A judge who finds himself face to face with a circular priority system typically reacts in the manner of a bull who has been goaded by the picadors: He paws the ground and roars with rage; the spectator can only sympathize with [the] judge and [the] bull."
—G. Gilmore, Security Interest in Personal Property, §39.1 at 1020-21 (1965).

Recently, the Eighth Circuit Court of Appeals decided In re Dial Business Forms, holding that a confirmed chapter 11 reorganization plan acts like a contract; therefore, a creditor that agrees to subordinate its security interest as part of a confirmation plan does not "advance in priority" when the priority lienholder allows its financing statement to lapse. In re Dial Business Forms, 341 F.3d 738 (8th Cir. 2003). In doing so, the Eighth Circuit agreed with other courts¹ that the confirmed plan defines the post-bankruptcy priorities among the creditors that participate in the confirmation process. However, the court's holding leaves unanswered the potential priority implications that the confirmed plan has on post-bankruptcy creditors. Moreover, by holding that a confirmed plan "fixes" the priorities of the participating creditors, the court invites the type of circular priority systems that leave spectators only to "sympathize" with both judges and practitioners.

For example, a typical case may involve a post-bankruptcy creditor (C) who perfects its security interest after the priority secured creditor's (A) financing statement has lapsed. Additionally, the case would involve a secured creditor who has subordinated (B) its priority interest to A as part of a confirmed plan. Therefore, creditor C is junior to the secured interest of a perfected creditor B. "Who's on First?" In theory, C is superior to A, but C is also junior to B; B is superior to C, however, B is junior to A; and A is superior to B, but junior to C.

This article will examine the rationale of the Second Circuit's holding in In re Dial Business Forms and how Uniform Commercial Code (UCC) §9-403(2) and the bankruptcy law, as applied by the court, interplay with the doctrine of "circular priority." In addition, it attempts to answer "Who's on First?" by reconciling the holding of In re Dial Business and the doctrine of circular priority.

Factual Background

In Dial Business Forms, the debtor's confirmed chapter 11 reorganization plan granted General Electric Capital Corp. (GECC), a secured creditor, an allowed secured claim in the amount of $1 million. Additionally, the plan granted a group of previously unsecured creditors (Class 3 creditors) an allowed unsecured claim of $950,000 plus a subordinated interest in all of the debtor's assets. The trustee filed a UCC-1 financing statement, thereby perfecting the subordinated security interest of the Class 3 creditors. Thereafter, GECC allowed its own UCC-1 financing statement to lapse. Following the debtor's default on its installment obligations to the Class 3 creditors, the trustee gave GECC notice of his intent to sell the debtor's assets to satisfy the Class 3 creditor's security interest. GECC then filed an adversary proceeding to determine the priority of its lien.

The trustee reasoned that it was entitled to foreclose on its security interest because its lien was superior to that of GECC. Specifically, the trustee cited Missouri's version of U.C.C. §9-403(2) for the proposition that upon lapse of a financing statement, a security interest is deemed to have been unperfected against a person holding an existing security interest. Therefore, when GECC allowed its financing statement to lapse, its security interest became unperfected as to that of the Class 3 creditors. Moreover, the trustee argued that Missouri's version of U.C.C. §9-316 was inapposite. Under Missouri's version of U.C.C. §9-316, a party "entitled to priority" may subordinate its security interest pursuant to an agreement. Mo. Stat. Ann. §400.9-316 (1994). However, the trustee alleged that the Class 3 creditors could not have subordinated their security interest because, as unsecured creditors, the Class 3 creditors were not "entitled to priority" in the first place; therefore, Mo. Stat. Ann. §400.9-316 was inapplicable.

Conversely, GECC argued that despite its lapsed financing statement, its security interest retained priority relative to that of the class 3 creditors. Specifically, GECC contended that the plan—not U.C.C. §9-403(2)—defined the priorities "as between" itself and the class 3 creditors.

The bankruptcy court agreed with GECC, holding that the case did not turn on the priority of perfection, but rather on the trustee's agreement, as reflected in the plan, to subordinate the security interest of the Class 3 creditors to that of GECC. In re Dial Business Forms Inc., 273 B.R. 594 (Bankr. W.D. Mo. 2002). The bankruptcy court reasoned that U.C.C. §9-403(2) would "control as to any post-bankruptcy creditor" to whom the debtor granted a security agreement, but not the Class 3 creditors. Id. at 598. Specifically, the court noted that the Class 3 creditors were aware of GECC's security interest and agreed to grant it priority in the plan; thus, they agreed to subordinate their interest as permitted by Mo. Stat. Ann. §400.9-316. Id. On different grounds, the Eighth Circuit Bankruptcy Appellate Panel (BAP) affirmed. In re Dial Business Forms Inc., 283 B.R. 537 (BAP 8th Cir. 2002). The BAP held that GECC's lien retained priority because, under 11 U.S.C. §1141(a), a "confirmed chapter 11 plan binds the debtor and creditors..." Id. at 540. The BAP reasoned that the "[t]he confirmation of the plan created a new and legally binding agreement amongst all of the parties to Dial's bankruptcy case." Id. The court concluded that §1141(a) of the Bankruptcy Code "trumps" conflicting state law; therefore, "GECC maintains its priority position over the trustee and Class 3 [creditors]." Id. at 542.

Eighth Circuit Holding

The Eighth Circuit affirmed, holding that "[w]hen the plan preserved GECC's pre-existing security interest and granted the Class 3 creditors a 'subordinated interest,' it defined the relative post-bankruptcy priorities between the security interests preserved and granted by the plan." In re Dial Business Forms Inc., 341 F.3d 738, 743 (8th Cir. 2003). Specifically, the court rejected the Class 3 creditors' argument that they did not "expressly agree" to subordinate their security interest, noting that as a "matter of law, a particular creditor's intent is irrelevant, because a chapter 11 plan may be confirmed over the objections of one or more creditors, who are then every bit as bound as if they had voted to approve the plan." Id. Therefore, "as between themselves," GECC and the Class 3 creditors agreed that the Class 3 creditors' security interest was subordinate to that of GECC. Id. at 744.

The Eighth Circuit's holding agrees with well-reasoned case law that, among participating creditors, a confirmation plan acts as a contract. See, e.g., In re Varat Enterprises Inc., 81 F.3d 1310 (4th Cir. 1996); In re Commercial Millwright Serv. Corp., 245 B.R. 603 (N.D. Iowa 2000). Therefore, the plan—not U.C.C. §9-403(2)—controls priority disputes among competing creditors. The court's holding, however, is limited to "creditors who agreed to their relative priorities in the plan (as opposed to post-bankruptcy creditors)..." Id. Thus, one may reason that a post-bankruptcy creditor is entitled to priority over a secured party whose financing statement has lapsed pursuant to U.C.C. §9-403(2). Doing so, however, raises the following question: What are the relative priorities "as between" a post-bankruptcy creditor and a perfected creditor who has subordinated its security interest as part of a chapter 11 confirmation plan?

"Who's on First?" Practical Issues

Application of the common-law formula of "circular priority" helps resolve the above-referenced issue. Prof. Grant Gilmore's treatise, Security Interest in Personal Property §39.1 (1965), exemplifies the best treatment of circular priorities. See Nation, George A. III, "Circuitry of Liens Arising from Subordination Agreements: Comforting Unanimity No More," 83 B.U. L. Rev. 591, 617 (2003). Prof. Gilmore provides the following formula for resolving circular priority systems:
For example, A, B and C have claims against the debtor which are entitled to priority in alphabetical order. A subordinates his claim to C. After foreclosure of the secured interest, the resulting fund is insufficient to satisfy all three claims. The proper distribution of the fund is as follows[:]

1. Set aside from the fund the amount of A's claim.
2. Out of the money set aside, pay C the amount of its claim, pay A to the extent of any balance remaining after C's claim is satisfied.
3. Pay B the amount of the fund remaining after A's claim has been set aside.
4. If any balance remains in the fund after A's claim has been set aside and B's claim has been satisfied, distribute the balance to C and A.

See Gilmore, Security Interests in Personal Property §39.1 at 1021 (1965).

The question that is raised by the Eighth Circuit's holding in Dial Business Forms Inc. represents a slight variation on the facts as compared to the fact pattern offered by Prof. Gilmore's hypothetical. However, the formula's rationale is still applicable. In the context here in question, A does not subordinate to C; rather, B subordinates to A. The formula should be applied as follows:

1. Set aside from the fund the amount of A's claim.
2. Out of the money set aside for A's claim, pay C the amount of its claim, pay A to the extent of any balance remaining after C's claim is satisfied.
3. Pay B the amount of the fund remaining after A's claim has been set aside.
4. If any balance remains in the fund after A's claim has been set aside and B's claim has been satisfied, distribute the balance to C and A.

Application of the formula results in the equitable distribution of the proceeds. By setting aside the amount of A's claim, one is assured that B will not receive a windfall because of C's entry into the picture. As between A and B, B is subordinate to A, pursuant to a confirmed plan. In re Dial Business Forms, 341 F.3d 738 (8th Cir. 2003). Thus, B is neither harmed nor benefited when C is given priority in distribution to the extent of A's claim. The amount set aside for A's claim is then to be disputed between A and C. As between these two creditors, C has priority pursuant to U.C.C. §9-403(2). Therefore, C is to be paid first to the extent of A's claim, followed by B, then C again, and finally A to the extent there are monies left over.

Conclusion

A confirmed plan acts like a contract; therefore, a secured creditor whose financing statement has lapsed, at least in the Eighth Circuit, retains priority over the subordinated creditors of the confirmed plan. However, priority is non-existent for "lapsed" secured creditors as related to parties that were not part of the confirmed plan. As demonstrated by the referenced circular priority hypothetical, a lapsed financing statement may well leave a "lapsed" secured creditor last in the pecking order of distribution priority. Given these risks, the importance of filing timely continuation statements to financing statements remains as important as ever.

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Footnotes

¹ See, e.g., In re Varat Enterprises Inc., 81 F.3d 1310 (4th Cir. 1996); United States v. Lincoln Sav. Bank, 245 B.R. 603 (N.D. Iowa 2000). Return to articl