Seventh Circuit: Secured Creditor that Participated in Chapter 11 Case Bound by Terms of Confirmed Plan that Extinguished Lien

A hornbook principle of U.S. bankruptcy jurisprudence is that valid liens pass through bankruptcy unaffected. This long-standing principle, however, arguably conflicts with section 1141(c) of the Bankruptcy Code, which provides that, under certain circumstances, "the property dealt with by [a chapter 11] plan is free and clear of all claims and interests of creditors," except as otherwise provided in the plan or the order confirming the plan. Several courts have attempted to reconcile the pass-through principle with the statute by requiring the creditor to "participate in the reorganization" as a prerequisite to the application of section 1141(c). This judicial gloss raises the question of whether the terms of a chapter 11 plan providing for the treatment of secured creditor claims are binding on nonparticipating secured creditors.

The U.S. Court of Appeals for the Seventh Circuit recently addressed the participation question in In re Aguirre, 37 F.4th 427 (7th Cir. 2022). The court affirmed a lower court ruling that, because a tax lien creditor was "a party in the bankruptcy case," the creditor's tax lien did not pass through bankruptcy unaffected by the terms of a confirmed chapter 11 plan that extinguished the lien in exchange for an agreement to pay the creditor's secured claim in full in cash. The court also vacated an order directing a state court to vacate a tax deed issued to the creditor.

Section 1141(c)

Section 1141(c) states:

Except as provided in subsections (d)(2) [debts of individual debtors that are excepted from discharge under section 523] and (d)(3) [denial of discharge for, among others, liquidating corporations] 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. 

With respect to liens and security interests, section 1141(c) means that "unless the plan of reorganization, or the order confirming the plan, says that a lien is preserved, it is extinguished by the confirmation." In re Penrod, 50 F.3d 459, 463 (7th Cir. 1995); accord JCB, Inc. v. Union Planters Bank, NA, 539 F.3d 862 (8th Cir. 2008). But see Bowen v. United States (In re Bowen), 174 B.R. 840 (S.D. Ga. 1994) (holding that a "lien" is not an "interest" within the meaning of section 1141(c); any release of a lien must rely on section 506(d)).

Concern regarding the impact of lien-stripping has led a number of (principally appellate) courts to add a judicial gloss to section 1141(c) requiring the secured creditor to have "participated in the reorganization" before its lien will be deemed extinguished. See generally Collier on Bankruptcy ¶ 1141.04[1] (16th ed. 2022) (discussing cases).

In Penrod—apparently, the first decision to add the participation gloss to section 1141(c)—the debtor's chapter 11 plan made provision for payment of a secured claim, but neither the plan nor the order confirming it stated whether the lien would be extinguished. The Seventh Circuit, acknowledging the "old saw" that liens pass through bankruptcy unaffected, nevertheless concluded that "when lienholders participate in a bankruptcy proceeding, and especially in a reorganization, they know that their liens are likely to be affected, and indeed altered." Penrod, 50 F.3d at 462. It ruled that liens are "interests" covered by section 1141(c) and that "unless the plan of reorganization, or the order confirming the plan, says that a lien is preserved, it is extinguished by the confirmation … provided, we emphasize, that the holder of the lien participated in the reorganization." Id. at 463.

In Elixir Indus., Inc. v. City Bank & Trust Co. (In re Ahern Enters., Inc.), 507 F.3d 817 (5th Cir. 2007), the Fifth Circuit held that four conditions must be met for a lien to be voided under section 1141(c): (i) the plan must be confirmed; (ii) the collateral must be dealt with by the plan; (iii) the lienholder must participate in the reorganization; and (iv) the lien must not be preserved under the plan. 

In City of Concord, N.H. v. Northern New England Telephone Operations LLC (In re Northern New England Telephone Operations LLC), 795 F.3d 343 (2d Cir. 2015), cert. denied, 577 U.S. 1009 (Nov. 30, 2015), the Second Circuit adopted a similar test, ruling that a lien is extinguished by a chapter 11 plan if: (i) the text of the plan does not preserve the lien; (ii) the plan is confirmed; (iii) the property encumbered by the lien is "dealt with" by the plan; and (iv) the secured creditor participated in the bankruptcy case.

The New England Telephone court explained that section 1141(c) provides a caveat to the long-standing "background" rule that "liens pass through bankruptcy unaffected." Id. at 346 (citing Dewsnup v. Timm, 502 U.S. 410, 417 (1992); Penrod, 50 F.3d at 461). The court also stated that the phrase "interests of creditors" in section 1141(c) includes liens and that, despite the absence of any express reference to lien extinguishment in section 1141(c), courts have uniformly held that confirmation of a chapter 11 plan can act to extinguish liens. Id. at 346-47 (citing In re Chrysler LLC, 576 F.3d 108, 126 (2d Cir.) (citing cases), vacated as moot sub nom. Ind. State Police Pension Tr. v. Chrysler LLC, 558 U.S. 1087 (2009)).

The Second Circuit concluded that a requirement of lienholder participation "is located squarely within" section 1141(c). It explained that "[t]he text of the Code allows a plan to extinguish a lien only if the underlying property is 'dealt with,' and that condition cannot be fairly satisfied in the absence of the interested parties, including the security holder." Id. at 348.

According to the Second Circuit, this conclusion is reinforced by the interaction between section 1141(c), which permits certain liens to be extinguished, and section 506(d), which preserves certain liens. Section 506(d) provides in relevant part:

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, the Second Circuit observed:

Section 506(d)(2) … preserves liens of non-participating lienholders whose liens would otherwise be extinguished solely as a result of their non-participation. If extinguishment under § 1141(c) is consistent with this provision (as we must and do assume), then § 1141(c) must apply only to liens located outside of § 506(d)(2)'s safe harbor. Reading the "dealt with" limitation in § 1141(c) to include only participating lienholders harmonizes these provisions.

Id. at 348 (citing 8 Collier on Bankruptcy ¶ 1141.04[1] (16th ed. 2013)).

Other circuit courts have similarly required secured creditor participation in the case as a condition to lien extinguishment under section 1141(c). See, e.g., In re Barton Indus., Inc., 104 F.3d 1241, 1245 (10th Cir. 1997); FDIC v. Union Entities (In re Be-Mac Transport Co.), 83 F.3d 1020, 1025-26 (8th Cir. 1996); see also Airadigm Communications, Inc. v. FCC (In re Airadigm Communications, Inc.), 519 F.3d 640, 648 (7th Cir. 2008) (reaffirming the Penrod approach).

Although the four-part Ahern test has been adopted in one form or another by many other courts, relatively few have examined what constitutes "participation" for purposes of the test. See, e.g., In re Vitro Asset Corp., 656 F. App'x 717, 724 (5th Cir. 2016) (a late-filed amended proof of a tax lien claim amounted to participation); New England Telephone, 795 F.3d at 350 (a municipality filed several proofs of claims "closely related" to tax lien claims, thereby assuring that "the procedural safeguards embedded in the 'dealt with' language of §1141(c) [were] satisfied"); Acceptance Loan Co., Inc. v. S. White Transp., Inc. (In re S. White Transp., Inc.), 725 F.3d 494, 498 (5th Cir. 2013) (the level of participation necessary to trigger extinguishment of a lien under section 1141(c) "requires more than mere passive receipt of effective notice" of the chapter 11 case; instead, participation "connotes activity, and not mere nonfeasance"); Ahern, 507 F.3d at 823 (filing a proof of claim as an unsecured priority creditor constitutes participation); In re Regional Bldg. Systems, Inc., 254 F.3d 528 (4th Cir. 2001) (participation is found where the creditor sat on the unsecured creditors' committee and filed a proof of unsecured claim, yet failed to object to confirmation of the plan after the estate realized settlement proceeds that would have rendered the creditor's claim partially secured); Greater Am. Land Res., Inc. v. Town of Brick, 2012 WL 1831563 (D.N.J. May 17, 2012) (no participation where the creditor taxing authority did not file a proof of claim and the plan neither listed nor treated the tax claim); In re Omega Optical, Inc., 476 B.R. 157, 165 (Bankr. E.D. Pa. 2012) (to the extent participation is required by section 1141(c), filing a proof of claim, then entering a notice of appearance of counsel, constitutes participation); In re WorldCom, Inc., 382 B.R. 610 (Bankr. S.D.N.Y. 2008) (the secured creditor participated by filing a proof of claim).

The Seventh Circuit revisited the question of secured creditor "participation" for purposes of section 1141(c) in Aguirre. 

Aguirre

Ramon and Bertha Aguirre (the "debtors") owned a restaurant property in Illinois. The property acted as collateral for a $1.3 million loan provided by a commercial bank (the "lender").

After the debtors failed to pay their 2010 real estate taxes on the property, the county sold the tax lien debt to Wheeler Financial, Inc. ("Wheeler"). Wheeler continued to pay the property taxes in subsequent years.

The debtors filed for chapter 11 protection in the Northern District of Illinois on June 30, 2014. They did not list either the county or Wheeler as a creditor. In August, at the lender's request, the bankruptcy court issued an order directing the debtors to pay 2013 real estate taxes on the property—a debt that was not purchased by Wheeler. In connection with its motion, the lender informed the court that the debtors had not paid taxes on the property in years and attached an exhibit to its court submissions identifying Wheeler as the holder of the tax debt.

Wheeler did not file a claim in the chapter 11 cases.

The debtors filed a chapter 11 plan in November 2014. The plan classified the county's tax lien claim, but not in any detail. The plan did not mention Wheeler. 

Wheeler filed a petition for a tax deed in state court on December 2014. Although served with the summons, the debtors did not file an appearance in the case and defaulted. Wheeler did not serve the lender with a summons.

Also in December 2014, the debtors filed an amended chapter 11 plan that listed the county and Wheeler as the holders of a secured tax lien debt in the amount of $40,000. The debtors did not provide notice of filing of the plan or the bankruptcy to Wheeler. The debtors also listed Wheeler as a creditor in a second amended plan filed in February 2015, but never notified Wheeler.

In late February 2015, the debtors filed a notice with the bankruptcy court indicating that plan ballots had been provided to Wheeler and the county. Wheeler later informed the court that it received a ballot and certain other notices "on or about" March 1, 2015. However, Wheeler never voted on the plan. 

In April 2015, the bankruptcy court confirmed the chapter 11 plan, as amended at Wheeler's request to require the debtors to pay the tax lien debt to Wheeler within six months. The debtors defaulted on the plan by failing to make the payment when due.

In November 2015, Wheeler filed a motion for relief from the automatic stay to pursue its state court litigation, arguing that the debtors' post-confirmation payment default under their chapter 11 plan was "cause" for such relief. In connection with the motion, Wheeler's attorney acknowledged that Wheeler was a party in the bankruptcy case, but was uncertain how and when it became a party. However, Wheeler's attorney argued that Wheeler's tax lien passed through the bankruptcy unaffected and that it was not bound by the terms of the confirmed plan. Wheeler filed several other pleadings in the bankruptcy and district courts thereafter.

In December 2015, the debtors filed a motion to modify the plan to extend the due date for their payment to Wheeler by six months and to provide a guaranty of such payment by the lender. At a January 2016 hearing, the debtors and the lender offered to pay Wheeler $50,000 immediately, rather than within the proposed six-month extension. Nonetheless, in April 2016, the bankruptcy court granted the motion to lift the stay and denied the motion to modify the plan.

In May 2016, the lender appealed the stay relief order. However, the state court issued a tax deed to Wheeler before the appeal could be heard. 

In January 2017, the district court on appeal held that after the plan was confirmed, "Wheeler no longer had a lien on the Debtors' restaurant property." In re Aguirre, 565 B.R. 646, 654 (N.D. Ill. 2017). Accordingly, the district court wrote, "it was an abuse of discretion for the bankruptcy court to lift the stay and permit Wheeler to pursue legal action in the state court." Id. The district court vacated the bankruptcy court's order modifying the automatic stay and remanded the case below. It also vacated the bankruptcy court's order denying the debtors' motion to modify the plan without discussing the merits of that denial. 

Wheeler appealed the district court's decision to the Seventh Circuit, which ultimately dismissed the appeal for lack of appellate jurisdiction after determining that the district court's decision was not a final and appealable order. 

On remand, the lender filed a motion in the bankruptcy court for an order directing the state court to vacate the tax deed. The bankruptcy court, retroactively imposing the automatic stay, granted the motion, and the state court later vacated the tax deed. The debtors then filed a motion to modify their chapter 11 plan to provide for payment in full of Wheeler's tax debt within seven days. The court granted that motion as well as a motion to stay Wheeler from renewing its state court litigation seeking a tax deed on the restaurant property. Wheeler appealed all of the bankruptcy court's orders. 

The district court affirmed the stay order and the plan modification order, but vacated the tax deed order. Among other things, the district court held that it would not disturb the lower court's determination that Wheeler no longer had a lien on the property after confirmation of the plan. See In re Aguirre, 2021 WL 3674612, at *4 (N.D. Ill. Aug. 19, 2021). The district court vacated the tax deed order because it was based on an erroneous legal conclusion (i.e., that a tax deed granted while a stay was not in effect, but was later granted retroactively, is void ab initio). 

Wheeler appealed the district court's order regarding the extinguishment of its tax lien to the Seventh Circuit. The lender appealed vacatur of the tax deed order. 

The Seventh Circuit's Ruling 

A three-judge panel of the Seventh Circuit affirmed. 

Writing for the panel, U.S. Circuit Judge Frank H. Easterbrook noted at the outset of his opinion that "[l]itigants' indifference to procedures has made a mess of this bankruptcy proceeding." 

Judge Easterbrook explained that, if Wheeler was not bound by the plan, its lien would pass through bankruptcy, and the plan would need to be revised "to eliminate all Wheeler-specific causes." Aguirre, 37 F.4th at 429. Moreover, he noted, if this were so, the bankruptcy case would not be over, and the appeal would have to be dismissed for lack of jurisdiction because the district court's order would not be final and appealable. 

However, Judge Easterbrook concluded that Wheeler was bound by the terms of the confirmed chapter 11 plan because it was a party in the bankruptcy case, "even though Wheeler did not become a party through the means normally employed for that purpose." According to the judge, although Wheeler did not vote on the plan, "it negotiated for better terms, got the terms it sought, accepted the plan's confirmation as a fait accompli, and claimed rights under it." Those steps, he wrote, "effectively consent[ed] to have the lien replaced by a cash payment and waive[d] any entitlement to better or earlier notice." Id. Judge Easterbrook further noted that "[t]he confirmed plan knocks out any entitlement that Wheeler may once have had to obtain a tax deed and foreclose on its lien," provided Wheeler receives the payment it is entitled to under the plan. Id. at 431. 

Outlook

Aguirre is consistent with the Seventh Circuit's earlier rulings in Penrod and Airadigm that, if it participates in a chapter 11 case, a secured creditor will be bound by the terms of a confirmed plan in that case. In Aguirre, the confirmed plan extinguished the secured creditor's lien in exchange for a cash payment. Although the court does not mention section 1141(c) in its ruling, it assumes that participation in the case (or, in its parlance, "becoming a party") is necessary before the confirmed plan can be binding on the secured creditor.  

The problem with this approach is that section 1141(c) does not expressly include a case participation requirement. Reading the provision to mandate such a requirement means that a secured creditor cannot be stripped of its lien under section 1141(c), even if it receives notice of the chapter 11 plan and deliberately ignores it, unless the creditor actively participates in the case by, among other things, filing a proof of claim or, as in this case, negotiating for better treatment of its claim under a plan. 

Thus, absent active participation by the secured creditor, a plan proponent may not be permitted to modify or avoid the creditor's lien solely through the plan confirmation process, but instead may be required to object affirmatively to the secured claim or initiate an adversary proceeding to challenge the lien. Given this, the participation requirement means that a secured creditor can opt to "wait in the wings" during the bankruptcy case and then proceed to exercise its remedies in a more favorable forum after confirmation of a plan, without regard for the plan's terms. 

As suggested in an article written shortly after the Second Circuit issued its ruling in New England Telephone, "[t]wo possible solutions to this problem are evident." See Dan B. Prieto, "Problems in the Code: Power to Lien-Strip Through a Plan," 34 Am. Bankr. Inst. J. 26 (Mar. 2015). First, courts could follow the Supreme Court's rationale in United States Aid Funds v. Espinosa, 559 U.S. 260 (2010), and allow lien-stripping under a chapter 11 plan, so long as notice to the secured creditor satisfies due process. The creditor's rights would be safeguarded because it could object to a plan that impermissibly treats its secured claim. However, "if the creditor does not object, the terms of a chapter 11 plan would be binding and, pursuant to the plain language of § 1141(c), liens would be extinguished." Second, lawmakers could solve the problem by amending section 1141(c) "to clarify that a specified degree of secured creditor participation in a chapter 11 case is or is not a precondition to lien-stripping under a confirmed plan." 

However, courts have persisted in imposing a participation requirement, and Congress has to date declined to amend section 1141(c).