It is often said that the acid test of a security interest or lien on property is the bankruptcy of the property owner. If that person or entity files a bankruptcy petition, the bankruptcy trustee has a number of options to challenge or even avoid certain liens. A lien that is not properly perfected is subject to attack by a trustee under both the “strong-arm clause” (Bankruptcy Code § 544) and the preference provisions (Bankruptcy Code § 547). If the lien is avoided, the property can then be sold and the proceeds distributed to the unsecured creditors. The trustee must act timely, however, if he or she is to be successful in avoiding the lien. The Sixth Circuit Court of Appeals recently addressed the timeliness of a trustee’s actions against the holder of an allegedly unperfected lien on a debtor’s property. Its conclusion raises several important questions regarding the timeliness of trustees’ actions to challenge the propriety of a secured creditor’s claim.

In In re McKenzie, 737 F.3d 1034 (6th Cir. 2013), the debtor granted a security interest in certain of his property to secure his obligation to pay fees to his attorneys. Among the assets pledged as security for the fees was the debtor’s equity interest in a limited liability company. The trustee challenged the creditor’s security interest asserting that the creation of the security interest was a preferential transfer on account of an antecedent debt. The trustee did not issue this challenge, however, until almost three years after the commencement of the bankruptcy case. Under Bankruptcy Code §546(a)(1)(A), the trustee must commence an action to avoid a preferential transfer within two years of the commencement of the case. Nevertheless, the Court of Appeals concluded that the trustee could assert that power in a specific procedural context.

Section 546 provides that any action by a trustee to avoid a preferential transfer under § 547 of the Bankruptcy Code or to exercise the strong arm powers of § 544 must be initiated before two years after the commencement of the case. (The statute extends this limitation if a trustee is first appointed in the case during the second year that the case is pending. In that event, the limitation on these avoiding powers actions allows the trustee to pursue those cases for up to one year after his or her appointment as trustee.) In McKenzie, had the trustee brought an action to recover the alleged preference from the creditor, he would have been met with a motion to dismiss the action as being outside the statute of limitations established by § 546(a). This motion would presumably have succeeded. The matter did not arise in that context. Instead, the creditor brought a motion for relief from the automatic stay apparently so that it could recover its claim out of the collateral that was securing the debt. It brought this motion in May of 2011, well after the § 546(a) time limitation had passed. In response to the motion for relief from the stay, the trustee asserted that the creditor’s security interest was preferential and that under §502(d) of the Code, the creditor’s claim could not be allowed until it had turned over any property that it held as a result of a preferential transfer. It was this position of the trustee that the Court of Appeals found persuasive. Whether the court properly applied the section is subject to question.

Section 502(d) keeps a creditor who is holding property that should be in the bankruptcy estate from sharing in any distribution of estate assets until they have returned the property that they arguably are improperly holding. If they did not return that property, they would receive a greater percentage repayment of their claim than other similarly situated creditors. To illustrate, assume that creditor A is owed $10,000 and has a preferential transfer of a security interest in the debtor’s vehicle that is worth $5,000. If the unsecured creditors in the case would be paid 10% of their claims, Creditor A would get a total of $5,500 on its claim. It would receive the $5,000 from the automobile, and 10% of its remaining $5,000 unsecured claim, for a total of $5,500. This is substantially more than the creditor would receive if Creditor A’s security interest in the vehicle were avoided as a preference and the vehicle sold for the benefit of all of the debtor’s creditors. In that way, §502(d) protects the bankruptcy estate by ensuring that avoided transfers are not ignored in the distribution system. A closer look at the language of § 502(d), however, arguably shows that the Sixth Circuit may have misapplied the provision.

Section 502(d) provides that “the court shall disallow any claim of any entity from which property is recoverable under section 542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable under section 522(f), 522(h), 544, 545, 547, 548, 549, or 724(a) of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section 522(i), 542, 543, 550, or 553 of this title.” The Sixth Circuit concluded that this provision operates to effectively extend the time that a trustee has to use the avoiding powers even after the expiration of the normally applicable statute of limitations. The court stated:

Section 502(d) does not refer to § 546(a)(1)(A)’s two-year statute of limitations, nor does § 502(d) contain a limitations period of its own. See 11 U.S.C. § 502(d); see also McLean Indus., 196 B.R. at 676-77 (” ‘If such a limitations period on claim objections under section 502(d) was intended by Congress, it easily could have included a reference to section 502(d) in section 546(a).’ “)(quoting In re Stoecker, 143 B.R. 118, 132 (Bankr.N.D.Ill.1992)). At bottom, nothing in the text of § 502(d) prevents a trustee from using his avoidance powers defensively after the expiration of the statute of limitations set forth in § 546(a)(1)(A).

In re McKenzie, 737 F.3d 1034, 1039 (6th Cir. 2013).

The court’s view is troubling in that its interpretation of the section seems to ignore the requirement of the section that the creditor holds property that is “recoverable” under specific sections of the Bankruptcy Code. Arguably, the passage of time makes the transfer no longer “recoverable” under § 547. If that is the case, then § 502(d) would not apply, and the creditor could assert its claim in the case. Of course, the creditor would hold a secured claim, and that claim would not be paid from the assets that would be distributed to the holders of unsecured claims. If the creditor’s claim exceeded the value of the collateral, the creditor would hold an unsecured claim to that extent, and it would have a right to participate in the distribution of estate funds based on the amount of its unsecured claim.

The Sixth Circuit’s decision in McKenzie bars the creditor from pursuing any unsecured claim in the case. To that extent, the decision penalizes the creditor vis a vis other creditors. What the decision does not do, however, is to prevent the creditor from asserting its secured claim. The decision seems to do so, but the subsequent history of the case could be of assistance in determining the extent to which the court’s action improperly punishes secured creditors whose rights to their collateral should not be avoided once the statute of limitations period on avoidance actions has expired. Specifically, the decision that the court of appeals affirmed was a decision denying the creditor relief from the automatic stay of § 362 of the Bankruptcy Code. Importantly, the court did not indicate what would happen next in the case. Denying relief from the stay does not indicate what happened to the property that was collateral for the extension of credit. If the property remained in the estate, it is still there for the creditor to seek at a later time (although the denial of relief from the stay suggests that another such motion would be futile). The creditor or the trustee could seek to have the property sold, but the property is still subject to the creditor’s security interest. The property could be sold subject to that interest, and it would then be in the hands of a third party and would be subject to the security interest. If the trustee sought to sell the property free and clear of the security interest, that interest should still attach to the proceeds of the sale under § 363. Regardless of the form of the sale, the secured creditor still should receive the value of its claim from the proceeds of the sale. This is consistent with the long standing policy of the bankruptcy laws that a lien against property survives a bankruptcy notwithstanding any discharge that the debtor may receive.

Assuming that the value of the collateral is less than the outstanding debt that is secured, if the property is sold and the proceeds paid to the secured creditor, the estate (and other unsecured creditors) will be enriched in that the total unsecured claims in the case will be reduced in the amount of the unsecured balance still owed to the creditor. The secured creditor will be damaged in the amount that it would have recovered if its unsecured claim shared pro rata in the distribution of the estate’s assets to the unsecured creditor class. In the meantime, the estate has incurred significant administrative expenses from the litigation of the issues in the case all the way to the court of appeals. Perhaps all would have been better served by a settlement of the stay relief litigation by a surrender of the property to the secured creditor in return for a waiver of the creditor’s unsecured claim. In future cases, trustees who have failed to act timely to attack certain transfers as avoidable may be reluctant to enter into such agreements given the decision in this case. That would be an unfortunate use of the Bankruptcy Code.