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The United States Court of Appeals for the Sixth Circuit recently issued an opinion (i ) that resolved two bankruptcy-related issues of first impression within the Sixth Circuit: (1) which party bears the burden of establishing the validity of a creditor’s security interest in the debtor’s property; and (2) whether a trustee may use his hypothetical lien-creditor status and avoidance powers to oppose a motion for relief from the automatic stay after the expiration of the two-year statutory limitation on avoidance actions (ii).   On the first issue, the court determined that a purported secured creditor (and party seeking relief from the automatic stay) bears the burden of proof as to the validity of its liens.  On the second issue, the court held that a trustee is permitted to use his Bankruptcy Code avoidance powers defensively even after the expiration of the relevant statutory limitations period.  Although this ruling generally follows the majority view espoused by other courts, practitioners should take note: those seeking or opposing relief from the automatic stay may now find the process slightly more complex and contested in courts domiciled in the Sixth Circuit.

The opinion stems from an involuntary bankruptcy proceeding against Steve A. McKenzie (“McKenzie”) filed in Tennessee bankruptcy court in November 2008.  The case ultimately converted to a chapter 7 case in 2010.  Grant, Konvalinka & Harrison, P.C. (“GKH”) was the prepetition law firm for the debtor, McKenzie.  In the weeks prior to the bankruptcy filing, McKenzie executed a promissory note and pledge agreement in favor of GKH to secure legal fees owed to the law firm.  GKH later filed secured proofs of claim and moved for relief from the automatic stay.  The chapter 7 trustee opposed the motion on the grounds that the security interests granted to GKH in the equity interests in McKenzie’s ventures constituted preferential transfers under bankruptcy law.  The chapter 7 trustee did not file a separate adversary proceeding against GKH asserting any avoidance claims.  After multiple hearings, the bankruptcy court affirmed in part and denied in part GKH’s stay relief.  The bankruptcy court found, among other things, that GKH failed to carry its burden of showing that it possessed a valid security interest in certain pledged equity.  The bankruptcy court also determined that the chapter 7 trustee could use his avoidance powers defensively after the expiration of the limitations period.  After an initial appeal, the district court affirmed the bankruptcy court’s rulings.

On appeal to the Sixth Circuit, GKH contended that the lower courts erred in requiring GKH to establish the validity of its security interest in the pledged equity interests for which stay relief was denied (iii).   The Sixth Circuit upheld the bankruptcy court’s determination that a party must first establish itself as a creditor who has a valid lien on the property of the debtor and that such lien existed prior to the bankruptcy filing.  The court reasoned that the validity of a creditor’s security interest is often determinative of the debtor’s lack of equity in the property, and consequently affects whether the bankruptcy court should terminate the bankruptcy stay.  The Sixth Circuit also reasoned that it is sound judicial policy to place the burden of the validity of proving the security interest on the purported secured creditor because the creditor is in a better position easily prove the validity of its lien (rather than a debtor having to disapprove the validity of such lien).

As to the other issue of first impression, the Sixth Circuit followed the majority view that a trustee may use his avoidance powers under chapter 5 of the Bankruptcy Code defensively following the expiration of the statutory limitation for filing avoidance actions.  In the instant case, the time for filing avoidance actions expired 11 months before the bankruptcy court ruled on GKH’s stay motion.  However, the chapter 7 trustee contended that GKH’s claim required disallowance under section 502(d) of the Bankruptcy Code because GKH, as a transferee of the pledged equity interests, would be required to turn over the property received (i.e. the liens or the equity interests) as preferential transfers under section 547(b) of the Bankruptcy Code.  The Sixth Circuit reasoned that this approach was proper because of the distinction between avoidance actions (requesting affirmative relief) and defenses (not seeking affirmative relief).  For example, section 502(d) of the Bankruptcy Code (governing disallowance of claims) really only operates in this context to offset the claim asserted by the creditor, but does not permit any additional recovery from such creditor by the trustee.  In formulating its decision, the Sixth Circuit cited the legal principle that limitation periods generally do not apply to defenses.  Finally, the court concluded that allowing a trustee to use avoidance powers defensively promoted one of the central purposes of the Bankruptcy Code – ensuring equality of distribution among creditors of the debtor.

While this opinion does not fundamentally change the way motions for relief from the stay will be prosecuted, it does offer some additional procedural hurdles for the moving party and additional defenses for a debtor or trustee.  Namely, a debtor or trustee (or liquidating trustee) can oppose motions for relief using statutory avoidance powers at any point in the litigation regardless of when the affirmative right to commence those actions expires.  This decision suggests that plans of reorganization and plans of liquidation should expressly reserve these defensive rights for the liquidating trustee.  This ruling may also substantiate the argument that trustees may be able to disallow claims at any point simply by alleging the avoidability of a transfer to the holder of a claim.  Again, without a time limitation, trustees will be afforded this ability to challenge a claim based on avoidability at any point in the case.  Finally, it is advisable for parties seeking requests for relief to now allege additional facts and provide substantive proof that they are properly secured.  This additional evidentiary burden coupled with the trustee’s undisputed avoidance defense should make prosecuting motions for relief more expensive and prone to greater delay in certain circumstances.

 

i. Grant, Konvalinka & Harrison, P.C. v. C. Kenneth Still (In re: Steve A. McKenzie), 737 F.3d 1034 (6th Cir. 2013).

ii. See 11 U.S.C. § 546(a)(1)(A).

iii. The Bankruptcy Code permits a bankruptcy court to grant a motion for relief from stay if the “debtor does not have an equity [interest] in [the] property.”  See 11 U.S.C. § 362(d)(2)(A).

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