Category Archives: Creditor Rights

March 1, 2016

Tenth Circuit Holds Default Judgments for Violations of Securities Laws Must be Given Preclusive Effect in Non-dischargeability Actions Under Section 523(a)(19)

The Tenth Circuit has in the past refused to give preclusive effect in bankruptcy non-dischargeability actions brought under § 523(a)(2) to pre-petition default judgments arising from claims of actual fraud. In re Jordana, 216 F.3d 1087 (10th Cir. 2000). However, the Tenth Circuit recently held that this refusal does not extend to pre-petition default judgments based on violations of securities laws where the claim for non-dischargeability is brought under § 523(a)(19), and that such judgments must be given preclusive effect for purposes of denying the dischargeability of the debt. Tripoldi v. Welch et al, 810 F.3d 761 (10th Cir. 2016).

Robert Tripoldi brought an action in the U.S. District Court for the District of Utah against Nathan Welch and others alleging violations of state and federal securities laws. Welch answered the complaint, but during the course of the litigation, his attorneys withdrew and Welch never retained new counsel. Eventually, the trial court issued a default judgment against Welch. Welch subsequently filed a chapter 7 bankruptcy petition, and then filed motions with the district court to set aside the default judgment and grant judgment on the pleadings in Welch’s favor. Tripoldi filed a motion with the district court to declare the pre-petition default judgment non-dischargeable under § 523(a)(19). The district court denied Welch’s motions and granted Tripoldi’s.

On appeal, after determining the district court did not abuse its discretion in entering the default judgment or in denying the motion to vacate it, the Tenth Circuit then turned to the issue of whether the default judgment could be the basis for a denial of discharge under § 523(a)(19). Welch argued that a default judgment should not be the basis for the denial of a discharge, relying on the Tenth Circuit’s prior opinion in Jordana. The Tenth Circuit disagreed, and noted what it considered to be significant differences between § 523(a)(2) and § 523(a)(19). The court stated that it declined to extend its reasoning in Jordana to default judgments based on violations of securities laws because § 523(a)(2) and § 523(a)(19) “have different requirements and different purposes.” The court placed great importance on the fact that § 523(a)(19) contains the specific requirement that the debt be memorialized in a “judgment, order, decree or settlement agreement” stemming from a violation of securities laws, whereas § 523(a)(2) contains no such requirement. The court also that Congress, in enacting § 523(a)(19) to include the requirement of a judgment, intended to close what it perceived to be a “loophole in the law.” The noted its decision was consistent with those of two other courts to rule on the issue: In re Pujdak, 462 B.R. 560 (Bankr. D. S.C. 2011) and Meyer v. Rigdon, 36 F.3d 1375 (7th Cir. 1994) (interpreting § 523(a)(11) which contained a similar requirement).

February 25, 2016

“Structured Dismissals” within the Tenth Circuit

  1. Introduction

The United States Bankruptcy Court for the District of Utah has published the first opinion within the Tenth Circuit analyzing and authorizing the “structured dismissal” of a chapter 11 case. See In re Naartjie Custom Kinds, Inc., 534 B.R. 416 (Bankr. D. Utah 2015) (Thurman, J.)  In Naartjie, Judge Thurman addressed two issues: first, whether the bankruptcy court has statutory authority to grant a “structured dismissal,” and second, whether the debtor met its burden of establishing cause for the court to grant such a relief.  Answering both of these questions in the affirmative, the court joined a growing number of jurisdictions, including the Third Circuit, where structured dismissals are now a viable alternative to traditional exit strategies from chapter 11 cases.  This article introduces the debate about the propriety of structured dismissals by comparing Naartjie to the Third Circuit’s decision in Jevic Holding Corp., 787 F.3d 173 (3rd Cir. 2015) decision – an opinion from the highest court to have weighed in on the debate.  It concludes with  ten “practice pointers” to consider when seeking or opposing an order authorizing a structured dismissal in the Tenth Circuit.

  1. Structured Dismissals Generally

Generally, “structured dismissals are simply dismissals that are preceded by other orders of the bankruptcy court (e.g., orders approving settlements, granting releases, and so forth) that remain in effect after dismissal.” Jevic Holding, 787 F.3d at 181.   “Unlike old-fashioned one sentence dismissals order – ‘this case is hereby dismissed’ – structured dismissal orders often include some or all of the following additional provisions: ‘releases’ (some more limited than others), protocols for reconciling an paying claims, ‘gifting’ of funds to unsecured creditors and provisions providing for the bankruptcy court’s continued retention of jurisdiction over certain post-dismissal matters.’” In re Strategic Labor, Inc., 467 B.R. 11, 18 (Bankr. D. Mass. 2012) (quoting Norman L. Pernick & G. David Dean, Structured Chapter 11 Dismissals: a Viable and Growing Alternative After Asset Sales, 29 Am. Bankr.Inst. J. 1, 56 (June 2010)).  The most contentious features of some structured dismissals are provisions that authorize distribution of funds outside the priority scheme prescribed by § 507 of the Bankruptcy Code. 

III.       Structured Dismissals in Practice: Jevic and Naarjie

The recent decisions of the Third Circuit in Jevic and the Utah Bankruptcy Court in Naartjie illustrate the nature of and issues surrounding structured dismissals.

  1. Jevic and Structured Dismissals that Deviate from Section 507’s Priority Scheme

As of December of 2015, the Third Circuit was the highest court to have opined on the propriety of “structured dismissals” under the Code. In Jevic, the Third Circuit upheld the bankruptcy court’s order authorizing a dismissal of a Chapter 11 case pursuant to a settlement agreement that, among other things, included broad exculpatory clauses and authorized the distribution of estate assets outside the priority scheme of § 507 of the Code.

Jevic was a typical case with an atypical outcome.  In 2006, CIT Group financed Sun Capital Partners’ leveraged buyout of Jevic Transportation, Inc. See Jevic, 787 F.3d at 175.  Jevic was a trucking company in decline, and as part of the acquisition, CIT advanced an $85 million revolving credit facility to Jevic secured by substantially all of Jevic’s assets. Id. The acquisition did not alter Jevic’s fate, and by May of 2008, the company had been forced to enter into a forbearance agreement with CIT, which also required a $2 million guarantee from Sun. See id. On May 19, 2008, Jevic ceased business operations and notified employees that they would be terminated.   See id. at 175-176.  The next day, the company filed a petition for protection under Chapter 11 of the Code in Delaware. See id. at 176.  As of the petition date, Jevic owed $53 million to CIT and Sun.   See id. It owed also over  $20 million in tax and general unsecured claims. See id.

The court appointed a committee of unsecured creditors, which filed an adversary proceeding asserting fraudulent and preferential transfer claims against CIT and Sun. See Jevic, 787 F.3d at 176.  In essence, the committee alleged that “Sun, with CIT’s assistance, acquired Jevic with virtually none of its own money based on baseless projections of almost immediate growth and increasing profitability.” Id. Meanwhile, a group of truck drivers filed a class action against Jevic and Sun, alleging that the defendants had violated the Worker Adjustment and Retraining Notification (“WARN”) Act by failing to give the workers 60 days’ written notice of their layoffs. See id.

By March of 2012, the estate’s sole remaining assets consisted of $1.7 million in cash and the committee’s action against CIT and Sun. See Jevic, 787 F.3d at 176.  The $1.7 million were subject to Sun’s lien, and although the committee had partially succeeded in defeating a motion to dismiss the fraudulent and preferential transfer claims, it had concluded that the estate lacked sufficient funds to finance prosecution of its action.  Accordingly, the committee, Sun, Jevic, CIT and Sun reached a settlement agreement whereby: (1) all parties would exchange releases, (2) the committee’s fraudulent and preferential transfer action would be dismissed with prejudice, (3) CIT would deposit $2 million into an account earmarked to pay the estate’s administrative expenses, including the fees of the committee’s and the debtor’s professionals, (4) Sun would assign its lien in the remaining $1.7 million to a trust for the payment of tax and administrative creditors first, and the remainder to unsecured creditors on a pro rata basis, and (5) the chapter 11 case would be dismissed. See id. at 177.  Although the truck drivers participated in the settlement discussions, the parties could not agree on a settlement of the WARN Act claims, which the drivers valued at $12.4 million, inclusive of 8.3 million entitled to priority under § 507(a)(4) of the Code. See id. Consequently, the drivers were not included in the settlement presumably because Sun, who remained a defendant in their WARN Act lawsuit, did not want to fund litigation against itself. See id. The effect of the drivers’ exclusion from the settlement would be that the drivers would receive nothing from the estate, even on the $8.3 million wage claim, but all other general unsecured would receive about four percent of their claims. See id. at 177, 177 n.1.

The truck drivers and the United States Trustee objected to the proposed settlement, arguing, in part, that the proposed distribution violated the priority scheme prescribed by § 507 of the Code. See Jevic, 787 F.3d at 178.[1]   The drivers argued that the Code does not authorize “structured dismissals,” but rather only three ways for the debtor to exit chapter 11: (1) confirmation of a plan, (2) conversion to chapter 7, or (3) “plain dismissal with no strings attached.” See id. at 180.  The Third Circuit addressed these objections in reverse.

First, the Third Circuit affirmed the district court and bankruptcy court’s conclusion that while structured dismissals are not expressly authorized by the Code, they are not prohibited by the Code either. See Jevic, 787 F.3d at 181.  Specifically, the Third Circuit held that “though § 349 of the Code contemplates that dismissal will typically reinstate the pre-petition state of affairs by revesting property in the debtor and vacating orders and judgments of the bankruptcy court, it also explicitly authorizes the bankruptcy court to alter the effect of dismissal ‘for cause’ – in other words, the Code does not strictly require dismissal of a Chapter 11 case to be a hard reset.” Id.

Second, the Third Circuit rejected the argument that “even if structured dismissals are allowed, they cannot be approved if they distribute estate assets in derogation of the priority scheme of § 507 of the Code.” See Jevic, 787 F.3d at 182.  In essence, the drivers argued that § 103(a) required settlements in Chapter 11 cases to comply with § 507’s priority scheme. See id.[2] Although the Third Circuit acknowledged “some tacit support in the caselaw for the [d]river’s position,” it concluded that “neither Congress nor the Supreme Court has ever said that the [absolute priority rule] applies to settlements in bankruptcy.” Id. at 182-83.  The Third Circuit noted that the Fifth and Second Circuits “had grappled with whether the priority scheme of § 507 must be followed when settlement proceeds are distributed in Chapter 11 cases.” Id. (citing Matter of AWECO, Inc., 725 F.2d 293, 295-96 (4th Cir. 1984) (declining to approve a settlement agreement because unsecured creditor would be paid ahead of senior claims); In re Iridium Operating LLC, 478 F.3d 452, 463-64 (2nd Cir. 2007) (rejecting the AWECO ruling as too rigid because and finding that the absolute priority rule is not necessarily implicated in settlements outside of plans of reorganization)).  The Third Circuit agreed with the Second Circuit’s approach, and held that “bankruptcy courts may approve settlements that deviate from the priority scheme of § 507 of the Bankruptcy Code only if they have specific and credible grounds to justify the deviation.”   Id. at 184 (citation and quotation omitted). 

Having concluded that the bankruptcy court had authority to grant structured dismissals, and that the “structure” could include distributions outside the priority scheme of § 507, the Second Circuit found that although it was a “close call,” the bankruptcy court had “sufficient reasons” to approve the settlement in Jevic and overrule the Trustee’s and the truck drivers’ objections. See Jevic, 787 F.3d at 184-85.  The court emphasized that there was “no evidence calling into question the Bankruptcy Court’s conclusion that there was ‘no realistic prospect’ of a meaningful distribution to Jevic’s unsecured creditors apart from the settlement under review.”   Id. at 185.  Instead, it was apparent that if the court did not approve the proposed settlement, the unsecured creditors would not receive anything at all because the estate lacked sufficient funds to prosecute the fraudulent claims against Sun and CIT, both of which claimed they would not enter into the same settlement with a trustee were the case converted to chapter 7.  Thus, the court concluded, the movants had shown cause for approval of a structured dismissal that deviated from § 507, “[a]lthough this result is likely to be justified only rarely.”   Id. at 186.[3]

  1. Naartjie – a Simple Structure

Naartjie was a much narrower decision than Jevic. See Naartjie, 534 B.R. 416. 

Naartjie was a children clothing retailer that filed Chapter 11 intending to reorganized using pre-arranged financing. See id. at 418.  The financing fell through shortly after the petition date, and the debtor shifted to an orderly liquidation. Id. Over the next six months, the court approved multiple orders authorizing the debtor to sell significantly all of its assets pursuant to § 363 of the Code. See id. Following the proof of claim deadline, four principal creditor constituencies emerged: (1) a group of secured noteholders claimed a senior lien against virtually all of the debtor’s assets in the amount of $8.8 million; (2) a trade creditor of the debtor – Target Ease – asserted a $7 million claim, of which $2.1 was entitled to administrative priority and $2.6 million consisted of a reclamation claim;(3) a shipping company asserted a claim secured by a maritime line in the amount of $339,923.47; and (4) general unsecured creditors. See 418-19.

The parties sought and obtained approval of a settlement agreement to distribute the estates’ assets as follows: (1) payment of all allowed administrative claims subject to a negotiated budget, and priority claims up to $382,000; (2) payment of $140,000 to the shipping company in satisfaction of its claim; (3) all remaining funds to be distributed among the secured creditors (45%), the trade creditor Target Ease (30.5%), and the unsecured creditors excluding Target Ease (24.5%). All parties agreed to mutual releases and to seek dismissal of the case or confirmation of a plan. See id. at 419. No one objected to the settlement proposal, and the court approved it pursuant to Rule 9019 and the factors set out in In re Kopexa Realty Venture Co., 213 B.R. 1020 (BAP 10th Cir. 1997).

After liquidating all assets, and consummating much of the settlement agreement, the debtor moved for approval of a structured dismissal under §§ 305(a) and 349 of the Code, whereby (1) all of the court’s orders would remain in full force; (2) the court would retain jurisdiction over the approval of professional fees and any disputes arising from the interpretation and implementation of an order approving the dismissal; (3) the court’s dismissal order would incorporate the exculpation clauses and releases negotiated through the settlement agreement; and (4) the debtor and committee of unsecured creditors would distribute all funds pursuant to the terms of the settlement agreement. See Naartjie, 534 B.R. at 420. 

No party with an economic interest in the estate objected, and the senior secured creditors, the committee and Target Ease supported the motion for approval of the structured dismissal. See Naartjie, 534 B.R. at 521.  The U.S. Trustee objected, however, arguing that the Code does not authorize the approval of “structured dismissals” because “there are only three ways to exit a Chapter 11 case: (1) by  confirmation of a plan pursuant to § 1129; (2) by dismissal of the case pursuant to § 1112(b); or (3) by conversion of the case pursuant to §1112(b).” See id.  

The court granted the debtor’s motion, holding that §305(a) authorized dismissals of any case if the interest of creditors and the debtor would be better served by such dismissal or suspension. Naartjie, 534 B.R. at 422.  The court then turned to the determinative question: “may the Court alter the effect of dismissal?”  Id.  Quoting § 349(b), the court held that “[t]his subsection describes the effect of dismissal, but it qualifies the effect by providing that the Court may, for cause, order otherwise.  It follows that, if cause is shown, a bankruptcy court may alter the effect of dismissal.  The statute is clear and unambiguous on this point.” Id. at 422-23.  Furthermore, analyzing § 349’s legislative history, the court concluded that “[t]he effect of dismissal is to put the parties, as much as practicable, back in the positions they occupied pre-bankruptcy.” Id. at 423.  “But, if cause is shown, such as when a structured dismissal will better serve the interests of the creditors and the debtor, the bankruptcy court may order otherwise and alter the effect of dismissal.” Id.

Having concluded that it had statutory authority to authorize a structured dismissal, the court found that the debtor had shown cause for dismissal under § 305(a) because (1) “it [was] clear that the proposed structured dismissal [was] the most efficient and economic[cal] way to administer” the case; (2) the parties’ rights were protected and preserved since the court’s orders would remain in full force and effect; (3) the parties would have access to a forum where they could enforce those orders (i.e, the bankruptcy court); and (4) the settlement agreement was an out-of-court workout that equitably distributed the assets of the estate. See Naartjie, 534 B.R. at 426 (applying factors adopted in In re Zapas, 530 B.R. 560, 572 (Bankr.E.D.N.Y. 2015), In re AMC Investors, LLC, 406 B.R. 478, 488 (Bankr.D.Del. 2009), In re RCM Global Long Term Capital Appreciation Fund, Ltd., 2000 B.R. 514, 525 (Bankr.S.D.N.Y. 1996), In re Picacho Hills Util. Co., No. 11-13-10742 TL, 2013 WL 1788298, at *9 (Bankr.D.N.M. Apr. 26, 2013)). 

The court found that the debtor had also met the standard for altering the effect of dismissal under § 349. Naartjie, 534 B.R. at 426.  In addition to the bases discussed above, it found that despite receiving notice of both the settlement motion and the motion for approval of a structured dismissal, “no economic stakeholder [] objected.”  Moreover, there was little for the debtor to do in the case, other than distributing the assets.  The court concluded that the motion was “not an attempt to work around the protections of § 1129; it is simply the rare case where cause is shown to alter the effect of dismissal.” Id. Thus, the court concluded, the movants had shown cause for alternating the effect of dismissal under § 349.

  1. Ten Factors to Consider When Proposing or Opposing a Structured Dismissal

As Judge Thurman noted in Naartjie, that case was part of a “growing trend of structured dismissals.” Naartjie, 534 B.R. at 421.  Given their perceived or actual benefits, including speed and lower cost, structured dismissals are likely to become more common over the next few months or, at least, are highly likely to be litigated more frequently.  In seeking approval of or opposing structured dismissals, practitioners should consider the following:

  1. Statutory Relief: Consider whether dismissal should be or is sought under §§ 305(a) or 1112(b). As Judge Thurman noted in Naartjie, “[s]ection 305(a)(1) is a narrower provision for dismissing a Chapter 11 case than § 1112(b).” Naartjie, 534 B.R. at 422. Under § 305(a), a court may dismiss a case if “the interests of creditors and the debtor would be better served by” the dismissal. 11 U.S.C. § 305(a)(1). By contrast, under § 1112(b), the court may appoint a trustee, convert or dismiss a chapter 11 case, “whichever is in the best interest of creditors and the estate.” 11 U.S.C. § 1112(b). Courts are less likely to grant relief under § 305(a) than 1112(b) particularly because the court’s decision under § 305(a) is not subject to appellate review pursuant to § 305(c) of the Code. Nevertheless, movants may be tempted to seek relief under § 305(a) over § 1112(b) to limit the range of potential relief – i.e., to avoid the possibility that the court may appoint a trustee or convert the case rather than dismiss it. Section 305(a) is particularly attractive where all parties with an economic interest in the outcome of the case have reached a settlement.
  2. Focus on “Cause” Under § 349: At this point, the debate on whether the court has statutory authority to grant a structured dismissal is largely academic. Even the courts that have denied motions for approval of structured dismissals have recognized that they have the statutory authority to alter the effect of dismissal under § 349(b) of the Code. Although “cause” for altering the effect of § 349 is a developing concept, the Naartjie opinion provides some guidance on factors that may be considered when determining whether the movant has met this burden. See Naartjie, 534 B.R. at 426 (considering the notice provided to the parties, objections filed, and whether movant was attempting “work around the protections of the Bankruptcy Code”).
  3. Anticipate the U.S. Trustee’s Objection: In virtually every reported opinion, the U.S. Trustee has objected to motions seeking approval of structured dismissals. The reasons for the U.S. Trustee’s distaste for structured dismissals are articulated in an article by the Associate General Counsel for Chapter 11 Practice at the Executive Office for the U.S. Trustee titled Structured Dismissals, or Cases Dismissed Outside of the Code’s Structure, 30 Am. Bankr. Inst. J. 20 (March 2011). Practitioners proposing or opposing structured dismissals can anticipate the U.S. Trustee’s position and address, to the extent possible, the concerns raised in this article.
  4. Timing: Movants should seek relief under § 349(b) as soon as it becomes significantly likely that confirmation of a plan is not a viable option, but after resolution of as many preliminary matters as possible. Correspondingly, opponents should highlight loose ends that may affect negatively the rights of creditors or other stakeholders. For example, the court may reject a structured dismissal motion where claim disputes are outstanding.
  5. Consider sub rosa Jurisprudence: Strictly speaking, a proposal constitutes a sub rosa plan where it dictates the terms of a reorganization plan. See Jevic, 787 F.3d at 188 (Scirica, J., dissenting); see also, In re Shubh Hotels Pittsburgh, LLC, 439 B.R. 637, 644-45 (Bankr. W.D. Penn. 2010) (“a transaction would amount to a sub rosa plan or reorganization if it: (1) specifies the terms of any future reorganization plan; (2) restructures creditors’ rights; and (3) requires that all parties release claims against the Debtor, its offices and directors, and its secured creditors”). Structured dismissals, by definition, do not implicate the confirmation of a plan, and thus are distinguishable from sub rosa plans. Structured dismissals, however, implicate the same policy concerns as sub rosa plans. Accordingly, practitioners should consult case law analyzing sub rosa plans and may rely on it by analogy particularly when opposing structured dismissals motions.
  6. 9019 Settlements and Asset Sales: Most successful structured dismissals follow approval of a settlement under Rule 9019, the sale of substantially all assets of the debtor under § 363, or both. The practical reason for this sequence is that by the time the court has to determine whether there is cause for altering the effect of § 349, all other major disputes in the case have been resolved. This is particularly true in cases like Naartjie, where all constituents with an economic interest in the case reach a settlement (or, at least, are represented during settlement discussions). Thus, in seeking structured dismissals, movants increase the likelihood of succeeding if they first obtain relief, were applicable, under § 363 and seek consensus from stakeholders in the form of a settlement under Rule 9019.
  7. But if no Consensus, Invoke Jevic: Failure to obtain consensus from all stakeholders with an economic interest in the case, however, is not a dispositive post Jevic. The effect of that opinion appears to be that so long as objecting creditors like the truck drivers in Jevic can vindicate their rights elsewhere or against another party, the court may approve a structured dismissal that violates the absolute priority rule. In other words, movants should seek consensus, but if they must, then they should abandon only creditors who can fend for themselves.
  8. Remain Vigilant: Opponents of structured dismissal motions should object to any Rule 9019 or §363 motion that sets up the dismissal motion. For example, in Naartjie, the Rule 9019 Motion that predated the structured dismissal motion contemplated a filing of the latter. In dismissing the case, the court noted that no party had objected to the earlier motion. See Naartjie, 534 B.R. at 426.
  9. Prove Efficiency: One of the primary justifications for granting a structured dismissal motion is the movant’s ubiquitous proffer that the structured dismissal will save the estate significant resources over an expensive plan confirmation process. Typically, however, the estate is not fully administered as of the date the court enters an order approving a structured dismissal. Thus, part of the “structure” will likely include process for wrapping up the case. Practitioners should be careful not to surprise the court with professional fees or administrative expenses incurred post-approval of a structured dismissal that disprove its professed efficiency.

10.       Equitable Mootness: The Jevic dissent points out that the doctrine of equitable mootness was not applicable to a court’s order approving a structured dismissal because that doctrine applies only where a plan of reorganization is confirmed. See Jevic, 787 F.3d at 186 (Scirica, J., dissenting) (citing In re Semcrude, L.P., 728 F.3d 314 (3d. Cir. 2013). It is unclear, however, whether Judge Scirica’s rationale holds true in the Tenth Circuit, specially when the structured dismissal is approved pursuant to a rule 9019 motion, or where the court dismisses the case under § 305(a). See e.g., Rindlebach v. Jones, 532 B.R. 850, 856-58 (Bankr. D. Utah 2015) (appeal from order approving settlement equitably moot).  Opponents of structured dismissal motions should therefore consider whether and when to ask a court to stay an order pending post-ruling motions.


[1] The drivers also claimed that the committee of unsecured creditors violated its fiduciary duties to the estate because the settlement it negotiated excluded the drivers. See Jevic, 787 F.3d at 178.

[2]               Section 103(a) provides, “[e]xcept as provided in section 1161 of this title, chapters 1, 3, and 5 of this title apply in a case under chapter 7, 11, 12, or 13 of this title, and this chapter, sections 307, 362(0), 554 through 557, and 559 through 562 apply in an case under chapter 15.” 11 U.S.C. § 103(a).

[3] Judge Scirica dissented, arguing that it was not clear that the only alternative to the settlement was a chapter 7 liquidation. See Jevic, 787 F.3d at 186. He emphasized that the settlement at bar was not substantially distinguishable from sub rosa plans, and emphasized that this was not a “gifting” case because the assets to be distributed were assets of the estate since the settlement resolved the estate’s fraudulent transfer claims. See id. at 187-88.

February 16, 2016

Seventh Circuit Finds Suspicion, Negligence and Ineptitude Sufficient to Defeat a Claim that a Transferee Received a Fraudulent Transfer in Good Faith, but Insufficient to Equitably Subordinate the Transferee’s Claim

Section 548(c) of the Bankruptcy Code entitles the recipient of a fraudulent transfer in certain circumstances to retain a lien on the property received through the debtor’s fraud if the transferee took the property in good faith and for value. The Seventh Circuit recently, In addressing a case where the bankruptcy trustee asserted the recipient of a fraudulent lien did not take in good faith and its claim should be equitably subordinated to unsecured claims, held suspicion, negligence and ineptitude on the part of the claimant to be sufficient to defeat the recipient’s claim that it acted in good faith but insufficient to equitably subordinate the claim. Grede v. Bank of New York Mellon Corp. (In re Sentinel Management Group, Inc.), 809 F.3d 958 (7th Cir. 2016).

In Sentinel, the debtor was a cash management firm which borrowed money from BNYM to funds its operations. Sentinel received money from its customers, which it used to purchase securities for its customers and which it was required by law to maintain in segregated accounts separate from the accts which Sentinel used for its own trading. Sentinel had a capitalization of less than $3 million, but also had securities it had purchased for its customers’ accounts which exceeded $300 million. When securities markets became shaky in the summer of 2007, Sentinel found itself unable to meet both its collateral levels with the bank and its customers’ requests to redeem their securities. Sentinel embarked on a scheme under which it borrowed on its line of credit with the bank to meet its customers’ redemption demands, and transferred its customers’ securities from their segregated accounts into Sentinel’s personal accounts on which the bank held a lien. By transferring customer securities to accounts on which the bank held a lien, Sentinel violated federal law. When Sentinel filed bankruptcy, a dispute arose between the bank and the trustee over whether the bank received its lien in good faith or whether the trustee could avoid the lien under § 548. The district court ruled in favor of the bank, finding the bank’s actual belief that Sentinel had not pledged the securities in question without its customers’ consent, was sufficient to establish it acted in good faith. The Seventh Circuit reversed.

The Seventh Circuit stated the district court’s conclusion was wrong. The court held that inquiry notice, which it defined as “awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing,” prevents the recipient of a fraudulent transfer from the protections afforded a good faith transferee. The court further stated “inquiry notice is not knowledge of fraud or other wrongdoing but merely knowledge that would lead a reasonable, law-abiding person to inquire further—would make him in other words suspicious enough to conduct a diligent search for possible dirt.” As a result, an actual belief that the transfer is not fraudulent is insufficient if the recipient has knowledge of facts which place him on notice that further investigation is warranted. In this instance, the fact that the debtor’s capital was less than $3 million yet it had the ability to post $300 million of collateral to secure its debt to the bank, were sufficient to place the bank on notice that the debtor was using someone else’s property to collateralize the loan. A memo from a bank employee who worked on the Sentinel account to the bank evidencing “puzzlement” at the source of the collateral and a suspicion that the collateral was owned by parties other than the debtor, was sufficient to require additional investigation on the bank’s part. As a result, the court held the bank did not qualify as a good faith transferee with respect to its lien on securities owned by the debtor’s customers.

The next question before the court was whether the bank’s conduct was sufficient to warrant equitable subordination of its unsecured claim to claims of general unsecured creditors. The trustee argued that the same conduct which prevented the bank from being considered a good faith transferee was sufficient to warrant equitable subordination of its claim. The court disagreed, stating that, while mere negligence or ineptitude may be sufficient to place a transferee on inquiry notice for purposes of a good faith defense, they are insufficient to warrant equitable subordination under § 510(c)(1). In order to warrant equitable subordination, the court held the transferee’s conduct must not only be inequitable but “seriously so,” using the words “egregious,” “tantamount to fraud” and “willful” as the type of conduct required. The bank should have suspected something was amiss, and that was sufficient to eliminate its good faith defense, but because the trustee did not establish the bank knew Sentinel had pledged its customers’ securities without their consent, the court found there was insufficient evidence to equitably subordinate the bank’s unsecured claim.

December 29, 2015

Tenth Circuit Refuses to Allow Guarantors to Shirk Their Guaranty Liability by Relying on Primary Obligor’s Confirmed Plan

May a chapter 11 debtor who is a guarantor require a creditor to look solely to the provisions of the primary obligor’s confirmed plan for repayment? The Tenth Circuit recently held that, in many cases, guarantors will not be able to restrict creditors’ rights in this fashion.

In FB Acquisition Property I, LLC v. Larry Gentry et al, 2015 WL 8117969 (10th Cir. 2015), Larry and Susan Gentry personally guaranteed a loan made by FirstTier Bank to their company, Ball Four, Inc. Their guaranty provided they would pay “all of the principal amount” of the “Indebtedness” of Ball Four to the bank, whether that amount was barred or unenforceable against Ball Four for any reason. In addition, their guaranty contained a waiver of any defenses arising because of the “cessation of Borrower’s liability from any cause whatsoever.” Third, the Genrtrys agreed not to assert “any deductions to the amount guaranteed under this Guaranty” through setoff, counterclaim, counter demand or other method.

Ball Four defaulted on the loan and filed a chapter 11 proceeding. Ball Four filed an adversary proceeding against FirstTier Bank, asserting various breaches of the loan agreement entitling Ball F our to setoffs and reductions of amounts it owed the bank. Ball Four obtained confirmation of a plan that provided payment of the bank’s claim at interest, amortized over twenty-five years with a five year call. During the course of Ball Four’s bankruptcy proceedings, the Colorado Division of Banking closed FirstTier Bank and the FDIC was appointed receiver. Eventually the Ball Four loan was transferred to FB Acquisition.

After Ball Four filed bankruptcy, FirstTier sued the Gentrys on their guaranties. The Gentrys filed a personal chapter 11 petition. The creditor filed a proof of claim in the Gentry bankruptcy case based on the guaranties of the loan, with the amount of the claim exceeding the amount of the proof of claim filed in the Ball Four bankruptcy case by the amount of default interest accruing on the debt between the two petition dates. The Gentrys took the position that their liability under their guaranties was co-extensive with Ball Four’s liability on the debt, and that they would enjoy any reduction of the debt through the adversary proceeding in the Ball Four bankruptcy case. The Gentrys proposed a plan which provided the debt owed on the FirstTier loan would be paid by Ball Four pursuant to its confirmed plan, with the Gentrys not paying any amounts to the creditor unless and until Ball Four defaulted on its plan obligations on the debt.

FB Acquisition appealed the confirmation of the Gentry plan, arguing the bankruptcy court erred in two regards: (1) basing its analysis of the feasibility of the Gentry plan on the feasibility of the Ball Four plan and (2) confirming the Gentry plan which treated the Gentrys’ liability under their personal guaranties as co-extensive with the liability of Ball Four under its confirmed plan.

The Tenth Circuit affirmed the feasibility findings. The court rejected FB Acquisition’s argument that the bankruptcy court relied solely on the Ball Four plan’s feasibility in determining the feasibility of the Gentry plan. The Tenth Circuit held that the bankruptcy court properly determined feasibility of the Gentry plan because the Gentrys had sufficient financial wherewithal to pay the debt if Ball Four defaulted under its plan and because the Gentrys would not receive a discharge in their case until the debt was paid in full.

However, the Tenth Circuit held that the bankruptcy court erred in confirming the Gentrys’ plan, which provided their guarantor liability on the debt was co-extensive with Ball Four’s liability. First, while Colorado law provides that a guarantor’s liability is co-extensive with that of the primary obligor, the Tenth Circuit held that “this rule of equivalent liability is inapplicable in the bankruptcy context. The court noted the majority rule that the Bankruptcy Code’s discharge provisions do not affect a guarantor’s liability. The court pointed to the specific language of § 524(e), which states the “discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.” The Tenth Circuit stated that “Holding otherwise would impair a guaranty. Guaranties act as a safeguard, assuring performance of a guarantor even if the borrower defaults,” and further stated “Extending this rule of equivalent liability into the bankruptcy context would destroy the value of a guaranty.”

Second, the Tenth Circuit held that the specific terms of the guaranties themselves precluded the Gentrys from asserting their liability was co-extensive with Ball Four’s. The guaranties provided contained the Gentrys’ promise to pay “all of the principle amount outstanding” whether “barred or unenforceable against Borrower for any reason whatsoever.” The guaranties also contained waivers of defenses arising from the cessation of Ball Four’s liability from any cause whatsoever.” In addition, the Gentrys in their guaranties agreed not to assert any deductions to the amount guaranteed by way of setoff or counterclaim. The Gentrys contended that, since the guaranties provided they guaranteed the “Indebtedness” of Ball Four, they were entitled to any reductions in that indebtedness which might arise from a judgment in the adversary proceeding brought by Ball Four in its case. The Tenth Circuit disagreed, concluding that while a bankruptcy court may grant a discharge, “a discharge does not extinguish the underlying debt, rather it changes a debtor’s liability for that debt.” Therefore, although the confirmation of the Ball Four plan modified Ball Four’s liability for its debt, it did not modify the indebtedness itself. Because the indebtedness remained unchanged, the Gentrys’ liability also remained unchanged.

December 26, 2015

Eleventh Circuit Holds That An Assignee for the Benefit of Creditors has no Authority to File a Bankruptcy Petition for the Assignor

In analyzing the parameters surrounding a state law assignment for benefit of creditors, as well as the extent and limits of the powers of the assignee, the Eleventh Circuit in Ullrich v. Welt (In re NICA Holdings, Inc.), 2015 WL 9241140 (11th Cir. 2015) held that an assignee for the benefit of creditors lacks the authority to file a bankruptcy petition on behalf of the assignee.

In NICA Holdings, the debtor owned stock in a company a company commonly called “Nicanor” which owned and operated a fish farm in Nicaragua. Peter Ullrich and a company called Biotec Holdings owned the remaining shares in Nicanor. When NICA Holdings experienced financial difficulties, it executed an Assignment for the Benefit of Creditors, pursuant to the applicable Florida statute. Under the Florida ABC statute, an assignment for the benefit of creditors serves as an alternative to bankruptcy, with the statute providing for the irrevocable assignment by the assignor of its assets to the assignee, with the assignee charged with disposing of the assets in accordance with state law. In this instance NICA Holdings assigned its assets to Kenneth Welt. When his efforts to sell NICA Holdings’ stock in Nicanor came to naught, Nicanor ceased business operations, and Ullrich instituted litigation against him, Welt filed a bankruptcy petition on behalf of NICA Holdings. Welt believed he had authority to cause NICA Holdings to file bankruptcy under the terms of the Assignment which NICA Holdings had signed in his favor. Ullrich disagreed and filed a motion to dismiss the bankruptcy case on the argument that Welt, as an assignee of NICA Holdings, lacked authority to file a bankruptcy petition on its behalf. The bankruptcy court denied Ullrich’s motion to dismiss, but the Eleventh Circuit agreed with Ullrich and reversed and remanded the case to the bankruptcy court with instructions to dismiss it.

The Eleventh Circuit began its analysis of the authority issue by notice that Florida’s Assignment for Benefit of Creditors (“ABC”) statute is designed to provide a simpler and cheaper process to the more complex procedures provided by the Bankruptcy Code. The ABC process may, in certain instances, be preferable because it is more flexible, faster, more private and less supervised than bankruptcy proceedings. In addition, the Eleventh Circuit noted that Florida courts had described the ABC statute as “an alternative to bankruptcy [that] allows a debtor to voluntarily assign its assets to a third party in order to liquidate the assets.” Hillsborough Cty. V. Lanier, 898 So. 2d 141, 143 (Fla. 2d DCA 2005). The Eleventh Circuit held that ABCs and bankruptcy proceedings are alternative proceedings—a debtor chooses to pursue one to the exclusion of the other. The ABC statute lacked any provision empowering an assignee to file a bankruptcy petition on behalf of the assignor, and the Eleventh Circuit refused to read any such power into the statute. Furthermore, the Assignment Agreement itself under which NICA Holdings assigned its assets to Welt did not contain any language specifically authorizing Welt to file a bankruptcy petition on NICA Holdings’ behalf. The court noted that the language of the agreement, while granting Welt broad powers, authorized him to exercise those powers only in furtherance of the ABC.

Could an assignee for the benefit of creditors file a bankruptcy on behalf of the assignor if the assignor grants specific authority to the assignee to do so? The Eleventh Circuit did not reach this question. I did note, however, that the Florida ABC statute requires all ABC agreements to “substantially” adopt the language in the proposed forms accompanying the statute, an indication that, in Florida at least, an assignee for the benefit of creditors could not be granted authority to file a bankruptcy petition on behalf of the assignor.

November 10, 2015

The Tenth Circuit Joins the Sixth, Seventh and Ninth Circuits in Holding that a First-Time Transaction May Qualify for the Ordinary Course Defense under 11 U.S.C. sec. 547(c)

In issuing its decision in Jubber v. SMC Electrical Products, Inc. (In re C.W. Mining Company), 2015 WL 4717709 (10th Cir. 2015), the Tenth Circuit joined the Sixth, Seventh and Ninth Circuits in holding that a first-time transaction between the debtor and a creditor may qualify for the ordinary course defense of § 547(c). [1]  In C.W. Mining the debtor purchased equipment from SMC with the intent of changing its mining operation from continuous mining to longwall mining.  The debtor and SMC had never conducted business with each other before.  The debtor paid SMC $200,000 on for the equipment within ninety days before filing bankruptcy.  The bankruptcy trustee asserted the payment was a preference, but SMC contended the payment was made in the ordinary course.  While noting that it construes preference defenses narrowly, the court reiterated that the ordinary course defense is “intended to leave undisturbed normal financial relations,” and a payment will be within the defense if it is in the ordinary course of both the debtor and the transferee.  The court noted that several bankruptcy courts have held that first-time transactions cannot qualify for the defense, interpreting the statute as requiring the transaction to be in the ordinary course of business between the debtor and the transferee.  The Tenth Circuit declined to follow these decisions and instead agreed with its sister circuits to decide the issue that a first-time transaction can qualify for the defense.

In reaching its conclusion, the Tenth Circuit looked to the language of the statute itself, and noted that it stated the defense refers to ordinary course of business or financial affairs of the debtor and the transferee, not to the business or financial affairs between the debtor and the transferee.  The Tenth Circuit agreed with the Seventh Circuit’s analysis in Kleven  that “the court can imagine little (short of the certain knowledge that its debt will not be paid) that would discourage a potential creditor from extending credit to a new customer in questionable financial circumstances more than the knowledge that it would not even be able to raise the ordinary course of business defense, if it is subsequently sued to recover an alleged preference.”  Kleven, 334 F.3d at 643). 

The court stated that it had previously defined “ordinary business terms” to mean “those used in ‘normal financing relations’: the kinds of terms that creditors and debtors use in ordinary circumstances, when debtors are healthy.”  In re Meredith Hoffman Partners, 12 F. 3d. at 1553.  As a result, the court said that determination of what is ordinary contemplate an examination of what is ordinary in the relevant industry, not what is ordinary in each party’s respective practices.  Agreeing with the Ninth Circuit in Ahaza, the Tenth Circuit concluded that a “first-time debt must be ordinary in relation to this debtor’s and this creditor’s past practices when dealing with other, similarly situated parties.”  In re Ahaza Sys., Inc., 482 F.3d at 1126. 

The Tenth Circuit’s decision reached a balance between the justification for allowing an ordinary course defense for a first-time transaction and the general policy of the preference statute to discourage unusual action by either the debtor or its creditors during the debtor’s slide into bankruptcy.

[1] The sister circuit opinions are:  (1) Gosch v. Burns (In re Finn), 909 F.2d 903 (6th Cir. 1990); (2) Kleven v. Household Bank F.S.B., 334 F.3d 638 (7th Cir. 2003) and (3) Wood v. Stratos Prod. Dev., LLC (In re Ahaza Sys. Inc.), 482 F.3d 1118 (9th Cir. 2007).

October 27, 2015

Creditors May Collect Debts From Funds Distributed to a Debtor From His/Her Exempt Retirement Account Under Tenth Circuit Ruling that Distributed Funds are not Exempt

In a case of first impression, the Tenth Circuit has held that a resident of Colorado may not assert an exemption under Colo. Rev. Stat. § 13-54-102(1)(s) for funds distributed from an exempt pension or retirement plan.  In re Gordon, 791 F.3d 1182 (10th Cir. 2015).  In Gordon the debtors received a lump sum distribution of $16,700 from an exempt 401(k) plan prior to filing bankruptcy.  They deposited the funds into a savings account, where the funds remained segregated from all other funds the debtors had received from other sources.  The debtors used these funds to pay their living expenses prior to filing bankruptcy, and on the petition date had $2,051 remaining.  They asserted an exemption in these remaining funds.  The trustee objected to the claim of exemption, contending the exemption does not apply to funds after their distribution from the exempt retirement account.  The bankruptcy denied the exemption, and the Tenth Circuit agreed with the bankruptcy court’s holding.

The court concluded the language of the statute was clear in allowing an exemption only for funds that are within the exempt retirement account, noting the statute provides an exemption for “property, including funds, held in or payable from any pension or retirement plan or deferred compensation plan.”  Colo. Rev. Stat. § 13-54-102(1)(s).  Noting that Colorado courts have not addressed the question whether the exemption applies to funds which have been distributed, the Tenth Circuit stated that it “must ascertain and give effect to the intent of the legislature, and that task begins with the language of the statute itself.”  The court concluded that the statutory exemption applies only to funds that are actually in the exempt plan.  Although the court agreed with the debtors that Colorado liberally interprets statutes granting exemptions, the court stated that “even a liberal construction must find support in the statutory text,” and determined that such support was lacking in the statute at hand.  The fact that the Colorado legislature had provided an exemption in other statutes for distributed funds but did not do so in the pension and retirement account statute also supported its reasoning.  For example, the court noted that Colorado law provides for an exemption for proceeds of life insurance policies, Colo. Rev. Stat. § 13-54-102(1)(l)(I)(B), as well as for all money received as a pension arising out of service as a member of the armed forces of the U.S., Colo. Rev. Stat. § 13-54-102(h). 

The court concluded that creditors are prohibited by the statute from going after the plan itself, but once the funds in the plan are distributed to the debtor, the creditor is free to execute. 

October 20, 2015

Ninth Circuit Holds That Debtor May Recover Attorneys’ Fees Incurred Prosecuting Action for Damages Relating to Violation of Automatic Stay

    The Ninth Circuit has overruled its own relatively recent decision and has held that a debtor who sues for damages to redress a violation of the automatic stay may recover the reasonable fees it incurs prosecuting the action, even after the stay violation is cured.

    The Bankruptcy Code’s automatic stay provision, section 362, includes this fee recovery clause: “[A]n individual injured by any willful violation of a stay provided by this section shall recover actual damages, including costs and attorneys’ fees . . . .”  11 U.S.C. § 362(k).  The Ninth Circuit, in contrast to every other court to consider the issue, held in 2010 that section 362(k) allows a debtor to recover only those fees incurred to end the stay violation itself, not the fees incurred to prosecute an action for damages.  See Sternberg v. Johnston, 595 F.3d 937 (9th Cir. 2010).  In a decision issued last week, the Ninth Circuit overruled its own Sternberg decision and held that a debtor may recover the reasonable fees it incurs prosecuting a damages action relating to a stay violation.  See In re Schwartz-Tallard, Case No. 12-60052 (9th Cir. Oct. 14, 2015).  (See opinion here.)

    In Schwartz-Tallard, a loan servicer foreclosed on the home of a chapter 13 debtor during the debtor’s bankruptcy, while the debtor was making its monthly payments.  The bankruptcy court found that the creditor had violated the automatic stay and ordered the creditor to reconvey the home to the debtor.  The creditor promptly complied.  The debtor also sought a damages award, and prevailed.  The creditor appealed the damages award, and the debtor prevailed on appeal.  The debtor then sought to require creditor to reimburse the attorney fees the debtor incurred defending its damages award on appeal.  The bankruptcy court denied the motion because under Sternberg, debtors could be reimbursed only for the fees they incurred to end the stay violation.  Here, the creditor had remedied the stay violation before the successful appeal, and thus no fees could be awarded in connection with the appeal. 

    The Bankruptcy Appellate Panel reversed on grounds not relevant here and held that the debtor could recover her fees relating to the appeal.  The Ninth Circuit, first as a three-judge panel and then sitting en banc, affirmed the BAP’s decision, but not on the same grounds.  The Ninth Circuit held that Stenberg was decided incorrectly and that the plain text of section 362(k) allows a debtor to collect attorney fees regardless of whether the fees were incurred to remedy the stay violation or to seek damages resulting from a stay violation.  Though it found the text of section 362(k) unambiguous, the Ninth Circuit went on to state that the policies presumably underlying section 362(k) would be advanced only if debtors had adequate “means or financial incentive (or both)” to “vindicate their statutory right to the automatic stay’s protection.”

    The most obvious practical impact of Schwartz-Tallard is identified in the decision itself: debtors who previously lacked the financial incentive to pursue damages for stay violations may now be more willing to bring those actions.  For creditors and their attorneys, Schwartz-Tallard is simply another reminder to scrupulously respect the automatic stay.

October 13, 2015

Tenth Circuit Holds that U.S. Supreme Court Decisions in Law v. Siegel and Travelers Casualty v. Pacific Gas & Electric do no Change Established Tenth Circuit Law on Recharacterization of Debt to Equity

Recently, the Tenth Circuit considered a case involving the question of whether the U.S. Supreme Court’s decisions in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co., 549 U.S. 443 (2007) and in Law v. Siegel, 134 S. Ct. 1188 (2014) affected established Tenth Circuit precedent that a bankruptcy court’s authority to recharacterize debt as equity arises under 11 U.S.C. § 105(a).  In its decision in Redmond v. Jenkins, et al (In re Alternate Fuels, Inc.), 789 F.3d 1139 (10th Cir. 2015), the Tenth Circuit held that neither Supreme Court decision eliminated a bankruptcy court’s authority under § 105(a) to recharacterize debt as equity.  In so ruling, the Tenth Circuit reiterated the continued application of its decision in In re Hedged-Invsetments Assocs., Inc., 380 F.3d 1292 (10th Cir. 2004) and its factors for determining when debt should be recharacterized as equity.

In Hedged-Investments, the Tenth Circuit held that recharacterization of debt as equity involves a mixed question of law and fact which a bankruptcy court addresses pursuant to its general equitable powers under § 105(a) of the Bankruptcy Code.  In recharacterizing debt as equity, a court “effectively ignores the label attached to the transaction at issue and instead recognizes its true substance.”  In re Hedged-Investments, 380 F.3d at 1297.  In Alternate Fuels, the appellant/creditor argued that the U.S. Supreme Court’s decisions in Travelers Casualty and Law v. Siegel eliminated a bankruptcy court’s ability to recharacterize debt under § 105(a), leaving a court to do so only under § 502(b).   The appellant urged the court to follow the conclusions of the Fifth Circuit in In re Lothian Oil, Inc., 650 F.3d 539 (5th Cir. 2011) and the Ninth Circuit in In re Fitness Holdings Int’l, Inc., 714 F.3d 1141 (9th Cir. 2013), both of which rejected reliance on § 105(a) as a source of authority to recharacterize debt.  The Tenth Circuit declined and instead reiterated its conclusions in In re Hedged-Investments.  First, the Tenth Circuit noted that the Supreme Court did not expressly overrule Hedged-Investments in either opinion, nor did either opinion mention—much less deal with—recharactierization of debt.  The Tenth Circuit stated that disallowance of claims and recharacterization of debt require different inquiries and serve different functions.  In fact, the court noted that a claim can be allowed under § 502 and still recharacterized as equity as appropriate under the court’s equitable powers of § 105(a).  The court held that disallowance is appropriate where the claimant has not right of recovery against the debtor, whereas recharacterization is not an inquiry into the enforceability of the claim but rather an inquiry into the nature of the transaction between the claimant and the debtor. 

For these reasons, the Tenth Circuit held that courts continue to have equitable power under § 105(a) to recharacterize debt as equity.

October 6, 2015

File a Proof of Claim, Lose Your Lien? Ninth Circuit Holds That Lien Associated With Disallowed Claim is Void

A recent decision by the Ninth Circuit Court of Appeals (found here) changes the strategic calculus for a secured creditor deciding whether to file a proof of claim in a bankruptcy case in the Ninth Circuit.  It has long been true that a secured creditor does not necessarily imperil his lien if he ignores a bankruptcy proceeding and declines to file a claim in connection with his lien.  See U.S. Nat’l Bank in Johnstown v. Chase Nat’l Bank of N.Y.C., 331 U.S. 28, 33 (1947).  But the Ninth Circuit’s decision in In re Blendheim, 2015 WL 5730015 (Oct. 1, 2015) holds that a creditor who actually files a claim, and has that claim disallowed, may have its lien voided under Bankruptcy Code § 506(d).  Thus, filing a proof of claim, at least in a chapter 13 case, may expose a secured creditor to greater risk than simply observing the case from the sidelines.  This contradicts the conventional wisdom that (issues of jurisdiction aside) it is often advisable to file a “protective” proof of claim to preserve your rights.

In re Blendheim was a “chapter 20” case—a chapter 13 case that followed a chapter 7 case by the same debtors.  HSBC Bank (“HSBC”) filed a proof of claim reflecting its first position lien on the Blendheims’ home.  The Blendheims objected to the claim on the basis that HSBC had not produced a copy of the promissory note upon which the claim was based, and that a previously provided promissory note appeared to bear a forged signature.  HSBC never responded to the claim objection and HSBC's claim was disallowed.  In the words of the bankruptcy court, HSBC “slept on its rights.”  Id. at *3.  In a subsequent adversary proceeding, the bankruptcy court held that HSBC’s lien would be void and cancelled “upon Debtors’ completion of a Bankruptcy.”  Id.

The Ninth Circuit, on appeal, was asked to consider whether the bankruptcy court properly voided HSBC’s lien.  The Blendheims argued that, because HSBC’s claim had been disallowed, the lien associated with that claim was void under the plain language of Bankruptcy Code § 506(d).  That section provides:

To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void, unless—

(1) such claim was disallowed only under section 502(b)(5) or 502(e) 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 section 501 of this title.

The Ninth Circuit held that the bankruptcy court properly voided the lien.  Under the plain language of the introductory clause of § 506(d), HSBC’s lien was void because it secured a claim that was disallowed.  Although a creditor may decline to participate in a bankruptcy case, and its lien may ride through the bankruptcy unaffected, “where a claim is timely filed and objected to,” and ultimately disallowed, the lien becomes void.  The Ninth Circuit recognized an exception, reflected in the decisions of other circuits, where a claim is disallowed solely because it was not timely filed.  In that situation, the lien is not void.  But, under the Ninth Circuit’s Blendheim decision, if a secured creditor’s claim is disallowed for any reason other than (1) untimeliness, or (2) the exceptions listed in section 502(d), the lien associated with the disallowed claim is void. 


Secured creditors should consider carefully the advantages and disadvantages of filing a proof of claim in a chapter 13 case.  Depending on the facts of the case, a better strategy may be to play a passive monitoring role and allow liens to ride through the bankruptcy.  If the decision is made to file a claim, secured creditors should be vigilant in defense of their claims.  If the creditor’s claim is disallowed, the creditor will lose its lien, and with it the right to seek foreclosure in the future.