Do Pre-existing Liens Really Pass Through Bankruptcy Unaffected

Journal Issue

Nov 1999

Column Name

Journal HTML Content

Sections 1141(c)<a href="#1" name="1a">1</a> and 1327(c)<a href="#2" name="2a">2</a> of the Bankruptcy Code set forth the status of the debtor's
property upon confirmation of a plan of reorganization. Although property vests in the debtor,
the majority of courts have upheld the general rule that pre-existing liens pass through
bankruptcy unaffected. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Timm, 502 U.S. 410, 418, 112 S.Ct. 773, 778,
116 L. Ed.2d 903 (1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Bullard, 117 U.S. 617, 620-21, 6 S.Ct. 917, 29 L. Ed.
1004 (1886)</a>. This allows a secured creditor to elect not to participate in the bankruptcy case
and instead to look to its pre-existing lien for the satisfaction of its debt after the debtor has
emerged from bankruptcy. In recent years, however, courts have been more willing to find
exceptions to this general rule.

While the Supreme Court has not directly addressed the issue since Dewsnup, three recent
circuit court cases—<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Penrod, 50 F.3d 459 (7th Cir. 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Corporation v.
Hanson, 58 F. 3d 89 (4th Cir. 1995)</a>; and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Dutchman, 1999 WL 734687 (4th Cir., Sept.
21, 1999)</a>—have specifically dealt with this issue. The Seventh Circuit in Penrod held that
where a creditor holding a lien participates in a chapter 11 case, §1141(c) will extinguish
that lien on confirmation unless the plan or confirmation order provides otherwise. In
comparison, the Fourth Circuit in Cen-Pen and Dutchman affirmed the general rule that liens
pass through bankruptcy unaffected and held that liens may only be affected by the debtor taking
some affirmative step toward that end, such as instituting an adversary proceeding against the
lienholder.

The issue before the Seventh Circuit in Penrod was whether a secured creditor's lien is
extinguished upon plan confirmation if that secured creditor actively participated in the
bankruptcy case and the confirmed plan of reorganization makes provision for the payment of
the secured claim. In Penrod, the creditor filed a proof of claim to which the debtors did not
object. The reorganization plan classified the secured creditor as the only Class 3 creditor and
provided that the claim would be paid in full with interest on a monthly basis. The debtors
subsequently sold the property on which the lien was secured, and the creditor brought suit in
state court to enforce its lien in the proceeds. The Bankruptcy Court for the Northern District of
Indiana agreed with the debtors that the lien was extinguished. The District Court for the
Northern District of Indiana affirmed.

The Seventh Circuit stated that, pursuant to §1141(c), liens do pass through bankruptcy
unaffected "unless they are brought into the bankruptcy case and dealt with there." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 463</a>. The court held that unless the plan of reorganization or order confirming the plan specifically
states that the lien is preserved, the lien is extinguished upon confirmation where the holder
of that lien participated in the reorganization. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; Because the creditor participated in the
bankruptcy case by filing a proof of claim, the lien became "property dealt with by the plan"
and was extinguished upon confirmation. The court further concluded that if a creditor does not
participate in the bankruptcy case, e.g., does not file a proof of claim, then his lien is not
"property dealt with by the plan" and §1141(c) does not apply. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

The Fourth Circuit dealt with this same issue somewhat differently in Cen-Pen Corp. v. Hanson.
From 1969 through 1985, the debtors executed four promissory notes secured by deeds of
trust on their residence. In 1985, to forestall foreclosure, the debtors entered into a financing
agreement with the creditor, which provided that the creditor succeeded to the rights and
remedies under the second and third deeds of trust. Subsequently, the debtors filed separate
chapter 7 bankruptcy petitions in 1985 and 1986 and ultimately received discharges. As the
result of a suit filed by the debtors against the creditor alleging violations of the Truth in
Lending Act, the parties entered into a settlement agreement in April 1987 whereby the debtors
were to refinance their outstanding indebtedness to the creditor within 90 days. The creditor
subsequently filed a state court action alleging that the debtors never obtained alternative
financing nor did they execute any documents to refinance the debt. Thereafter, the debtors filed
chapter 13 bankruptcy petitions in September 1992, which stayed the state court action. Based
on the language of the releases contained in the settlement agreement, the debtors' chapter 13
plan treated the creditor's claim as unsecured, which entitled the creditor to a distribution
equaling 25 percent of its claim. The plan also provided that it would be automatically confirmed
if there were no objections and that "all claims to be allowed must be filed." Finally, the plan
provided that "to the extent that the holder of a secured claim does not file a proof of claim, the
lien of such creditor shall be voided upon entry of the Order of Discharge." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 58 F.3d at
91</a>. The creditor did not file a proof of claim and did not object to the plan. The debtors received
their discharge in December 1993.

On Feb. 2, 1994, the creditor filed a complaint in the bankruptcy court to determine the
validity of its lien on the debtors' residence. The bankruptcy court declined to address the effect
of the settlement agreement on the creditor's security interest. Rather, the court held that even
if the creditor possessed a valid lien as of the date of the debtors' petitions, confirmation of the
plan vested the residence in the debtors free and clear of the liens. The District Court for the
Eastern District of Virginia disagreed and held that confirmation of the plan simply vested in the
debtors the same interest in the residence that they had before filing the bankruptcy
petition—the residence subject to the creditor's lien. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 92</a>.

The debtors appealed. They argued that, under the terms of §1327, confirmation of their plan
voided the liens held by the creditor. Because the chapter 13 plan failed to address the creditor's
liens or make any provision for payment or satisfaction of such liens and only stated that the
creditor's claims were unsecured, the Fourth Circuit held that the liens passed through the
bankruptcy case intact. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 94</a>. The court further held that a bankruptcy discharge
extinguishes only in personam claims against debtors, but generally has no effect on in rem

claims against the debtors' property. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;, citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Home State Bank, 501 U.S. 78, 84,
111 S.Ct. 2150, 2154, 115 L.Ed.2d 66 (1991)</a>. The Fourth Circuit concluded that where a
plan does not "provide for" a creditor's lien, that lien passes through bankruptcy intact, absent
the initiation of an adversary proceeding to determine the validity, priority or extent of the
liens. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 93</a>. According to the Fourth Circuit, "a plan 'provides for' a claim or interest when
it acknowledges the claim or interest and makes explicit provision for its treatment." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 94</a>.

In response to the debtors' argument that the creditor failed to file a proof of claim or otherwise
object to the plan, the Fourth Circuit opined that, based on §506(d)(2), failure to file a proof
of claim is not the basis for avoiding the lien of a secured creditor. Furthermore, the court
concluded that it was unnecessary for the creditor to participate in the bankruptcy case because
unchallenged liens survive the discharge. The secured creditor need only look to the liens for
satisfaction of the debt. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 94</a>, citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Tarnow, 749 F.2d 464, 465 (7th Cir. 1984)</a>.

Most recently, the Fourth Circuit reaffirmed its commitment to, if not expanded its holding in,
the Cen-Pen decision in In re Dutchman. In Dutchman, the chapter 13 debtor sought a
declaratory judgment that the IRS's liens would be extinguished upon completion of the
payments specified to be paid to the IRS under its confirmed plan of reorganization (the
payments amounted to substantially less than the amount of the IRS's asserted secured claim).<a href="#3" name="3a">3</a>

That confirmed plan, however, listed the majority of the IRS' secured claim as a "Class II
Priority Claim." The plan also provided that the liens of the Class II creditors "shall be
considered released and of no effect" upon the payment of all "allowed claims" due them.
Notwithstanding the substantially reduced amounts called for in the plan to be paid to the IRS,
the debtor argued that the plan was binding on the IRS and thus the property subject to the IRS's
liens will vest in him free and clear of the liens upon payment of the requisite amounts set forth
in the plan.

The Fourth Circuit acknowledged that the IRS participated in the bankruptcy case by filing a
secured proof of claim. The court further acknowledged that the debtor's plan provided for
payment of the IRS's claims and that the IRS did not object to the plan, a copy of which it had
received, or attend the confirmation hearing. However, the court held that because the debtor
failed to commence an adversary proceeding to extinguish the IRS's lien, object to the proof of
claim filed by the IRS or in any way attempt to modify the IRS's lien, the debtor would not then
be allowed to avoid the lien on the grounds that its plan had "provided for" the IRS's claims.
According to the Fourth Circuit, simply attempting to "provide for" liens, and thereby
obtaining a favorable result by "camouflaging" the treatment of a secured creditor's liens, is
insufficient. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 189</a>. An "appropriate affirmative step" must be taken by the debtor to avoid
a lien. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; "In order to 'provide for' a creditor for purposes of §1327(c), the plan must, at a
minimum, clearly and accurately characterize the creditor's claim throughout the plan." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at
10</a>. In this case, the plan improperly characterized all of the IRS's claims as priority claims
and failed to give specific notice to the IRS of the debtor's intent to accord the liens less than full
protection. As a result, the Fourth Circuit held that the IRS's liens passed through the
bankruptcy case.

<h3>Survey of Other Cases</h3>

The District Court for the Eastern District of Pennsylvania held, in the case of <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Malvern
Federal Savings Bank, 189 B.R. 323 (E.D. Pa. 1995)</a>, that the liens held by a creditor survived
the chapter 13 bankruptcy case. The district court found that, although the proof of claim and
confirmed plan addressed the arrearage amounts, they both failed to address the entire debt
secured by the liens. Thus, the liens were not "property dealt with by the plan" under §1141,
and therefore were not extinguished. Coffin at 327. Similarly, the Bankruptcy Court for the
Eastern District of Pennsylvania held that the IRS' secured claims passed through the
bankruptcy case unaffected where the chapter 13 plan failed to provide for the claims. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Vandy Inc., 189 B.R. 342, 349 (Bankr. E.D. Pa. 1995)</a>. The confirmed plan referenced
priority tax claims; however, the IRS's claim was not a priority claim. Moreover, the
confirmed plan failed to reference the IRS in the class of secured creditors. Therefore, the
claims were not "property dealt with by the plan."

In Green Tree Financial Servicing Corp. v. Smithwick, the District Court for the Southern
District of Texas adopted the Penrod decision by holding that Green Tree was put on notice that
the confirmed chapter 13 plan might alter the terms of the payment underlying the lien when it
chose to participate in the bankruptcy case. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 420, 424 (S.D. Texas 1996)</a>.
Consequently, Green Tree had to abide by the confirmed plan, which altered the interest rate at
which the debtors would repay the secured claim.<a href="#4" name="4a">4</a>

The District Court for the Eastern District of Arkansas concluded that the secured claim of the
IRS passed through the bankruptcy case unaffected where the chapter 13 plan failed to address
it. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. United States of America, et al., 172 B.R. 95 (E.D. Ark. 1994)</a>. The court
discharged the personal liability of the debtors as to the IRS; however, the lien remained
enforceable.

In the case of <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Deposit Insurance Corp. v. Union Entities (In re Be-Mac Transportation
Co.), 83 F.3d 1020 (8th Cir. 1996)</a>, the Eighth Circuit held that the FDIC's lien was not
property dealt with by the plan nor was it extinguished upon confirmation because the FDIC did
not participate in the bankruptcy case. The court concluded that, because the bankruptcy court
ruled that the FDIC's second amended claim clarifying the status of the amended claim was
untimely, the FDIC did not participate in the case as a secured creditor and its lien was never
brought into the case. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1026</a>. The Penrod decision was also followed in the case of <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
v. United States, 101 F.3d 574 (8th Cir. 1996)</a>, which held that confirmation of a chapter 12
plan operates to avoid the liens of all participating secured creditors that are provided for by
the plan unless the terms of the plan provide otherwise. And in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Burton Securities, 202
B.R. 411, 420 (S.D. Texas 1996)</a>, the court followed Penrod and Be-Mac when it held that
because the creditor had participated in the debtors' chapter 11 bankruptcy and the plan did not
expressly preserve its lien, the lien was extinguished upon confirmation.

Bankruptcy courts in Iowa, Minnesota and Alabama all followed the Penrod decision in their
rulings in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Harnish, 224 B.R. 91 (Bankr. N.D. Iowa 1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Siemers, 205 B.R. 583
(Bankr. D. Minn. 1997)</a>; and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. American Health & Life Insurance Co., 203 B.R. 326
(Bankr. N.D. Ala. 1996)</a>, respectively, by holding that confirmation of the chapter 13 plan of
reorganization operates to avoid liens of all participating secured creditors who are provided
for in the plan. Similarly, in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re CIS Corp., 1997 WL 666265, *3-*4 (S.D.N.Y. Oct. 24,
1997)</a>, the District Court for the Southern District of New York held that because the creditor
neither filed a proof of claim nor had its claim provided for by the debtors' chapter 11 plan, the
creditor's pre-petition lien would survive bankruptcy.

The Bankruptcy Court for the District of Massachusetts held in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Winchell, 200 B.R. 734
(Bankr. D. Mass. 1996)</a>, that the creditor's lien was extinguished upon confirmation of the
debtor's plan pursuant to the express terms of the plan, even though the creditor failed to file a
proof of claim. The bankruptcy court reasoned that the circumstances of that case differed from
Penrod in that Penrod was governed by the general rule, while this case was governed by the
exception set forth in §1141(c) ("Except as otherwise provided in the plan or in the order
confirming the plan..."). <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 200 B.R. at 737</a>. Therefore, the plan and confirmation
order displaced the general rule. The bankruptcy court concluded that the estate property vested
in the debtor free and clear of any claims pursuant to the plan and confirmation order,
regardless of whether the creditor filed a proof of claim. The court noted that the creditor did
not dispute that the property at issue belonged to the debtor at the commencement of the case and
that the property became an asset of the bankruptcy estate.

<h3>Conclusion</h3>

The majority of the cases on the issue of whether pre-existing liens pass through bankruptcy
support the Penrod decision that a lien may be avoided or modified during the bankruptcy case
without an adversary proceeding, thus providing exceptions to the general rule. However, the
creditor must have participated in the proceeding or been provided adequate notice of the
debtor's intent to modify the lien, and the plan of reorganization or confirmation order must
specifically "deal with" the lien. It is the debtor's obligation to state expressly that the secured
creditor's liens are not passing through the plan unaffected and specify how the secured
creditor's claims are being treated.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Section 1141(c) of the Bankruptcy Code provides:

<blockquote>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 the plan, the property dealt with by the plan is free and clear of all claims and interests of creditors, equity security holders and
general partners in the debtor. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1141(c)</a>. <a href="#1a">Return to article</a></blockquote>

<a name="2">2</a> Similarly, §1327(c) of the Bankruptcy Code provides:

<blockquote>
Except as otherwise provided in the plan or in the order confirming the plan, the property vesting in the debtor under subsection (b) of this section
is free and clear of any claim or interest of any creditor provided for by the plan. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1327(c)</a>. <a href="#2a">Return to article</a>
</blockquote>

<a name="3">3</a> The parties stipulated
that, following the designated plan payments, the remaining amount of the IRS' secured claim would be $139,750.89. <a href="#3a">Return to article</a>

<a name="4">4</a> Reversed and remanded by the U.S. Court of Appeals for the Fifth Circuit to permit the bankruptcy court to apply a rebuttable presumption that the
contract rate was the appropriate post-confirmation interest rate to apply to the creditor's claim. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 211 (5th Cir. 1997)</a>. <a href="#4a">Return to article</a>

<hr>

</td>
<td valign="top" width="125">

</td>
<td width="5"><img src="/AM/graphics/spacer.gif" alt="" height="1" width="5">

Journal Authors

Mark D. Collins

Journal Date

Monday, November 1, 1999 - 12:00