On August 5, 2013, the US Court of Appeals for the Fifth Circuit, in Acceptance Loan Co., Inc. v. S. White Transportation., Inc. (In re S. White Transportation, Inc.), affirmed a district court decision that a secured creditor's mere receipt of notice of a debtor's bankruptcy without any activity does not satisfy the participation requirement necessary to void a lien upon confirmation of a plan of reorganization under section 1141(c) of the Bankruptcy Code.

On June 14, 2012, the US District Court for the Southern District of Mississippi found, in Acceptance Loan Co., Inc. v. S. White Transportation, Inc. (In re S. White Transportation, Inc.), that a lender's lien was not voided upon confirmation of the debtor's Chapter 11 plan, reversing a prior decision and order of the US Bankruptcy Court for the Southern District of Mississippi (for more information on the facts of this case, see Legal Update, In re S. White Transportation: Creditor's Participation Beyond Receipt of Bankruptcy Notice Required to Void its Lien).

Secured creditors are generally allowed to ignore bankruptcy proceedings without endangering their liens. However, section 1141(c) of the Bankruptcy Code provides an exception to this general rule, allowing an existing lien to be extinguished if the plan or confirmation order otherwise provides. The Fifth Circuit has held that this requires the following four conditions be satisfied:

(See Elixir Indus., Inc. v. City Bank & Trust Co. (In re Ahern Enters., Inc.)).

The Bankruptcy Court held that the third condition, that the lien holder must participate in the reorganization, was satisfied by the lender receiving notice of the debtor's bankruptcy. Therefore, that Court determined that the lender's lien was voided by virtue of the Chapter 11 plan confirmation process.

On appeal, the District Court ruled that mere notice of a bankruptcy proceeding does not satisfy the participation requirement necessary to void a lien under section 1141(c). It held that a higher level of participation is required and ruled that the lender's lien survived confirmation of the plan.

The lender appealed the District Court's ruling to the Fifth Circuit.

The Fifth Circuit affirmed the District Court's decision and ruled that passive receipt of notice of a debtor's bankruptcy is insufficient to satisfy the participation requirement of section 1141(c) to void a lien upon confirmation of a plan.

The Fifth Circuit noted that its decision in In re Ahern Enterprises merely recognized a split among courts regarding the necessity of active participation to void a lien, but did not provide a clear answer regarding the extent of participation necessary. Providing that clarity, the Fifth Circuit explained that participation connotes activity, noting that Black's Law Dictionary defines "participation" as "the act of taking part in something, such as partnership, a crime, or a trial."

In addition, the Fifth Circuit pointed out that in addressing similar issues, both the Seventh Circuit and Eight Circuit Courts of Appeal have required a more active level of participation to void a lien (see In re Penrod; FDIC v. Union Entities (In re Be-Mac Transp. Co.)). It also distinguished a case in which a Maryland bankruptcy court stated that notice alone satisfies the participation requirement by noting that the secured creditor in that case was extensively involved in the bankruptcy proceeding, filed a proof of claim and served on a creditors' committee (see In re Reg'l Bldg. Sys., Inc., aff'd by Universal Suppliers, Inc. v. Reg'l Bldg. Sys., Inc. (In re Regl Bldg. Sys. Inc.)). The Fifth Circuit's inability to find a case in which a secured creditor's lien was voided without the creditor's involvement, other than its passive receipt of notice, provided further support for the Fifth Circuit's holding that voiding a creditor's lien requires the creditor to actively participate in the bankruptcy case.

The Fifth Circuit's decision clarifies the standard for debtors seeking to void liens. It provides that creditors who merely receive notice of a bankruptcy will preserve their liens unless, assuming the other Ahern conditions are satisfied, they take some action in the bankruptcy proceedings, such as filing a proof of claim or other pleading in the case. This interpretation inserts a judicial gloss to the statutory language of the Bankruptcy Code which merely states that "property dealt with by a plan is free and clear of all claims and interests" by interpreting it to mean that "property dealt with by a plan is free and clear of all claims and interests of parties who actively participated in the bankruptcy case." While this interpretation is favorable for secured creditors, it may be detrimental to the bankruptcy process because it enables these creditors to bypass the Chapter 11 plan by merely neglecting to actively participate.

For more information on the Chapter 11 plan process, see Practice Note, Chapter 11 Plan Process: Overview.