Automatically Perfected Liens and Their Danger to Post-Bankruptcy Lenders

Following a chapter 11 case, lenders face significant risks associated with debtor-in-possession (DIP) loans or cash-collateral orders that provide for automatically perfected liens encumbering a debtor’s assets. Section 364(d)(1) authorizes a debtor to obtain financing secured by a lien on estate property, and bankruptcy courts regularly grant creditors automatically perfected liens on a debtor’s assets without the need to perfect such liens through the applicable state law system.

Automatically perfected judicial liens create a potentially serious problem for subsequent secured lenders who fail to discover the liens. Most lenders are not in the practice of searching busy chapter 11 case dockets for orders that could affect proposed collateral; lenders typically limit their searches to the existing state system for lien perfection. Failure to discover an automatically perfected judicial lien could result in a post-bankruptcy lender providing credit against assets already securing an existing obligation. Of course, this would result in a greater risk of a limited recovery for the post-bankruptcy lender in the event of a default or subsequent bankruptcy filing. This would be especially troubling where a bankruptcy court grants a creditor automatically perfected liens encumbering titled vehicles without the requirement that the creditor undertake the typical actions to perfect such liens through the vehicle title laws. Subsequent lenders or buyers of the vehicle would have no practical method of realizing that they are involved in a transaction regarding a vehicle that is subject to an automatically perfected judicial lien.

In reviewing this issue, it is important to understand how lien priority is determined. A creditor secures its obligation against a debtor’s assets by entering into a contract that authorizes the creditor to take the collateral assets if the debtor defaults.[1] A secured creditor’s attachment of its security interest to collateral concerns rights against a debtor with respect to certain collateral,[2] and perfection concerns a secured creditor’s rights against a third party who may also have an interest in the collateral assets.[3] Generally, conflicting liens rank in priority in time of perfection, and this could create a serious notice issue for a lender that is unaware of a lien that was automatically perfected within a bankruptcy case.[4]

The limited case law regarding this issue supports that automatically perfected judicial liens are enforce- able against third parties. The Federal Rules of Bankruptcy Procedure also provide support for automatically perfected judicial liens by requiring that financing motions describe the nature and extent of, among other things, “a waiver or modification of the applicability of nonbankruptcy law relating to the perfection of a lien on property of the estate.”[5] Courts that have considered challenges to automatically perfected judicial liens have indicated that such liens would hold up against a subsequent secured lender, even if the lender was not involved in the bankruptcy case.

Small v. Beverly Bank

In Small v. Beverly Bank, in order to allow a debtor’s use of cash collateral, the bankruptcy court granted a bank an automatically perfected super-priority lien against a debtor’s post-petition personal property assets.[6] While the debtor’s bankruptcy case was still open, a supplier provided lumber to the debtor.[7] There- after, the case converted to chapter 7, and the bank exercised its lien rights against the lumber to reduce its debt.[8] The supplier argued that the bank’s lien had not been properly perfected under applicable state law and that the supplier held an equitable lien that was superior to the bank’s rights in the lumber.[9]

The Seventh Circuit Court of Appeals made it clear that “the Bankruptcy Code offers substantial protection to a lender willing to take the risk of extending credit to a trustee or [DIP]” and found the bankruptcy court’s order granting an automatically perfected lien to be dispositive of the issue.[10] In reaching this conclusion, the court relied on four different Bankruptcy Code sections: (1) § 101(36), a definitional section, defining “judicial lien” as a “judgment, levy, sequestration, or other legal or equitable process or proceeding”; (2) § 363(e), which grants protections to creditors that have an interest in a debtor’s property while the debtor remains a DIP; (3) § 364(d)(1)(B), which provides that if the DIP is authorized to continue operating, a bankruptcy court may authorize new credit secured by a lien against estate property if there is adequate protection of existing interestholders; and (4) § 507(b), which provides a higher-priority administrative claim to creditors that were granted adequate protection with a lien on the debtor’s property and if, notwithstanding such protection, the creditor has a claim allowable under § 363 from the use, sale or lease of such property or from the granting of a lien under § 364(d).[11]

Waste Conversion Techs.

In the Waste Conversion Techs. case, due to concerns about notice to third parties, the bankruptcy court denied a term in a cash-collateral order providing for automatic perfection of a secured creditor’s replacement liens in cash, inventory, accounts receivable, equipment, real property and titled motor vehicles.[12] On appeal, the district court reversed, and like Small v. Beverly Bank, invoked § 101(36) (the definitional section regarding “judicial lien”) and § 363(e) regarding adequate protection to creditors with an interest in

a debtor’s property.[13] The court acknowledged the potential lack of notice to third parties that a lien exists that is not recorded

in the typical places.[14] Yet the court stated that “any reasonable creditor investigating the debtor’s creditworthiness will become aware of the debtor’s prior bankruptcy, and thus can determine from the court record the existence of any judicial liens [that] may have been granted to bankruptcy creditors.”[15] The district court also noted that nothing limited the bankruptcy court, as a condition of dismissing the bankruptcy case, from requiring secured creditors to take steps to ensure that notice of its judicial lien be recorded in the appropriate place.[16]

Vandy

In Vandy, the bankruptcy court entered a cash-collateral order granting a stipulation between a debtor and a bank that provided the bank with an automatically perfected security interest in a debtor’s pre-petition assets.[17] Although the bank was listed as a secured creditor in the debtor’s confirmed chapter 11 reorganization plan, the plan did not mention the bank’s post-bankruptcy security interest that was granted in the cash-collateral order.[18] Prior to completing its plan, the debtor re- led for bankruptcy and initiated a chapter 7 case.[19]

In the chapter 7 case, the bank argued that even if the Internal Revenue Service (IRS) possessed a first-priority post-bankruptcy lien, the stipulation from the debtor’s prior bankruptcy case preserved the bank’s senior-lien status.[20] The bankruptcy court held that the bank’s stipulation with the debtor had terminated by operation of law upon confirmation of the debtor’s plan because the stipulation terms were not specifically incorporated into the plan.[21] Accordingly, the bank no longer retained the automatically perfected security interest created by the cash-collateral order, and the IRS’s lien prevailed in priority against the debtor’s assets.[22]

Other Similar Automatically Effective Liens

Automatically perfected liens outside of a formal state law perfection system are not without precedent. In Hilde, the Ninth Circuit Court of Appeals determined that California state law permitted a bank to create an automatically effective lien on a judgment debtor’s nonexempt personal property by serving the debtor with an examination order.[23] The trustee in the debtors’ chapter 7 case argued that the bank’s lien was not perfected.[24] The trustee noted that he and other creditors did not have notice that the bank had served the debtors with an order for appearance, and therefore, the lien was secretive in nature.[25]

In denying the trustee’s attempt to avoid the bank’s lien under § 544, the court concluded that the bank was not required to perfect the lien under state law, and accordingly, perfection of the lien was not required for the lien to be effective under the Bankruptcy Code.[26] The court reasoned that the trustee and creditors

could take actions to find these types of automatically effective liens by asking debtors questions about lawsuits and searching court records.[27]

Practical Considerations

Based on these reported cases, an automatically perfected lien created in a bankruptcy proceeding will likely hold up against an attack by a subsequent lienholder. This appears to be the case even if the subsequent lienholder was not a participant in the bankruptcy proceeding and did not have notice of the lien. Moreover, because courts have referred to these types of liens as “judicial liens” under § 101(36) rather than contracted security interests, the requirements and limitations of Article 9 of the Uniform Commercial Code (UCC) are likely not applicable.[28]

As is often the practice in bankruptcy cases, automatically perfected judicial liens can encumber more than the UCC permits. For example, liens created by bankruptcy courts can encumber titled vehicles that do not constitute inventory under the UCC,[29] cash in financial accounts without account control agreements[30] or even copyrights that would normally require a ling with the U.S. Copyright Office.[31] In addition to existing outside of the state law lien-perfection system, these automatically perfected judicial liens arguably remain in effect without renewal periods and do not require release or amendment documents to be led when there are changes regarding collateral or interested parties. These unique issues create traps for unwary subsequent lenders or purchasers that fail to exercise the utmost scrutiny when dealing with a post-bankruptcy debtor.

Case law regarding challenges to automatically perfected judicial liens has not been rmly established, and lenders exclusively relying on such liens risk costly litigation with subsequent lenders and bankruptcy trustees seeking to avoid liens under § 544.[32] The typical and best practice for lenders and any party granted a security interest or lien in a bankruptcy case is to request an automatically perfected lien and the authority to le any documents that are necessary to immediately comply with the applicable state lien perfection system. In order to avoid losing lien rights like the bank in Vandy, lenders should also ensure that any agreements during a bankruptcy case are specifically incorporated into any reorganization plan.[33]

As for lenders providing credit to parties that previously led for bankruptcy, these lenders should exercise increased scrutiny to ensure that they are getting the benefit of their bargain. Lenders should consider conducting searches for bankruptcy cases and searches within such cases for orders involving the use of cash-collateral and replacement liens or changes to existing liens, secured financing, settlements and stipulations that could include lien issues, and plan-confirmation issues that could involve changes to liens.

Unfortunately, even discovering an order that involves lien issues will likely not be enough for a post-bankruptcy lender without the assistance of experienced bankruptcy counsel. There is no perfect solution to this issue, but the best way to prevent most of the potential problems regarding notice to subsequent

lenders of automatically perfected judicial liens is for courts to follow the solution proposed by the court in Waste Conversion Techs.[34] This solution would involve bankruptcy courts, including a term in any orders to dismiss or close bankruptcy cases (or even in orders to convert cases) requiring that creditors take the necessary steps to ensure that a notice of any automatically perfected judicial liens is provided through the applicable state lien perfection system.[35]