Contributed by Katherine Doorley and Christopher Hopkins
One of the benefits of a bankruptcy discharge is that the debtor’s personal liability for discharged debts is extinguished. Courts have struggled, however, with how to deal with secured claims in light of two seemingly conflicting concepts: the requirement in most bar date orders that all creditors file proofs of claim and the lingering principle, not fully articulated in the Bankruptcy Code, that “liens ride through” a bankruptcy. Although the case law often is developed in the context of individual chapter 13 cases, the underlying reasoning of the cases could apply equally in the chapter 11 context. We previously discussed this issue in light of a Fifth Circuit decision that permitted a lien to “ride through” a chapter 11 case when the secured creditor did not participate in the case. Now, two other recent decisions — one out of the Eighth Circuit in In re Shelton, No. 12-3555 (8th Cir. Nov. 4, 2013) and the other from the United States Bankruptcy Court for the Northern District of Illinois in In re Batista-Sanechez, No. 12-48247 (Bankr. N.D. Ill. Oct. 25, 2013) — further demonstrate the difficulty of effectively enforcing a bar date order against a secured creditor even when the secured creditor does not timely assert its rights by filing a proof of claim.
The Eighth Circuit’s Decision — In re Shelton
In Shelton, the Eighth Circuit held that disallowance of a secured claim for untimeliness did not extinguish the secured creditor’s underlying lien.
Citimortgage held a lien on the individual debtors’ primary residence and filed a claim in the debtors’ chapter 13 bankruptcy case almost eight months after the bar date. The debtors objected to the untimely filed claim, but did not challenge the substantive validity of either the claim or the underlying debt and lien. After the claim was disallowed, the debtors filed an adversary proceeding seeking to avoid Citimortgage’s lien. The debtors argued that section 506(d) of the Bankruptcy Code, by its plain meaning, provides that disallowance of a claim as untimely necessarily voids any corresponding lien. Section 506(d) provides that, to the extent a secured claim is disallowed, any lien securing the claim is void unless the claim was disallowed under section 502(b)(5) or section 502(e) of the Bankruptcy Code, or if the claim was not an allowed claim solely because the secured creditor failed to file a proof of claim.
Citimortgage moved to dismiss the adversary proceeding, arguing that lien avoidance was unjustified and unnecessarily punitive given that liens generally survive if a secured creditor chooses not to file a proof of claim. The bankruptcy court granted Citimortgage’s motion to dismiss, and the debtors appealed first to the Eighth Circuit Bankruptcy Appellate Panel and then to the Eighth Circuit.
In affirming the ruling of the bankruptcy court, the Eighth Circuit discussed the Seventh Circuit’s decision in In re Tarnow, which held that avoidance of a lien where the secured claim was disallowed solely for untimeliness was too much of a departure from pre-Bankruptcy Code practices to have been Congress’s intent when drafting section 506, particularly because a secured creditor who failed to file a claim would preserve its lien. The Eighth Circuit further noted that the U.S. Supreme Court found that section 506 contained certain ambiguities while reaffirming that valid liens generally pass through bankruptcy cases unaffected, and concluded that Congress could not have intended to alter that general principal. Dewsnup v. Timm.
The Eighth Circuit next discussed the Fourth Circuit’s decision in In re Hamlett, where the Fourth Circuit joined the Seventh Circuit in holding that liens for disallowed claims survive bankruptcy where the sole basis for disallowance was the untimeliness of the proof of claim. In re Hamlett. The Fourth Circuit stated in particular that “the failure to file a timely claim, like the failure to file a claim at all, does not constitute sufficient grounds for extinguishing a perfectly valid lien. The contrary result . . . would lead to considerable inequity.” Relying on Tarnow and Hamlett, the Eighth Circuit affirmed the bankruptcy court’s decision to dismiss the lien avoidance action.
The Bankruptcy Court’s Decision — In re Batista-Sanechez
While Shelton considered whether a creditor’s lien could be avoided after the creditor’s claim was disallowed, Batista-Sanechez addressed whether a late-filed proof of claim could be disallowed when the claim was secured by a valid lien and the only grounds for disallowance was that the claim was untimely. In Batista-Sanechez, SunTrust Mortgage, which held a senior mortgage on real property of the chapter 11 debtor, filed a proof of claim one month after the bar date had expired. The debtor objected to SunTrust’s claim, arguing that the claim should be disallowed as untimely. As in Shelton, the debtor did not challenge the validity of the lien or the underlying debt. In response, SunTrust argued that its claim could not be disallowed because it evidenced a debt secured by a valid lien. Relying heavily on the Seventh Circuit’s holding in Tarnow, the bankruptcy court sustained the debtor’s objection and disallowed SunTrust’s claim, reasoning that because SunTrust’s claim against the bankrupt estate was distinct from its claim against the collateral itself, the court could disallow SunTrust’s claim without extinguishing its lien.
SunTrust argued that its claim could not be disallowed because disallowance would be excessively punitive and that such avoidance would require a nonsensical reading of section 506(d). The bankruptcy court agreed with both of Sun Trust’s arguments, largely on the same grounds echoed in the Eighth Circuit’s Shelton decision, but nonetheless disallowed SunTrust’s claim, noting that SunTrust had confused claim disallowance with lien avoidance. Although SunTrust was correct that its lien could not be avoided solely because it filed an untimely proof of claim, SunTrust failed to realize that those arguments were largely unrelated to whether its bankruptcy claim must be allowed.
Although Shelton and Batista-Sanechez addressed slightly different issues, they are essentially two sides of the same coin. These decisions join with other circuits in permitting secured creditors to retain their liens even if they do not comply with the terms of a bar date order. While most courts have not gone as far as the Fifth Circuit to allow liens to be enforced notwithstanding section 1141(c) of the Bankruptcy Code, it remains to be seen what the full impact of the concept of “liens ride through” that these decisions reflect would be in the context of a corporate chapter 11 case.