Secured Creditors Beware: File An Unsecured Proof of Claim, or Forever Hold Your Peace

On November 22, 2011, the Court of Appeals for the Eleventh Circuit issued a per curiam opinion that piqued the interest of bankruptcy practitioners nationwide and sent secured creditors scrambling to ensure that their rights to a deficiency claim had been properly preserved in pending bankruptcy cases. The Eleventh Circuit held that the IRS had waived its right to an unsecured deficiency by filing a proof of claim that evidenced a secured claim but failed to note that a portion of the claim may be unsecured.

Under the Bankruptcy Code, the holder of a claim secured by a lien actually has two claims:

1. It has a secured claim that is capped at the value of its collateral.
2. Any amount of its claim in excess of that secured claim is an unsecured claim.

Both claims carry important control and distribution rights.

As the holder of a secured claim, the creditor is entitled to vote its secured claim for or against a plan of reorganization and to receive certain statutorily defined distribution rights that, in general, entitle it to a payment stream with a value equal to the value of its collateral. As the holder of an unsecured claim, that same creditor is entitled to vote its unsecured claim for or against a plan of reorganization and receive the statutorily established payment right of an unsecured creditor.

Court Holds That Rights Can Be Waived

In In Re J.H. Investment Services, Inc., the Court of Appeals for the Eleventh Circuit held that the latter set of rights, plan voting and distribution towards the unsecured portion of an otherwise secured claim, could be waived if not pursued through express reference in a proof of claim. While the loss of the distribution right is problematic in itself, the loss of the leverage over the plan confirmation process that comes with the right to vote what is frequently a controlling unsecured claim, and to insist upon a debtor’s compliance with the substantial requirements for “cram down” of unsecured creditors removes one of the greatest sources of a secured creditor’s leverage over the plan process.

In J.H Investment, the IRS had a secured claim against an involuntary Chapter 11 debtor for unpaid corporate income taxes, interest and penalties. During the pendency of the case, the IRS filed multiple amendments to its original proof of claim. As to the amended proof of claim at issue, the IRS asserted a secured claim of approximately $46 million, but made no indication in the body of the proof of claim that a portion of that claim may be unsecured due to insufficient collateral value to support the full $46 million amount. Even when the trustee’s disclosure statement submitted in connection with a plan of reorganization later stated that the bankruptcy estate’s assets were valued at about $750,000, with $83,000 in carve-out funds reserved for distribution to general unsecured creditors, the IRS did not amend its proof of claim.

A week before the confirmation hearing, the IRS objected to the trustee’s proposed Chapter 11 liquidating plan. The IRS alleged that it not only held an unsecured claim entitled to priority treatment, it also alleged that the trustee’s plan violated the Bankruptcy Code because the plan proposed to pay general unsecured creditors prior to paying the IRS’ priority claim in full. The bankruptcy court found that the IRS did not hold either a priority or general unsecured claim.¹ The district court affirmed. On appeal, the Eleventh Circuit noted that “a creditor must take an affirmative step to pursue an unsecured claim.”

Court Cites Due Process Concerns

The IRS cited § 506(a)(1) of the Bankruptcy Code when it argued that its secured claim was automatically bifurcated into a secured and unsecured claim.² The Eleventh Circuit disagreed citing due process concerns: “Requiring an undersecured creditor to signal its intent to pursue a deficiency claim serves an important notice function.” Treating the IRS as the holder of an unsecured deficiency claim “would deprive [the trustee] and other creditors of due process as they had neither notice of nor an opportunity to contest any unsecured claim by the IRS.”

Using the facts as outlined in the decision, the IRS had a $46 million claim secured by about $750,000 in collateral value. Therefore, it had a $750,000 secured claim and a $45.2 million unsecured claim. The immediate impact of the Eleventh Circuit’s decision was to deprive the IRS of its distribution rights from the $83,000 carve-out that had been set aside for unsecured creditors – a fairly minor loss given the magnitude of the claim and the minimal funds available for distribution. The more important impact of disallowance of the IRS’ unsecured claim is that it deprived the IRS of the degree of control over the plan confirmation process, and the attendant negotiation leverage, that comes with holding the single largest unsecured claim in a Chapter 11 case. Had the IRS been able to assert its $45.2 million unsecured claim, it could have voted that claim to reject the plan – a vote that may have itself defeated plan confirmation, but at minimum would have forced the trustee into having to resort to the “cram down” provisions of the Bankruptcy Code to attempt to attain a confirmed plan.

Although the impact of this decision beyond the Eleventh Circuit remains to be seen, the Court’s message is clear. A secured creditor cannot indicate on its proof of claim that its claim is fully secured and expect to obtain both the distribution rights and the plan leverage of an unsecured claimant if there later proves to be insufficient collateral value to support that claim.

1 The IRS subsequently amended its proof-of-claim (Claim #6-5) to correct the deficiency, but the Eleventh Circuit did not address that amended claim, noting that the IRS did "not raise[] the disallowance of [that C]laim on appeal."

2 Bankruptcy Code §506(a)(1) states that

[a]n allowed claim of a creditor secured by a lien on property in which the estate has an interest ... is a secured claim to the extent of the value of such creditor's interest in the estate's interest in such property ... and is an unsecured claim to the extent that the value of such creditor's interest ... is less than the amount of such allowed claim.