan can extinguish a lien when the lienholder had participated in the bankruptcy proceedings (by, for instance, filing a proof of claim in the bankruptcy case).  This case is an important reminder that if you are a secured creditor, there is a risk to simply filing a proof of claim in a Chapter 11 case and not diligently defending your lien rights thereafter.

Section 506(d) and 1141(c) of the Bankruptcy Code  

The Second Circuit observed that “[t]he longstanding background rule has been that ‘liens pass through bankruptcy unaffected.’”.  Id. at *2, citing Dewsnup v. Timm, 502 U.S. 410, 417 (1992).  One of the statutory predicates for that rule is Section 506(d)(2) of the Bankruptcy Code, which provides:

“To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void, unless –

(2) such claim is not an allowed secured claim due only to the failure of any entity to file a proof of such claim under section 501 of this title.”

Thus, although a secured creditor’s failure to file a proof of claim affects that creditor’s claim against the debtor, such failure does not necessarily affect that creditor’s lien against the subject property.[1]

In Chapter 11 cases, however, Section 1141(c) of the Bankruptcy Code provides a caveat to that “background rule.”  Under that provision, liens on property that is “dealt with” by the Chapter 11 plan may be extinguished.  Section 1141(c) provides:

“Except as provided in subsections (d)(2) and (d)(3) 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.”

To extinguish a lien under a Chapter 11 plan, the text of Section 1141(c) of the Bankruptcy Code requires that: (1) the plan be confirmed; (2) the property subject to the lien be “dealt with” by the plan; and (3) neither the plan nor the confirmation order preserves the lien.[2]

Facts of the Case

In the Northern New England Telephone Operations LLC case, a city filed timely proofs of claim for property taxes for the first two quarters of the 2009 tax year (which had been billed pre-petition).  However, the city did not file proofs of claim with respect to the last two quarters of the 2009 tax year.  Under applicable law, a single lien secured payment of all of the debtor’s 2009 property taxes.  More than two years after the debtor’s Chapter 11 plan was confirmed, the city sought allowance and payment of the property tax claims.  The bankruptcy court denied the city’s motion, ruling that the debtor held its property free and clear of the city’s liens as a result of the confirmed Chapter 11 plan.  The district court affirmed.

The city appealed to the Second Circuit, arguing (among other things) that: (1) the debtor’s plan did not “deal with” the relevant property, so the lien could not be extinguished pursuant to Section 1141(c) of the Bankruptcy Code; (2) the city’s participation in the bankruptcy proceedings was insufficient to support the extinguishment of the lien; and (3) Section 506(d)(2) of the Bankruptcy Code preserved the lien because the city did not file a proof of claim with respect to the last two quarters of the 2009 tax year.

The Second Circuit’s Decision

The Second Circuit noted that it had not previously considered the circumstances under which a Chapter 11 plan extinguishes a lien under Section 1141(c).  It then held that a lien will be extinguished by a Chapter 11 plan if: (1) the text of the plan does not preserve the lien; (2) the plan is confirmed; (3) the property that is subject to the lien is “dealt with” by the terms of the plan; and (4) the lienholder participated in the bankruptcy proceedings.[3]

At issue in this case were the last two elements of the above test, since all parties agreed that the plan did not preserve the lien and that the plan was confirmed.  The Second Circuit found that the last two elements were also satisfied, and affirmed the lower courts’ rulings that the property was free and clear of the city’s liens.  

In particular, the Second Circuit found that the following language in the debtor’s plan adequately “dealt with” the property:

“As of the Effective Date, all property of FairPoint and Reorganized FairPoint shall be free and clear of all Claims, Liens and interests, except as specifically provided in the Plan, the Confirmation Order, or the New Credit Agreement.”

The Second Circuit rejected the City’s argument that the plan needed to list each specific property, and concluded that the plan’s general description of the properties was sufficient to alert parties that they had to take action to protect their interests in the property.

The Second Circuit also held that the extent to which the city participated in the bankruptcy proceedings was sufficient to extinguish the lien.  Although the city did not file proofs of claim with respect to the third and fourth quarters of the 2009 property tax year, it did file proofs of claim with respect to the first and second quarters of that year.  A single, automatic statutory lien arises under New Hampshire law to secure payment of the entire tax burden for a tax year.  The Second Circuit thus concluded that, by filing proofs of claim with respect to two quarters of the 2009 property tax year, the city participated in the bankruptcy proceedings as to the property subject to the statutory tax lien.

In addition, the Second Circuit held that Section 506(d)(2) of the Bankruptcy Code did not save the city’s lien, since Section 1141(c) is an exception to Section 506(d)(2).  Finally, the Second Circuit rejected the city’s arguments that extinguishment of the liens would be inequitable, and that the city should be allowed to file late proofs of claim under the doctrine of excusable neglect.

Conclusion

This case serves as a reminder that if a secured creditor files a proof of claim in a Chapter 11 case (or otherwise participates in the case), Section 1141(c) may allow a plan proponent to extinguish the lien under a confirmed Chapter 11 plan.  As always, creditors must vigilantly protect their rights in a bankruptcy case!

---

[1]  Debtors and trustees may have other avenues to seek avoidance of liens, even when the secured creditor does not file a proof of claim.  One such avenue would be the filing of an adversary proceeding against the secured creditor to “determine the validity, priority, or extent of a lien or other interest in property” pursuant to Bankruptcy Rule 7001.

[2]  Although Section 1141(c) does not explicitly reference the extinguishment of liens, courts have held that confirmation of a plan can extinguish liens.  See In re Northern New England Telephone Operations LLC, 2015 WL 4619576 at *3, citing In re Chrysler LLC, 576 F.3d 108, 126 (2d Cir. 2009).

[3]  Section 1141(c) does not contain an express requirement that the lienholder participate in the bankruptcy proceeding.  However, the Second Circuit concluded that the requirement that the property be “dealt with” in the plan cannot be fairly satisfied in the absence of the lienholder’s participation.