On June 14, 2012, the US District Court for the Southern District of Mississippi, Southern Division found in In re S. White Transportation, Inc. that a lien was not voided upon confirmation of the debtor's Chapter 11 plan, reversing the US Bankruptcy Court for the Southern District of Mississippi's opinion and order. The US Court of Appeals for the Fifth Circuit has required the satisfaction of four conditions to void a lien under section 1141(c) of the Bankruptcy Code. The Bankruptcy Court decided that the condition that the lien holder must participate in the reorganization was met by the creditor receiving notice of the debtor's bankruptcy, and therefore, it determined that the creditor's lien was voided by virtue of the debtor's Chapter 11 plan confirmation process.

On appeal, the District Court ruled that mere notice of a bankruptcy proceeding does not satisfy the participation requirement necessary to void a lien under section 1141(c). Because a higher level of participation is required, the District Court ruled that the creditor's lien was not voided by the Chapter 11 plan confirmation.

On July 30, 2002, the debtor executed a promissory note and a First Deed of Trust in favor of Acceptance Loan Company, Inc. (Acceptance). Acceptance was granted a lien on the debtor's real property. In 2004, the debtor refinanced the loan with Acceptance and executed a Second Deed of Trust secured by the same property. Shortly after, the parties argued over the lien's validity with the debtor seeking to quiet title or cancel the lien on its property and Acceptance counter-suing for judicial foreclosure. Three other entities have claims secured by the same real property, but they are presumed to be inferior to Acceptance's claim.

In 2010, the debtor filed a voluntary petition for Chapter 11 and designated Acceptance's claim as "disputed." The debtor submitted a plan of reorganization which maintained that Acceptance had not filed a proof of claim in the required time frame. It is uncontested that Acceptance received notice of the debtor's bankruptcy but did not file a proof of claim. The debtor's plan of reorganization was then approved by the Bankruptcy Court at the end of 2010.

Acceptance then filed a complaint, seeking a determination that its lien was not affected by the Chapter 11 plan confirmation and that it retained a first priority lien on the property. In the alternative, Acceptance sought to have the Bankruptcy Court amend the debtor's plan of reorganization to reflect their unaffected lien. The Bankruptcy Court determined that Acceptance did not have standing to seek modification of the plan of reorganization and that Acceptance's lien was voided by virtue of the Chapter 11 plan confirmation process. Acceptance appealed to the District Court.

The District Court first examined whether Acceptance had the necessary standing to appeal the bankruptcy order. The Fifth Circuit employs the "person aggrieved test" under which a party has standing to appeal a bankruptcy court's order if it is directly and adversely affected pecuniarily by the confirmation order.

At issue in this appeal was whether Acceptance's lien was voided through the Chapter 11 plan confirmation process. Secured creditors are generally allowed to ignore the bankruptcy proceedings without endangering their liens. However, section 1141(c) of the Bankruptcy Code provides an exception to this general rule and can extinguish an existing lien if the plan or confirmation order otherwise provides. The Fifth Circuit has held that this requires the following four conditions be satisfied:

(See Elixir Indus., Inc. v. City Bank & Trust Co. (In re Ahern Enters., Inc.), 507 F.3d 817, 822 (5th Cir. 2007)).

The dispute revolves around the third condition of whether Acceptance had participated in the reorganization. The Bankruptcy Court had determined that Acceptance's receipt of notice of bankruptcy was sufficient participation in the reorganization to void the lien.

The District Court first decided that Acceptance had the necessary standing for the appeal. It then found that receiving notice of a bankruptcy proceeding does not qualify as sufficient participation in a reorganization to warrant voiding a lien under section 1141(c) of the Bankruptcy Code.

The District Court acknowledged that while the Fifth Circuit has never resolved the question of whether receipt of notice alone constitutes participation, case law and other circuit courts' approaches provided persuasive authority that the participation requirement to void a lien requires more than mere receipt of notice of bankruptcy. Further, the District Court looked to Black's Law Dictionary for the definition of "participation" and found that the term contemplates some action, which was missing in this case, as Acceptance took no part in the reorganization.

The general rule that liens pass through bankruptcy unaffected further supported the District Court's conclusion that the confirmed plan did not void the lien because generally courts are reluctant to interpret unambiguous language to effect a major change in pre-code practice. The District Court also noted that if notice is considered to be a sufficient participation in reorganization, the consequences would produce inequitable results. Acceptance's lien would be extinguished and Acceptance would receive nothing either under the plan or on its first priority perfected lien, while lower-priority creditors received distributions under the plan.

Finally, the District Court noted that the Fifth Circuit distinguishes between the plan confirmation procedure and the adversary process by which claims are disputed. Because the debtor neglected to initiate adversary proceedings against Acceptance to resolve the question of the validity of the lien within the bankruptcy, the issue was never presented to or determined by the Bankruptcy Court.

In light of these factors, the District Court concluded that notice alone is insufficient to satisfy the requirement that Acceptance had participated in the reorganization. Participation, at minimum, requires some form of action. Therefore, the District Court concluded that Acceptance's lien survived confirmation of the plan. The matter was remanded to the Bankruptcy Court for further proceedings.

The District Court's ruling clarifies the standard for debtors seeking to void liens. It provides that creditors who merely receive notice of a bankruptcy will preserve their liens unless, assuming the other Ahern conditions are satisfied, they take some action in the bankruptcy proceedings, such as filing a proof of claim or other pleading in the case.

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