Tuesday, April 19, 2011

Judge Gargotta Writes Sweeping Opinion on Jurisdiction, Reverse Veil-piercing and Cayman Islands Law

In law school, students cope with concepts of subject matter jurisdiction, personal jurisdiction and stating a cause of action in civil procedure class. When they move on to bankruptcy class, they must try to make sense of the constitutionality of delegating jurisdiction to an Article I court when considering the Marathon Pipeline case. These are not easy issues to get your head around. Judge Craig Gargotta must have felt like he was writing a law school exam when faced with motions to dismiss in an adversary proceeding. Roberts, Trustee v. J. Howard Bass & Associates, Inc., et al, Adv. No. 10-1101 (Bankr. W.D. Tex. 2/15/11). You can find the opinion here.


James H. Bass filed chapter 7 bankruptcy on June 3, 2009. The creditors included two judgment creditors holding claims of $5.5 million (including one that had been found to be non-dischargeable in a prior filing). Filing bankruptcy proved to be a mistake, since the court denied the debtor’s discharge and the trustee launched an adversary proceeding against nine Bass-related defendants seeking to recover assets. The defendants sought to make the adversary proceeding go away with motions to dismiss for failure to state a cause of action and for lack of jurisdiction. Among their more creative arguments was that the bankruptcy court lacked jurisdiction to hear the case because the bankruptcy jurisdiction scheme was unconstitutional.

Have We Been Working Under a Constitutionally Defective System?

In 1982, the Supreme Court found that Congress had “impermissibly removed most, if not all, of the ‘essential attributes of the judicial power’ from the Article III district court, and has vested those attributes in a non-Art. III adjunct.” Northern Pipeline Construction Co. v. Marathon Pipeline Co., 458 U.S. 50, 87 (1982). However, the defendants cited other language not actually found in the opinion for the proposition that “Congress could not vest in a non-Article III court the power to adjudicate, render final judgment, and issue binding orders in a traditional contract action arising under state law, without consent of the litigants, and subject only to ordinary appellate review.” Citing non-existent quotes from the Supreme Court is not a good way to impress the Bankruptcy Court. The defendants also argued that 28 U.S. C. §157, which referred bankruptcy matters to the bankruptcy courts was unconstitutional for the reason that it was an impermissible delegation of power to an Article I court.

The Court noted that the argument would have had some merit—if it had been made in 1982.

If this is where history ended, Defendants would be correct in stating that the bankruptcy code is unconstitutional. However, Defendants’ argument ignores approximately 30 years of subsequent history. In 1984, Congress enacted the Bankruptcy Amendments and Federal Judgeship Act of 1984 (BAFJA). One of the major changes, meant to remedy the constitutional challenges of Marathon, was 28 U.S.C. §157(b)(1) . . . .

This statutory language gave the bankruptcy courts the same broad jurisdiction as the 1978 system, but it forbade the bankruptcy courts from rendering final judgments in cases that were only “related to” the bankruptcy case.

Opinion, p. 8.

In 1987, the Fifth Circuit found the revised jurisdictional grant to be constitutional in In re Wood, 825 F.2d 90 (5th Cir. 1987). The Supreme Court cited favorably to Wood in Celotex Corp. v. Edwards, 514 U.S. 300 (1995). Not wishing to overrule the Fifth Circuit and the Supreme Court, Judge Gargotta found the jurisdictional scheme to be constitutional.

Jurisdictional to the Core?

Having found jurisdiction, the Court had to find whether it had core jurisdiction. The claims asserted by the trustee included substantive consolidation, alter-ego and declaratory judgment. Rights created by the Bankruptcy Code constitute core proceedings. Substantive consolidation arises from section 105. As a result, it is a claim created by the Bankruptcy Code and thus a core proceeding.

Alter-ego posed a more difficult question because these claims arose under state law. However, §157(b)(3) states that the fact that a claim arises under state law is not dispositive in determining core status. Because the alter ego claims would bring assets into the estate, they would have a direct effect on the liquidation of the assets of the estate under 28 U.S.C. §157(b)(2)(O).

The declaratory judgment claims arose under the Bankruptcy Code and thus were core proceedings.

Jury Trial

The next argument raised by the Defendants was that they were entitled to a jury trial and that the Bankruptcy Court could not conduct one absent consent. Although Judge Gargotta went through several pages of serious discussion, the results can be summarized as: 1) there is not constitutional right to a jury trial in an equitable action; and 2) substantive consolidation and alter ego are equitable claims.

Although Judge Gargotta went through several pages of serious discussion, the results can be summarized as: 1) there is not constitutional right to a jury trial in an equitable action; and 2) substantive consolidation and alter ego are equitable claims.

Does Texas Law Allow A Reverse Veil-Piercing Claim Against An Entity That Is Not Owned by the Debtor?

Traditional veil-piercing seeks to hold the shareholder liable for the debts of the corporation. Reverse veil-piercing is more exotic and seeks to hold a corporation liable for debts of an individual. However, in this case, the individual was not a shareholder of the corporations. Would Texas law allow reverse veil-piercing in this situation?

Judge Gargotta relied on The Cadle Co. v. Brunswick Homes, LLC, 379 B.R. 284 (Bankr. N.D. Tex. 2007) for the proposition that while ownership is traditionally a requirement for reverse veil piercing, the doctrine could also be extended to de facto ownership. Because the trustee’s complaint alleged that the debtor sought to disguise his actual control of the companies, the trustee stated a cause of action.

Can You Do Reverse Veil-Piercing on a Cayman Corporation?

One of the defendants was a Cayman Islands corporation. The defendants argued that reverse veil-piercing was not available under Cayman law. The ever-scholarly Judge Gargotta noted that the Cayman Islands generally follow British law and that the United Kingdom has recognized veil piercing for over 100 years, from Saloman vs. Saloman & Co. [1897] A.C. 22 to Adams v. Cape Industries [1990] Ch 433; 2 WLR 657; [1991] 1 All ER 929; [1990] BCC 786 Sealy 66. Thus, the trustee stated a cause of action against the Cayman corporation.

Personal Jurisdiction over the Cayman Corporation

The Cayman defendant argued that no state or federal statute allowed service on it and that it transacts no business in the U.S. and only owns assets in the Cayman Islands. The Court found that the Texas long arm statute allows service to the fullest extent provided by the Constitution. This requires minimum contacts and that exercising jurisdiction is consistent with “traditional notions of fair play and substantial justice.” The Court found that if the Cayman corporation was found to be the alter ego of the debtor, then the court would have jurisdiction over it. As a result, the court found that it had jurisdiction to determine whether the Cayman corporation was the alter ego of the debtor. This poses an interesting conundrum. If the Cayman entity is not the debtor’s alter ego, then the Court may not exercise jurisdiction over it. However, to determine whether the court has jurisdiction, it must exercise its jurisdiction. Thus, the Cayman Islands entity must appear regardless of whether there is jurisdiction. Perhaps another way to approach the problem would have been to find that the Cayman entity had minimum contacts with the United States in that it was formed with money from a United States entity and its control persons were all residents of the United States.

Substantive Consolidation

Finally, the Defendants argued that the Bankruptcy Court could not grant substantive consolidation and that substantive consolidation between a debtor and a non-debtor was improper. The argument against the applicability of substantive consolidation was unlikely to succeed given the fact that the Court had a recent opinion approving use of substantive consolidation. In re Introgen Therapeutics, Inc. 429 B.R. 570 (Bankr. W.D. Tex. 2010).

The Court was similarly unreceptive to the argument that a nondebtor could never be substantively consolidated with a debtor. While the defendants quoted from a Fifth Circuit opinion, they left out the words “under these facts.” Those words were pretty important because in Peoples State Bank v. GE Capital Corp. (In re Ark-La-Tex Timber Co.), 482 F.3d 319 (5th Cir. 2007), the debtor believed that its purchase of the ownership interest in two other entities automatically effected a substantive consolidation. The Court found that if the Trustee was successful in proving alter ego that the assets of the two non-debtor entities would be property of the estate and substantive consolidation would be moot. As a result, the Court determined that it would reserve judgment on the substantive consolidation claim.


After working through twenty-one pages of discussion, the Court concluded:

Having gone through the facts of the case and considered the evidence submitted by the parties, this Court finds that (1) this Court and the current bankruptcy system are constitutional; (2) Plaintiff sufficiently pled a complaint for alter-ego liability that survives the motions to dismiss; (3) this Court can exercise personal jurisdiction over Esperada for the purposes of discovery; and (4) substantive consolidation in general is permitted in the Fifth Circuit, but the issue of whether it is appropriate in this case will be reserved for later determination after discovery and a trial on the merits. For these reasons, Defendant‟s Motions to Dismiss (docket nos. 66-74) are DENIED.

Opinion, p. 21. The lesson to be learned here is that the Bankruptcy Court is fully up to the challenge of sorting through difficult procedural and jurisdictional issues. However, when raising difficult procedural and jurisdictional issues, it is important to accurately quote the cases.

Class dismissed.

1 comment:

Anonymous said...

Great Blog! Could you give your thoughts on the Valence Technology chapter 11 that is in Judge Gargotta's, court. I am a investor with 20K at stake and that stock was going to be used for my son's college fund. Do you think we are sunk. Any advice would be welcome.
Thanks RM