In December, the Sixth Circuit, in Grant, Konvalinka & Harrison, P.C. v. Still (In re McKenzie), 737 F.3d 1034 (6th Cir. 2013), addressed two matters of first impression when it adopted the majority rules that (i) a creditor who seeks relief from the bankruptcy automatic stay has the burden to prove the validity of its perfected security interest in collateral; and (ii) the expiration of the two-year statute of limitations on bankruptcy avoidance actions does not prevent the trustee from asserting them defensively under section 502(d) of the Bankruptcy Code.

Prior to filing for bankruptcy, the Debtor in In re McKenzie pledged his interests in certain assets, including his equity in various entities, to his law firm, Grant, Konvalinka & Harrison (“GKH”) to secure legal fees owed to the firm.  As the purported first lien creditor, GKH moved for relief from the automatic stay as it related to those assets—alleging that it had a valid lien and that the debtor had no remaining equity.  The trustee objected on several grounds, and the bankruptcy court and district court sided with the trustee.

On appeal, GKH made several arguments, the most notable of which were (i) that GKH should not have to bear the burden of establishing the validity of it security interest in the pledged equity interests; and (ii) that the trustee cannot use his hypothetical lien creditor status and avoidance powers defensively under section 502(d) of the bankruptcy code, once the two year statute of limitations for filing an affirmative avoidance action has passed.

Though the parties cited no appellate or district court cases on point, the Sixth Circuit aligned with the majority of bankruptcy courts and held that GKH should bear the burden of establishing the validity of its security interests in the pledged collateral.  GKH’s argument that the plain language of section 362(g) of the Bankruptcy Code does not permit a court to alter burdens with regard to the automatic stay did not persuade the Sixth Circuit.  The Court held 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 the ultimate issue—whether the bankruptcy court should terminate the automatic stay.”  The Sixth Circuit was also persuaded by the fact that the creditor would likely be in the best position to demonstrate the validity of its own security interest.

The Sixth Circuit also affirmed the bankruptcy court’s decision to allow the trustee to use his avoidance powers defensively to defeat GKH’s motion for relief from the automatic stay.  The trustee argued that the Debtor’s conveyance of his equity interests to GKH were avoidable transactions pursuant to section 547 of the Bankruptcy Code and therefore section 502(d) of the Bankruptcy Code permitted the Trustee to defensively avoid GKH’s security interest.  The Sixth Circuit agreed, adopting the position of the Ninth Circuit in El Paso City of Texas v. Am W. Airlines, Inc. (In re Am. W. Airlines, Inc.), 217 F.3d 1161 (9th Cir. 2000) as well as the majority of bankruptcy courts.  The Court concentrated on the difference between seeking affirmative relief in the form of an avoidance action and the defensive use of avoidance powers, which seeks no affirmative relief.  The Sixth Circuit relied on the fact that the text of section 502(d) and its predecessor statute do not refer to the statute of limitations in section 546(a)(1)(A).  Finally, the Court held that the Trustee’s defensive use of avoidance powers outside of the statute of limitations is consistent with the central purpose of the Bankruptcy Code—to ensure equality of distribution among creditors.