March 2014

Lienholder Status in Bankruptcy Cases — Unaffected Notwithstanding Untimely Proof of Claim

Attorney Lesley Anne Hawes examines a recent Eighth Circuit Court of Appeals opinion reaffirming the established principle that secured creditors’ liens pass through bankruptcy unaffected. She notes that the decision is helpful to secured creditors because it confirms at the federal circuit level this important attribute of lienholder status in bankruptcy cases.

Lesley Anne Hawes,Partner,McKenna, Long & Aldridge

Lesley Anne Hawes,
McKenna, Long & Aldridge

On November 4, 2013, the Eighth Circuit Court of Appeals issued a published opinion rejecting a challenge to the secured creditor’s lien by the joint Chapter 13 debtors, upholding lower court rulings that the disallowance of an untimely proof of claim filed by the secured creditor does not alone provide a basis to avoid the secured creditor’s lien. The decision in Shelton v. Citimortgage, Inc. (In re Shelton), 753 F. 3d 747 (8th Cir. 2013) will be helpful to secured creditors, as it provides a recent published federal circuit level decision confirming this important attribute of lienholder status in bankruptcy cases.

Factual Context of the Dispute

The dispute arose in a joint Chapter 13 bankruptcy case filed by Gary and Elizabeth Shelton (debtors). The bankruptcy court set a claims bar date for creditors to file proofs of claim. Citimortgage, Inc. (Citimortgage) held a lien on the primary residence of the debtors. The secured creditor failed to file a proof of claim within the bar date. Instead, Citimortgage filed its proof of claim almost seven months after the bar date. In response, the debtors filed an objection to the allowance of the claim. The only basis for disallowance of the secured claim asserted by the debtors was untimeliness, since it was filed long after the bar date. The secured creditor and the debtors later stipulated to entry of an order for disallowance of the secured claim.

After the claim was disallowed, the debtors filed an adversary proceeding against Citimortgage seeking an order declaring that Citimortgage’s lien against the residence was void. Neither the debtors’ objection to the secured claim, nor the complaint in the adversary proceeding, challenged the substantive validity of the underlying debt or the lien securing it. Instead, the only basis the debtors asserted for avoidance of the Citimortgage lien was that the Citimortgage claim had been disallowed. Citimortgage filed a motion to dismiss the debtors’ avoidance action. Both the bankruptcy court and the bankruptcy appellate panel rejected the debtors’ claim to void the lien, granting the secured creditors motion to dismiss. The debtors appealed. The Eighth Circuit also rejected the debtors’ position, affirming the lower court orders dismissing the debtors’ avoidance action.

The Legal Framework

The legal basis on which the debtors relied to try to void the secured creditor’s lien is §506(d) of the Bankruptcy Code. That provision states, “To the extent that a lien secured a claim against the debtor that is not an allowed secured claim, such lien is void unless — (1) such claim was disallowed only under §502(b)(5) [generally, claim for an unmatured debt that is excepted from discharge] or 502(e) [generally, claim for reimbursement or contribution] of this title; or (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 §501 of this title.”

The debtors argued that the plain language of §506(d) states that where a claim has been disallowed, as Citimortgage’s claim was in that case, the lien securing the claim should be voided. Further, the debtors pointed out that the exception set forth in §506(d)(2) did not apply because Citimortgage in that case had in fact filed a proof of claim, and the disallowance of the claim was not “due only to the failure” of the secured creditor to file a proof of claim.

The Eighth Circuit admitted the “superficial” appeal of the debtors’ avoidance theory based on the text of the statute. While not explicitly referenced in the decision, the debtors’ position has some additional “superficial” support in the language of the legislative history of §506(d) when it was enacted as part of the Bankruptcy Code of 1978. The legislative history states in part: “Subsection [506](d) permits liens to pass through the bankruptcy case unaffected. However, if a party in interest requests the court to determine and allow or disallow the claim secured by the lien under §502 and the claim is not allowed, then the lien is void to the extent the claim is not allowed.” H.R. Rep. 95-595, 95th Cong., 1st Sess. (1977).

The Eighth Circuit nevertheless found the debtors’ position to be contrary to longstanding bankruptcy principles and unsupported by any evidence of congressional intent to make a radical departure from pre-Bankruptcy Code law to permit a secured creditor’s lien to be voided merely because it filed an untimely claim. The court looked to decisions of the Fourth and Seventh Circuits, which rejected similar arguments, finding the reasoning of those decisions to be persuasive and well-founded. For example, the Seventh Circuit in In re Tarnow, 749 F. 2d 464, 465-67 (7th Cir. 1984) ruled that such a statutory construction would lead to the absurdity that a secured creditor who files an untimely proof of claim would be severely penalized through the loss of its lien, while a secured creditor who simply ignores the bankruptcy and files no claim would retain its lien based on the second exception to §506(d) that prohibits the court from voiding the secured creditor’s lien where the secured creditor does not have an allowed secured claim based solely on its failure to file a proof of claim.

The Eighth Circuit in Shelton found this analysis to be consistent with United States Supreme Court precedent in Dewsnup v. Timm, 502 U.S. 410, 112 S. Ct. 773 (1992), in which the Supreme Court reaffirmed the general proposition that valid liens pass through bankruptcy unaffected and also stated that there is no indication that Congress intended to alter that pre-Bankruptcy Code principle. The more recent Fourth Circuit decision, In re Hamlett, 322 F. 3d 342, 347-50 (4th Cir. 2003), cited by the court in Shelton, found the avoidance of a secured creditor’s lien based on the untimeliness of filing a secured claim would lead to a highly inequitable result inconsistent with congressional intent. The fact that liens pass through bankruptcy unaffected is further supported by Rule 3002 of the Federal Rules of Bankruptcy Procedure, which provides that only unsecured creditors and equity security holders are required to file proofs of claim.

The Take Away

While the Eighth Circuit’s decision in Shelton resulted in a happy ending for the secured creditor and is consistent with similar holdings of the Fourth and Seventh Circuits, the fact that the debtors’ argument for voiding the lien was stated to have “superficial appeal” based on a plain-language interpretation of the text of §506(d), and the fact that the issue has resulted in extensive litigation through appeals at the circuit court level in these circuits, should be troubling to secured creditors. While an obvious response to these cases is for secured creditors to timely file proofs of claim within the bar date to avoid these disputes, filing a proof of claim should not be an automatic and invariable practice in bankruptcy cases, because filing a proof of claim may subject a creditor to the jurisdiction of the bankruptcy court to determine the merits of the creditor’s claim against the debtor as well as claims the debtor may have against the creditor.

There can be tactical reasons for a secured creditor to not file a claim in a specific bankruptcy case, particularly where the creditor may expect little if any distribution of assets from the bankruptcy estate and where the creditor is at risk of being sued for recovery of preferential transfers or for claims arising out of the underlying debt. Filing a proof of claim may also potentially result in the waiver of certain procedural rights the creditor might otherwise have in an action by the debtor against the creditor, such as the right to have a final judgment or order entered by the district court as an Article III judge and the right to a jury trial. The facts and circumstances of each case, including the chapter under which the bankruptcy case is filed, the likelihood that funds will be paid or distributed to creditors through the bankruptcy, and the extent to which there are disputes, claims and counterclaims likely to be asserted by the debtor against the creditor, should be considered.

Lesley Anne Hawes, a partner in the Los Angeles office of McKenna Long & Aldridge, specializes in the representation of secured and unsecured creditors in bankruptcy proceedings and in the representation of federal equity receivers appointed in civil enforcement actions by federal agencies such as the FTC and SEC.