Fifth Circuit Report: Oct.-Dec. 2015

The Fifth Circuit decided cases dealing with appellate procedure, exemptions, judicial estoppel, jurisdiction, sanctions, standing and surcharging collateral during the fourth quarter of 2015.  A common theme among the cases is parties being disappointed in a variety of contexts, including having an appeal dismissed on procedural grounds, having a lawsuit dismissed based on incomplete filings in a bankruptcy case, losing exemptions based on unfortunate timing and failure to establish damages after dismissal of an involuntary petition.  

Fifth Circuit Provides Valuable Guidance on Jurisdiction and Authority Post-Stern

Many cases deal with debtors who fraudulently convey away their assets before filing bankruptcy.   But what about the situation where the debtor is the victim of a fraudulent conveyance rather than the perpetrator?    In Galaz v. Galaz (In re Galaz), No. 13-50781 (5th Cir. 8/25/14), which can be found here, the Fifth Circuit answers important jurisdictional and Stern questions about the debtor's quest to recover wayward assets.   

What Happened

Lisa and Raul Galaz were once married to each other.   One of their assets was an interest held by Raul in Artist Rights Foundation, LLC ("ARF"), a company which owned the rights to the Ohio Players music catalog.    The other owner of ARF was Julian Jackson.   When Lisa and Raul were divorced in 2002, Raul assigned Lisa 50% of his 50% interest in ARF.   Because the transfer was made without Julian's consent, Lisa received a 25% economic interest in the company but was not a member.    While it is not really relevant to the opinion, another significant occurrence in 2002 was that Raul pled guilty to mail fraud and surrendered his California law license.    

From 1998 to 2005, the Ohio Players catalog was not generating any revenue.   While the opinion describes the Ohio Players as "a former funk band," a little more explanation is justified.   The Ohio Players were formed in 1959 and had gold records with "Funky Worm," "Skin Tight," "Fire" and "Love Roller Coaster."   Their heyday was between 1973 and 1976, when they had seven Top 40 hits.  Their last studio album was released in 1998 and they were inducted into the Official R & B Music Hall of Fame in 2013.  

On June 3, 2005, Raul transferred all of ARF's rights to the Ohio Players to Segundo Suenos, which was nothing more than a name at the time, but was later established as a Texas limited liability company.  According to the Fifth Circuit, when Segundo Suenos is spelled with the tilde (⁓--an accent mark used in Spanish), it means "Second Dreams" in Spanish.   Raul did not get permission from Lisa or Julian before embarking on his second dream of exploiting the Ohio Players music in an entity which excluded them.  Shortly after this transfer, the catalog began to make money, about a million dollars over five years.    The opinion does not say why the catalog started making money.   However, it is worth noting that the song "Love Rollercoaster" appeared in the film Final Destination 3 in 2006.  

In 2007, Lisa filed chapter 13 in the Western District of Texas.   She brought an adversary proceeding against Raul, his father, Alfredo, and Segundo Suenos.   The Defendants brought a third party complaint against Julian, who counterclaimed against them.   After a five day trial, Chief Bankruptcy Judge Ronald B. King found that the transfer to Segundo Suenos was invalid and that Raul had breached his fiduciary duty to Julian but not Lisa.   The Bankruptcy Court awarded $250,000 in actual damages and $250,000 in exemplary damages to Lisa and $500,000 in actual damages and $500,000 in exemplary damages to Julian.   After an appeal to the District Court, the fraudulent transfer judgment was affirmed but the case was remanded for a recalculation of damages.    The Bankruptcy Court reduced the actual damages slightly to reflect taxes incurred by Segundo Suenos, but otherwise left the award intact.   The District Court affirmed the second judgment and the case was appealed to the Fifth Circuit.

 Jurisdiction and Authority

The Fifth Circuit considered two important issues in its opinion:  whether the Bankruptcy Court had jurisdiction over the claims and whether it had authority to enter a final judgment.    These are very different concepts.   Jurisdiction looks at whether the federal courts have authority to consider a matter, while the authority question looks at whether the Bankruptcy Court or the District Court has authority to render a final judgment.

With regard to Lisa, the Fifth Circuit had no trouble finding jurisdiction.   The test for "related to" jurisdiction, which is the most expansive source of bankruptcy jurisdiction, is whether the dispute could "'conceivably' have any effect on the estate being administered in bankruptcy."   See Opinion, p. 5.  Since Lisa's suit could increase the size of the estate, there clearly was jurisdiction.   Julian was another matter.   He was a non-debtor suing another non-debtor.   That is the scenario that was struck down by the Supreme Court in Northern Pipeline.   Even though Julian was unwillingly dragged into the suit, there was ultimately no jurisdiction for his claims and so they went away.   Julian may have recognized this reality before the Fifth Circuit did, since he did not bother to file a brief in the appeal despite being ordered to.  

Although the Bankruptcy Court had jurisdiction to consider Lisa's claims, it did not have authority to enter a final judgment.    This was not a difficult question in 2014 (although it was much less obvious in 2010 when the case was originally tried).    The Fifth Circuit dutifully noted that

when a debtor pleads an action that would augment the bankruptcy estate, but not necessarily be resolved in the claims process, then the bankruptcy court is constitutionally prohibited from entering final judgment.

 Opinion, pp. 7-8.  The Bankruptcy Court had attempted to justify its final judgment on implied consent.   However, the Fifth Circuit's Frazin and BP RE decisions have eliminated consent as a ground for authority in the circuit.   The Supreme Court recently considered and dodged the consent issue in Bellingham and has granted cert to consider the issue again in Wellness International Network.   Nevertheless, the Court noted that "Until the Supreme Court decides, we are bound by controlling circuit precedent."  Opinion, p. 8.

Thus, the Bankruptcy Court had jurisdiction to consider Lisa's claims but not authority to enter a final judgment.    Where does that leave the case?  

The failure of the consent rationale does not vitiate the lower courts’ work altogether, however. As the Supreme Court recently held, claims designated for final adjudication in the bankruptcy court as a statutory matter, but prohibited from proceeding in that way as a constitutional matter, may still “proceed as non-core within the meaning of § 157(c).” (citation omitted). Because Lisa’s claim is “related to a case under title 11,” 28 U.S.C. § 157(c)(1), the bankruptcy court may still hear it and “submit proposed findings of fact and conclusions of law to the district court for de novo review and entry of judgment.” (citation omitted). Accordingly, the district court’s judgment on Lisa’s TUFTA claim must be vacated and remanded for de novo review of the bankruptcy court’s decision as recommended findings and conclusions.

Opinion, pp. 8-9.   Thus, the District Court which has already reviewed the case twice will get to take a third look at it.   This time, the District Court will consider the Bankruptcy Court's opinion as proposed findings of fact and conclusions of law which it may accept or reject on a de novo basis.  What this means is that the District Court is free to disregard the Bankruptcy Court's factual findings rather than being bound by the clearly erroneous rule.    However, given the Bankruptcy Court's greater familiarity with the facts and the District Court's workload, it is highly likely that the District Court's review will be very deferential.    

The Galaz opinion highlights the silliness of all of the attention paid to Stern and its progeny.  Notwithstanding Stern, Bankruptcy Courts can still hear cases within their jurisdiction.   If a case is non-core (or is designated as core but is outside of the Bankruptcy Court's authority), the Bankruptcy Court can still submit proposed findings of fact and conclusions of law to the District Court.  While the District Court could hear more evidence and re-open the record, the District Courts already have a pretty full docket.   As a result, my guess is that they will review proposed findings and conclusions in much the same manner as they have traditionally reviewed bankruptcy appeals.   However, if the District Courts are faced with a high volume of Bankruptcy Court reports and recommendations, they may be tempted to give them even more deferential review.   The District Courts have substantial experience reviewing reports and recommendations from their Magistrate Judges and, although I have not done the research, I suspect that the normal procedure is to approve them.   To quote the Talking Heads, the practical reality may be "same as it ever was."

Even though the Fifth Circuit sent Lisa back for another round of procedural hell, they did give her a parting gift by answering a substantive legal issue.   Lisa had filed suit under the Texas Uniform Fraudulent Transfer Act which allows a creditor to file suit to avoid a transfer.   Raul claimed that Lisa was not a "creditor" because he didn't owe her any money.    However, the Fifth Circuit concluded that a "creditor" under TUFTA means someone who has a "claim" which means a right to "payment or property."   Because Lisa had the right to a share of ARF's assets upon its dissolution, she had a right to property and was thus a creditor with standing to pursue a TUFTA claim.  

 

  

Fifth Circuit Affirms Ruling That "The Loan Has Been Paid!!!;" Rejects Stern and Jurisdictional Defenses

The case of a creditor who did not want to acknowledge that its debt had really and truly been paid received little sympathy from the Fifth Circuit which rejected a panoply of defenses and affirmed the Bankruptcy Court ruling that "The Senior Loan Has Been PAID!!!"   Fire Eagle, LLC v. Bischoff (Matter of Spillman Development Group, Ltd., Case No. 11-51057 (5th Cir. 2/28/13), which can be found here.   I previously wrote about the Bankruptcy Court decision from Judge Frank Monroe here.   The decision is significant because it shows that Stern v. Marshall is not a silver bullet for parties seeking to avoid bankruptcy court decisions.   As discussed below, it also rejects a magical approach to bankruptcy law.

What Happened

The case involved a golf course that filed for chapter 11, which was a common occurrence in Austin.   After the debtor and a lienholder fought to a stalemate, the Bankruptcy Court ordered a section 363 sale.   The lienholder, Fire Eagle, LLC, held two liens, a first lien which was guaranteed, and a second lien which was not.    Fire Eagle was the high bidder at the sale, making a $9.3 million credit bid, which was approximately $200,000 more than the amount of its guaranteed first lien debt.  

Rejoicing at their good fortune, the guarantors requested a declaratory judgment that their obligation had been satisfied.   Fire Eagle objected to the Bankruptcy Court's jurisdiction as well as venue.  It also contended that its credit bid reduced its "claim" but not its "debt" and that it was therefore free to continue pursuing the guarantors.    The Bankruptcy Court ruled for the guarantors.   In addition to the quoted language above, the Court told Fire Eagle that "This is the Bankruptcy Court; not fantasy land" and "This is not rocket science."    The District Court affirmed.

The Fifth Circuit Explains Jurisdiction and Authority

In the post-Stern era, it is helpful to remember that there are three separate doctrines that govern a bankruptcy court's ability to render a  final decision:

a.  Jurisdiction under section 1334;

b.  Statutory authority under section 157; and

c.  Constitutional authority under Article III of the Constitution.

Under 28 U.S.C. Sec. 1334, there is jurisdiction for "civil proceedings arising under title 11, or arising in or related to cases under title 11."   "Related to" jurisdiction, which is the broadest category, applies if the case "could conceivably have any effect on the estate being administered in bankruptcy."    While Fire Eagle correctly stated that bankruptcy courts generally cannot "entertain collateral disputes between third parties that do not involve the bankruptcy or its property," the Fifth Circuit found that if Fire Eagle were to succeed in recovering from the guarantors, this would reduce its deficiency claim which would free up more money for the other creditors.     The Court noted that "We have previously held that similar attenuated, hypothetical effects of third-party litigation can give rise to related-to bankruptcy jurisdiction."    Opinion, p. 5.

Thus, jurisdiction turns on the broad "any conceivable effect" test.   However, this is not the end of the inquiry.    Once jurisdiction is present, the question is which court has the power to exercise that jurisdiction.

Statutory authority to render a final judgment is contained in 28 U.S.C. Sec. 157(b).   If a matter is statutorily defined as a "core" proceeding the Bankruptcy Court may enter a final judgment.   Otherwise, the Court must submit proposed findings of fact and conclusions of law to the U.S. District Court absent consent of the parties.

The Fifth Circuit found that the dispute between Fire Eagle and the guarantors qualified as a core proceeding because it was "dependent upon the rights created in bankruptcy."

Because the basis for this dispute is whether Fire Eagle’s credit bid had the effect of extinguishing the Senior Indebtedness, and because the right to credit bid is purely a creature of the Bankruptcy Code, see 11 U.S.C. § 363(k), we fail to see how this proceeding does not qualify as core under § 157(b)(1) and therefore hold that the bankruptcy court’s entering an order without reference to the district court was within its statutory authority.

Opinion, pp. 6-7.

Finally, there is the matter of constitutional authority to render a final judgment.   This is the legacy of Stern v. Marshall.    Because the Court of Appeal's discussion of Stern is succinct and clear, I quote it in its entirety below:

 In Stern v. Marshall, the Supreme Court held that it was unconstitutional for a bankruptcy court to issue a judgment on a state-law counterclaim for tortious interference with a gift expectancy, despite the fact that the claim itself was statutorily “core” pursuant to § 157(b)(2)(C) (defining as core proceedings “counterclaims by the estate against persons filing claims against the estate”). 131 S. Ct. 2594, 2600–01 (2011). It based this decision on the fact that the counterclaim was in no way reliant or dependent on proceedings in bankruptcy—it just happened to have been a counterclaim to a claim asserted in a bankruptcy proceeding. Id. at 2611. Fire Eagle contends that its claims in this matter are similarly beyond the constitutional authority of the bankruptcy courts to decide.

However, Stern itself stated that its holding was reliant on the fact that the counterclaim at issue was “a state law action independent of the federal bankruptcy law and not necessarily resolvable by a ruling on the creditor’s proof of claim in bankruptcy.” Id. Fire Eagle’s claim, on the other hand, is inextricably intertwined with the interpretation of a right created by federal bankruptcy law—the interpretation of the effect of Fire Eagle’s credit bid is in fact determinative of Fire Eagle’s claim. We therefore conclude that Stern is inapplicable and that there was no constitutional bar to the bankruptcy court’s exercise of its jurisdiction over this statutorily core matter.

 Opinion, p. 7.

The Fire Eagle opinion contains a formulation that I believe will be widely used in Stern analysis, namely, that if an issue relates in some substantive manner to a creditor's claim, then the Bankruptcy Court has authority to enter a final judgment.   While this is not the full extent of authority under Stern, it is a convenient way to handle many of the disputes likely to arise.

Exploring the Zen of a Credit Bid

 There is a theory making the rounds of the creditor's bar that there is a critical distinction between a "debt" and a "claim" and that if a dispute can be phrased in terms of the "debt," that the Bankruptcy Court lacks the ability to act upon the "debt."   This theory finds its support in cases such as In re Five Boroughs Mortg. Co., Inc., 176 B.R. 708, 712 (Bankr. E.D. N.Y. 1995).  Fire Eagle made a variant of this argument, contending that the credit bid affected only the the claim in bankruptcy and not the underlying debt.   This required the Court to consider the meaning of a credit bid.   Not surprisingly, the Court of Appeals concluded that there is no functional difference between a credit bid and cash.   The Court wrote:

Fire Eagle’s first argument is logically unsound. If Fire Eagle had been outbid at the § 363(b) auction, as it nearly was, or if it had simply declined to credit bid its claims, then the cash proceeds from that auction would have been applied against the Senior Indebtedness as the most senior debt in the bankruptcy estate. If the Senior Indebtedness was paid in full with these cash proceeds, then it would be absurd to suggest that Fire Eagle could separately proceed against the guarantors. Under such a theory, Fire Eagle would be undeniably receiving recovery in excess of the face value of the Senior Indebtedness by virtue of guarantees that explicitly provide for their own termination on the payment in full of the Senior Indebtedness.

Consequently, for Fire Eagle’s argument to be correct, its credit bid must not have been equivalent to a cash payment for the assets purchased. Title 11U.S.C. § 363(k), though, provides that credit bidders “may offset [their] claim against the purchase price” of the property that is the subject of the § 363(b) bankruptcy sale. This provision explicitly contemplates mixed bids of cash and claims, implicitly presupposing an equivalence with cash of the value of the credit bid. We agree with the bankruptcy court and district court that Fire Eagle’s credit bid constituted a payment-in-full of the Senior Indebtedness, just as if SDG’s assets had been sold for cash.

Opinion, p. 10.    The Court of Appeals also rejected several other insubstantial arguments.

Conclusion

The Fifth Circuit should be commended for providing a clear road map on some difficult issues of bankruptcy law.   The Court also deserves kudos for rejecting the magical view of bankruptcy law.  I have heard apocryphal stories that when the Bankruptcy Code was in its infancy, creditors would make arguments that the automatic stay did not control over a creditor's contract rights or that the discharge was not effective without the creditor's consent.   These particular instances of wishful thinking are now in the distant past.    However, in recent years there have been a rash of cases in which unhappy parties asserted that the Bankruptcy Court simply did not have the power to do whatever it did.   The Supreme Court rejected these challenges in United Student Aid Funds, Inc. v. Espinosa, 130 S.Ct. 1367 (2010) and Travelers Indemn. co. v. Bailey, 129 S.Ct. 2195 (2009), each of which involved collateral attacks on bankruptcy court orders, but limited the Bankruptcy Court's power in Stern v. Marshall, 131 S.Ct. 2594 (2011).    The resurgence of these types of challenges requires practitioners to remain sharp in their basic bankruptcy concepts and requires courts to distinguish between serious arguments and those which are seductive but ultimately insubstantial.   In the present case, the Fifth Circuit succeeded in making this distinction.   

Fifth Circuit to Consider Impact of Stern v. Marshall on U.S. Magistrates

While the paparazzi followed every move of Anna Nicole Smith during her tragically shortened life, those of us of the legal paparazzi now stalk every new development in the case which bears her legal name, Stern v. Marshall. Some commentators have asked whether the newly emphasized limitations on the jurisdiction of U.S. Bankruptcy Judges to enter final judgments will apply to U.S. Magistrates as well. The Fifth Circuit has indicated that it will soon be considering this issue.

On September 9, 2011, the Fifth Circuit directed the parties to submit

letter briefs of not more than six pages addressing whether the reasoning of Stern applies to magistrate judges, which, like bankruptcy judges, are not Article III judges, and whether, under Stern, a magistrate judge can enter final judgment in a case tried to a magistrate judge by consent under 28 U.S.C. § 636(c) where jurisdiction is based on diversity of citizenship and state law provides the rule of decision.

Technical Automation Services Corp. v. Liberty Surplus Insurance Corporation, No. 10-20640 (5th Cir. 9/9/11), Order, p. 2.

Thus, it looks like there may be a circuit-level opinion on Stern v. Marshall sooner rather than later.

Hat Tip to Prof. Ken Klee.

You can read the order in full below.

Thoughts About the Impact of Stern v. Marshall

Since the Supreme Court dropped its constitutional bombshell on the bankruptcy system last week in Stern v. Marshall, 2011 U.S. LEXIS 4791 (2011) (aka Anna Nicole Smith II), lots of people are scratching their heads and wondering what this all means. While Chief Justice Roberts suggested that the decision had only a "narrow" impact, many others, including myself, are not so sure. In this post, I am going to focus on the practical and theoretical impact of the decision.

The Practical Side

On the practical side, we are going to spend a whole lot more time fighting turf wars about whether a particular action belongs in bankruptcy court or somewhere else. That means even more motions to withdraw reference and motions to abstain. While Stern v. Marshall focused on the distinction between an Article III federal court and an Article I federal court, the more likely choice will be between an Article I federal court and a state court. While the Supreme Court was troubled by final decision making by judges who lacked life tenure and salary protection, the opinion may lead more cases to be decided by state court judges who lack these protections. One of the chief virtues that Chief Justice Roberts attributed to Article III judges was their freedom from outside influences. However, elected state court judges who must seek campaign contributions from the lawyers who appear in front of them and who are placed in office by an electorate that knows little more than their party affiliation seem to be the polar opposite. Thus, the theoretical and practical underpinnings of the opinion appear to be in tension.

A second practical effect will be delay. Bankruptcy Courts have proven to be efficient engines for deciding cases. In the Bankruptcy Court for the Western District of Texas, it is common for an adversary proceeding to go to trial within six months. In the U.S. District Court for the Western District of Texas, a civil action will take closer to two years to make it to trial. Bankruptcy Courts can proceed faster because they do not have a criminal docket which can trump civil actions and because they are not allowed to conduct jury trials.

The third practical effect will be that we will be fighting endless battles about finality. If the Bankruptcy Court rendered a final decision based on now-infirm core jurisdiction, can that decision be set aside under Rule 60? If an action is currently pending in Bankruptcy Court and the other party mistakenly admitted core jurisdiction, can they go back and change their mind? Can they file an untimely jury demand and move to withdraw the reference? I think the answer is likely no, but we will spend a lot of time arguing about it.

Theoretical Impact

On the intellectual side, we are going to spend more time thinking about what makes the bankruptcy system unique. In Northern Pipeline Construction Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982), Justice Brennan's plurality opinion referred to "the restructuring of debtor-creditor relations, which is at the core of the federal bankruptcy power." 458 U.S. at 71. We now know that that "core" is smaller than we thought it was. It seemed that resolving claims between the estate and persons filing claims against the estate would be intimately tied to "the restructuring of debtor-creditor relations." However, based on Stern v. Marshall, it appears to be limited to those functions which are both fundamental to the bankruptcy system and/or unique to the bankruptcy system. What are those functions?

To me, deciding claims is the least defensible of these functions because most claims objections revolve around whether a claim is allowable under state law. However, in his concurrence, Justice Scalia opined that determining claims might be permissible. Why is this? Justice Scalia cited a law review article that I haven't read which could likely provide a definitive answer. However, going out on a limb, I would suggest that determining claims is integral to what the Bankruptcy Court does because it is a necessary component of allocating scarce resources between creditors and the debtor. A State Court is concerned with a dispute between the debtor and one of his creditors. A Bankruptcy Court must deal with the debtor and potentially thousands of creditors. If one creditor gets too large of a slice of the pie, it means that everyone else gets less. State Court is all about the race to the courthouse, while Bankruptcy Court is about the collective resolution of claims. This collective aspect is what distinguishes the Bankruptcy Court.

What else is fundamental to or unique about the bankruptcy system? At a minimum, I would say: the automatic stay, the discharge, plans and the ability to use cash collateral, to sell assets free and clear of liens and to assume or reject executory contracts and unexpired leases. Each of these provisions is based on a specific Code-created right and does not exist outside of bankruptcy. Consider the automatic stay. It is true that injunctions exist outside of Bankruptcy Court. However, there is no comparable provision that allows for a universal injunction without proving a substantive right or posting security. Additionally, the automatic stay is fundamental to the bankruptcy process because it allows for the collective process to take place.

Exemptions pose an interesting question. Most exemptions in bankruptcy are determined by state law. State courts make decisions about exempt property all the time. However, I think exemptions are fundamental for two reasons. First, federal law can displace state law, as in the homestead caps contained in Sec. 522(o)-(q) and the ability to avoid liens under Sec. 522(f). Secondly, a State Court only rules upon an exemption dispute relating to a debtor and a creditor at a specific point in time. A Bankruptcy Court, on the other hand, determines the debtor's exempt property with respect to all of his creditors and draws a line in the sand saying this property is available for creditors and this property is the debtor's.

The distinction between preferences and fraudulent transfers raises another interesting question. Both preferences and fraudulent transfers are Code-created rights. However, in Granfinanciera v. Nordberg, 492 U.S. 33 (1989), the Supreme Court held that fraudulent transfers did not involve "public rights." Is there a distinction between them? One distinction is that fraudulent transfer law exists outside of bankruptcy, while preference law does not. A preference is defined by the fact that it occurred on the eve of bankruptcy, while a fraudulent transfer can happen at any time. A fraudulent transfer action recovers property rightfully belonging to the debtor, while a preference action is designed to provide equality of distribution between creditors (and make money for trustee's lawyers).

In defining the new boundaries of core jurisdiction, I think it is important to ask three questions:

1. Does it involve a Code-created right?

2. Does it exist outside of bankruptcy?

3. Does it have a collective aspect to it?

I predict that an action that satisfies two out of three of these tests will be a core proceeding 99% of the time.

Supreme Court Finds Core Counterclaim Jurisdiction Unconstitutional, Sends Vickie Lynn Marshall Estate Packing

After fifteen years of litigation, two trips to the Supreme Court and the deaths of both of the original antagonists, the Supreme Court decided Stern v. Marshall, ___ U.S. ___ (2011). While Vickie Lynn Marshall, better known as Anna Nicole Smith, made a splash during her lifetime as a Playboy Playmate who married an aging oil billionaire, her posthumous legacy is the most important Supreme Court case on bankruptcy court jurisdiction since Northern Pipeline Construction Co. v. Marathon Pipe Line Co., 459 U.S. 813 (1982). It may also sow as much confusion as the latter case. You can find the opinion here.

The issue in Marshall was straightforward: does 28 U.S.C. §157(b)(2)(C) mean what it says-- that counterclaims to proofs of claim are core proceedings, and if so, is that grant of jurisdiction constitutional? In a 5-4 decision authored by Chief Justice Roberts, the Court concluded that §157(b)(2)(C) did authorize the bankruptcy court to determine a counterclaim to a proof of claim as a core proceeding, but that the statutory grant was unconstitutional. In doing so, the Chief laid out a manifesto on the meaning of Article III. Justice Scalia offered a curt concurring opinion and Justice Breyer wrote in dissent.

The Executive Summary

While the three opinions in the case make for compelling reading, the following two quotes from the beginning of the opinion carry the gist of it:

Chief Justice Roberts opened his opinion with a reference to Dickens’ Bleak House:

This “suit has, in course of time, become so complicated, that . . . no two . . . lawyers can talk about it for five minutes, without coming to a total disagreement as to all the premises. Innumerable children have been born into the cause: innumerable young people have married into it;” and, sadly, the original parties “have died out of it.” A “long procession of [judges] has come in and gone out” during that time, and still the suit “drags its weary length before the Court.”

Those words were not written about this case, see C. Dickens, Bleak House, in 1 Works of Charles Dickens 4–5 (1891), but they could have been. This is the second time we have had occasion to weigh in on this long-running dispute between Vickie Lynn Marshall and E. Pierce Marshall over the fortune of J. Howard Marshall II, a man believed to have been one of the richest people in Texas.

***

Although the history of this litigation is complicated, its resolution ultimately turns on very basic principles. Article III, §1, of the Constitution commands that “[t]he judicial Power of the United States, shall be vested in one supreme Court, and in such inferior Courts as the Congress may from time to time ordain and establish.” That Article further provides that the judges of those courts shall hold their offices during good behavior, without diminution of salary. Ibid. Those requirements of Article III were not honored here. The Bankruptcy Court in this case exercised the judicial power of the United States by entering final judgment on a common law tort claim, even though the judges of such courts enjoy neither tenure during good behavior nor salary protection. We conclude that, although the Bankruptcy Court had the statutory authority to enter judgment on Vickie’s counterclaim, it lacked the constitutional authority to do so.

Opinion, pp. 1-2.

For those who want the nitty, gritty details, here are several thousand more words about the opinion.

A Billionaire’s Death Paves the Way for the Destruction of Many Trees

On June 27, 1994, Vickie Lynn Smith married Howard Marshall. She was 26 and had been Playboy’s Playmate of the Year the prior year. He was 89. Howard passed away thirteen months later on August 4, 1995. However, the parties did not wait for his death to begin their legal battle.

In April 1995, Vickie filed suit in Probate Court in Texas seeking to invalidate Howard’s living trust and asserting that Howard son, Pierce, had tortiously interfered with her property rights in Howard’s assets. Pierce then filed suit against Vickie and two of her lawyers in Texas state court asserting that they had defamed him.

In January 1996, Vickie did what any destitute ex-stripper would have done and filed for chapter 11 relief in California. Pierce filed a dischargeability adversary and a proof of claim against Vickie. Vickie counterclaimed for tortious interference with an inter vivos gift, contending that Pierce had forged Howard’s name to a living trust and destroyed or suppressed a trust that Howard had asked his lawyers to draw up for Vickie’s benefit.

Things did not go well for Pierce in bankruptcy court. The Bankruptcy Court found that he had engaged in “massive discovery abuse.” Pierce then asked the District Court to withdraw the reference. The District Court initially indicated it would grant the motion but then reconsidered based on the fact that Pierce had voluntarily chosen the Bankruptcy Court forum.

The Bankruptcy Court commenced a trial on the adversary proceeding on October 25, 2009. It rendered a final judgment awarding Vickie $447 million on December 29, 2000.

Meanwhile, back in Texas, Vickie filed a parallel claim against Pierce in January 2000. Pierce defended asserting that there was not an agreement to be tortiously interfered with. After recovering a judgment against Pierce in Bankruptcy Court, Vickie non-suited her claims against Pierce in Texas Probate Court. The Bankruptcy Court initially ordered Pierce not to proceed, but changed its mind after Pierce represented that there was no risk of inconsistent judgments.

After a five month trial, the jury in the Probate Court returned a verdict adverse to Vickie on March 7, 2001. Among other things, the jury found that Howard had not agreed to make a gift to Vickie. The Probate Court entered a final judgment on December 27, 2001.

The two trials were a contrast in the evidence considered. The Bankruptcy Court did not allow Pierce to present any evidence because of his discovery abuse. On the other hand, the Probate Court heard 40 witnesses, including six days of testimony from Vickie Lynn and resulted in a jury verdict.

Up to the Supreme Court Round One

Pierce appealed the Bankruptcy Court judgment, contending among other things that the dispute was a non-core proceeding which must be reviewed de novo by the District Court. The District Court agreed that the claim was non-core and conducted additional hearings. It entered a judgment which affirmed the Bankruptcy Court’s findings on liability but reduced the damage award. This judgment was entered on March 7, 2002.

Pierce appealed to the Ninth Circuit which vacated the judgment, finding that the “probate exception” deprived the Bankruptcy Court of jurisdiction. Marshall v. Marshall, 392 F.3d 1118 (9^th Cir. 2004). The Supreme Court disagreed and remanded the case to the Ninth Circuit. Marshall v. Marshall, 547 U.S. 293 (2006). You can read more about that opinion here. (Note: The original opinion in Marshall v. Marshall was the subject of the inaugural post for this blog).

Shortly after the remand, both Pierce and Vickie passed away within a few months of each other. This left the contest over the assets of Howard as a battle between the estates of Pierce and Vickie.

The Ninth Circuit Tangles With Jurisdiction Again

When the case went back to the Ninth Circuit, it reached the same result although for different reasons. Stern v. Marshall, 600 F.3d 1037 (9^th Cir. 2010). (The caption of the case changed because Howard K. Stern was the executor of Vickie’s estate. However, it is Howard Stern the lawyer, rather than Howard Stern the radio shock jock). The Ninth Circuit basically held that 28 U.S.C. §157(b)(2)(C) did not mean what it said. While 28 U.S.C. §157(b)(2)(C) expressly provides that counterclaims to proofs of claim constitute core proceedings, the Ninth Circuit held that it only extended to counterclaims to the extent necessary to determine the proof of claim, but not to an affirmative recovery. Alternatively, it held that if §157(b)(2)(C) did extend to counterclaims in their entirety, that it was unconstitutional.

This set the stage for a second trip to the Supreme Court.

Bankruptcy Jurisdiction 101

As an introduction, Chief Justice Roberts summarized eight principles of Bankruptcy Court jurisdiction:

* District Judges have “original and exclusive jurisdiction of all cases under title 11.”

* Bankruptcy proceedings fall into three categories: those that arise under title 11, that that arise in a case under title 11 and those that are related to a case under title 11.

* District Courts may refer “any or all such proceedings to the bankruptcy judges of their district” and may withdraw the reference “for cause shown.”

* Since 1984, Bankruptcy Judges “have been appointed to 14-year terms by the courts of appeals for the circuits in which their district is located.”

* Bankruptcy Judges may enter final orders in “all core proceedings arising under title 11, or arising in a case under title 11.”

* Core proceedings include but are not limited to sixteen enumerated categories, including “counterclaims by [a debtor’s] estate against persons filing claims against the estate.”

* If the Bankruptcy Court can enter a final judgment, an aggrieved party has a right of appeal to the U.S. District Court.

* If a matter is not a core proceeding, then the Bankruptcy Court must submit proposed findings of fact and conclusions of law to the District Court for de novo review unless the parties consent to entry of a final judgment by the Bankruptcy Court.

Opinion, pp. 7-8.

Section 157(b)(2)(C) Means What It Says

Chief Justice Roberts found that Vickie’s counterclaim against Pierce was a core proceeding “under the plain text of §157(b)(2)(C).” This was a rebuke to the Ninth Circuit which had adopted the rather magical reasoning that a counterclaim was only a core proceeding to the extent that it reduced a claim against the estate, but not to the extent that it granted affirmative recovery.

The Chief then analyzed what the phrase “all core proceedings arising under title 11, or arising in a case under title 11” meant. This phrase is important because it identifies the types of proceedings that Bankruptcy Judges can enter final orders in. Pierce had suggested that the phrase was ambiguous and that there could be some core proceedings which neither arose under title 11 or in a case under title 11. The Court acknowledged that the phrase was ambiguous but concluded that “core proceedings are those that arise in a bankruptcy case or under Title 11.” Opinion, p. 10.

The Court also rejected the argument that core proceedings that did not arise under Title 11 nor in a Title 11 case should be “related to” proceedings.

Pierce argues that we should treat core matters that arise neither under Title 11 nor in a Title 11 case as proceedings “related to” a Title 11 case. Brief for Respondent 60 (internal quotation marks omitted). We think that a contradiction in terms. It does not make sense to describe a “core” bankruptcy proceeding as merely “related to” the bankruptcy case; oxymoron is not a typical feature of congressional drafting.

Opinion, p. 10.

Concluding its discussion of statutory interpretation, Chief Justice Roberts stated, “We agree with Vickie that §157(b)(2)(C) permits the bankruptcy court to enter a final judgment on her tortious interference counterclaim.” Opinion, p. 11.

The Court also shot down Pierce’s argument that the Bankruptcy Court lacked jurisdiction on Vickie’s defamation claim because it was a “personal injury tort claim.” Under §157(b)(5), “The District Court shall order that personal injury tort and wrongful death claims shall be tried in the district court in which the bankruptcy case is pending, or in the district court in the district in which the claim arose.” Pierce contended that this meant that the Bankruptcy Court lacked jurisdiction to hear these claims. Vickie contended that defamation was not a “personal injury tort” and that the statute was not jurisdictional. The Court declined the invitation to define the term “personal injury tort” and instead found that the section was not jurisdictional and could be waived. When Pierce waited 27 months to file his motion to withdraw reference, he waived his ability to seek a trial in the district court.

All About Article III

If the Opinion had stopped here, there would have been much rejoicing on Vickie’s side. However, it did not. “Although we conclude that§157(b)(2)(C) permits the Bankruptcy Court to enter final judgment on Vickie’s counterclaim, Article III of the Constitution does not.”

Article III of the Constitution vests the judicial power of the United States in the supreme court and “such inferior Courts as the Congress may from time to time establish.” While I am sure that District Court Judges don’t like to think of themselves as “inferior Courts,” at least the Constitution guaranties them life tenure and protection against reduction in pay. Bankruptcy Judges, being appointed under Article I of the Constitution, do not enjoy these protections.

The Chief described Article III as “an inseparable element of the constitutional system of checks and balances that both defines the power and protects the independence of the Judicial Branch.” Opinion, p. 16. It also “protects liberty.” Opinion, p. 17. In the Declaration of Independence , one of the grievances of the colonists was that King George “made Judges dependent on his Will alone, for the tenure of their offices and the amount and payment of their salaries.”

The Framers undertook in Article III to protect citizens subject to the judicial power of the new Federal Government from a repeat of those abuses. By appointing judges to serve without term limits, and restricting the ability of the other branches to remove judges or diminish their salaries, the Framers sought to ensure that each judicial decision would be rendered, not with an eye toward currying favor with Congress or the Executive, but rather with the “[c]lear heads . . . and honest hearts” deemed “essential to good judges.” 1 Works of James Wilson 363 (J. Andrews ed. 1896).

Opinion, p. 18. Thus, the Court’s consideration of the constitutionality of §157(b)(2)(C) is not just about which person in a black robe will decide a particular case or which estate of a dead person will receive a lot of money, but rather, it is a mighty bulwark protecting us against a new King George and his corrupt judges.

Public Rights and Private Lawsuits

While Article III jurisdiction is important in preventing tyranny, there is an exception for “public rights.”

The plurality in Northern Pipeline recognized that there was a category of cases involving “public rights” that Congress could constitutionally assign to “legislative” courts for resolution. That opinion concluded that this “public rights” exception extended “only to matters arising between” individuals and the Government “in connection with the performance of the constitutional functions of the executive or legislative departments . . . that historically could have been determined exclusively by those” branches. Id., at 67–68 (internal quotation marks omitted). A full majority of the Court, while not agreeing on the scope of the exception, concluded that the doctrine did not encompass adjudication of the state law claim at issue in that case.

Opinion, p. 19.

After Northern Pipeline, Congress tried again, creating bankruptcy courts appointed by the Court of Appeals and allowing them to enter final judgments in “core” proceedings only. Judgments in core proceedings were subject to only traditional appellate review with deference to judicial fact finding.

The Chief Justice then found that the Vickie Lynn Marshall case was just like the Northern Pipeline case in that

the Bankruptcy Court in this case exercise the “judicial Power of the United States” in purporting to resolve and enter final judgment on a state common law claim, just as the court did in Northern Pipeline. No “public right” exception excuses the failure to comply with Article III in doing so, any more than in Northern Pipeline.

Opinion, p. 21. The Court found that “Vickie’s claim is a state law action independent of the federal bankruptcy law and not necessarily resolvable by a ruling on the creditor’s proof of claim in bankruptcy.” Id.

So, what is a public right? We know that it is not a suit between two creditors, since that was the case in Northern Pipeline. We know that it is not a state law counterclaim by a debtor against a person filing a claim against the estate, since that is the holding in this case.

The public rights doctrine goes back to Murray’s Lessee v. Hoboken Land & Improvement Co., 18 How. 272 (1856). Here is how Chief Justice Roberts described the decision:

“To avoid misconstruction upon so grave a subject,” the Court laid out the principles guiding its analysis. Id., at 284. It confirmed that Congress cannot “withdraw from judicial cognizance any matter which, from its nature, is the subject of a suit at the common law, or in equity, or admiralty.” Ibid. The Court also recognized that “[a]t the same time there are matters, involving public rights, which may be presented in such form that the judicial power is capable of acting on them, and which are susceptible of judicial determination, but which congress may or may not bring within the cognizance of the courts of the United States, as it may deem proper.” Ibid.

Opinion, p. 22. Thus, the distinction was between public rights defined as

those arising “between the Government and persons subject to its authority in connection with the performance of the constitutional functions of the executive or legislative departments”

and private rights which are

the liability of one individual to another under the law as defined.

Opinion, p. 23. While it is not necessary for the government to be a party to an action to invoke the public rights doctrine, the Court

has continued . . . to limit the exception to cases in which the claim at issue derives from a federal regulatory scheme, or in which resolution of the claim by an expert government agency is deemed essential to a limited regulatory objective within the agency’s authority.

Opinion, p. 25.

While the discussion thus far was fairly general, the Court brought it back to the bankruptcy realm in discussing Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989). That case involved whether a defendant who had not filed a proof of claim was entitled to a jury trial in a fraudulent conveyance case.

In Granfinanciera we rejected a bankruptcy trustee’s argument that a fraudulent conveyance action filed on behalf of a bankruptcy estate against a noncreditor in a bankruptcy proceeding fell within the “public rights” exception. We explained that, “[i]f a statutory right is not closely intertwined with a federal regulatory program Congress has power to enact, and if that right neither belongs to nor exists against the Federal Government, then it must be adjudicated by an Article III court.” Id., at 54–55. We reasoned that fraudulent conveyance suits were “quintessentially suits at common law that more nearly resemble state law contract claims brought by a bankrupt corporation to augment the bankruptcy estate than they do creditors’ hierarchically ordered claims to a pro rata share of the bankruptcy res.” Id., at 56. As a consequence, we concluded that fraudulent conveyance actions were “more accurately characterized as a private rather than a public right as we have used those terms in our Article III decisions.” Id., at 55.7

Opinion, at 26-27.

Applying the Law to This Case

The Court clicked off the following reasons that Vickie Lynn’s counterclaim did not fall within the public rights exception:

* It was not a claim which could be pursued only by grace of the other branches of government.

* It was not a matter that historically could be determined only by the other branches.

* It did not flow from a federal regulatory scheme.

* It was not “completely dependent upon” adjudication of a claim created by federal law.

* It was a claim under state common law between two private parties.

The Court made an interesting observation about why consent to trial in the Article I court:

Pierce did not truly consent to resolution of Vickie’s claim in the bankruptcy court proceedings. He had nowhere else to go if he wished to recover from Vickie’s estate.

Opinion at 27. In Granfinanciera, the Supreme Court found that the defendant was entitled to a jury trial because he had not consented to the Bankruptcy Court’s jurisdiction by filing a proof of claim. Here, however, the Supreme Court is saying that even filing a claim does not constitute consent. More on this below.

Finally, this was not a case involving an

expert and inexpensive method for dealing with a class of questions of fact which are particularly suited to examination and determination by an administrative agency specially assigned to that task.

Opinion, p. 28.

The “experts” in the federal system at resolving common law counterclaims such as Vickie’s are the Article III courts, and it is with those courts that her claim must stay.

Id.

In summing up his public rights discussion, the Chief Justice stated:

What is plain here is that this case involves the most prototypical exercise of judicial power: the entry of a final, binding judgment by a court with broad substantive jurisdiction, on a common law cause of action, when the action neither derives from nor depends upon any agency regulatory regime. If such an exercise of judicial power may nonetheless be taken from the Article III Judiciary simply by deeming it part of some amorphous “public right,” then Article III would be transformed from the guardian of individual liberty and separation of powers we have long recognized into mere wishful thinking.

Opinion, p. 29. I think what the court was trying to say here was, “You don’t have jurisdiction. We really, really mean it.”

No Proof of Claim Waiver

In Katchen v. Landy, 382 U.S. 323 (1966) and Langenkamp v. Culp, 498 U.S. 42 (1990), the Supreme Court had held that a creditor who filed a proof of claim could be sued to recover a preference. The Court distinguished these cases on two grounds. First, the Court argued that the preference could be a ground for disallowing the claim, so that the preference claim was tied into allowance of the claim. Second, it found that the preference claim was created by the Bankruptcy Code and was part of the process of determining an equitable allocation of the assets of the debtor.

What’s the Big Deal?

Responding to concerns that its decision would radically change the workload of the Courts, Chief Justice Roberts stated:

We do not think the removal of counterclaims such as Vickie’s from core bankruptcy jurisdiction meaningfully changes the division of labor in the current statute; we agree with the United States that the question presented here is a “narrow” one. Brief for United States as Amicus Curiae 23.

***

Article III of the Constitution provides that the judicial power of the United States may be vested only in courts whose judges enjoy the protections set forth in that Article. We conclude today that Congress, in one isolated respect, exceeded that limitation in the Bankruptcy Act of 1984. The Bankruptcy Court below lacked the constitutional authority to enter a final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim. Accordingly, the judgment of the Court of Appeals is affirmed.

Opinion, pp. 37, 38.

Justice Scalia Would Throw the Whole System Out

In a brief concurrence, Justice Scalia reaffirmed his prior concurrence in Granfinanciera that at a minimum, a public rights case must arise between the government and others, a conclusion that would render most bankruptcy court jurisdiction unconstitutional. He mused that it could possibly be constitutional for bankruptcy judges to adjudicate claims against the estate, but demurred that “the subject has not been briefed, and so I state no position on the matter.”

The Dissent

In a vigorous dissent, Justice Breyer, joined by Justices Ginsburg, Sotomayor and Kagan, argued that counterclaim jurisdiction is constitutional. The dissent placed a different emphasis upon the Court’s prior precedents to arrive at the opposite conclusion. In particular, the dissent took the majority to task for relying so heavily on the plurality opinion in Northern Pipeline instead of the more recent decisions in Thomas v. Union Carbide Agricultural Products Co., 473 U.S. 568 (1985) and Commodity Futures Trading Commission v. Schor, 478 U.S. 833 (1986).

The dissent also questioned the majority’s view that the opinion does not change all that much.

The majority predicts that as a “practical matter” today’s decision “does not change all that much.” Ante, at 36–37. But I doubt that is so. Consider a typical case: A tenant files for bankruptcy. The landlord files a claim for unpaid rent. The tenant asserts a counterclaim for damages suffered by the landlord’s (1) failing to fulfill his obligations as lessor, and (2) improperly recovering possession of the premises by misrepresenting the facts in housing court. (These are close to the facts presented in In re Beugen, 81 B. R. 994 (Bkrtcy. Ct. ND Cal. 1988).) This state-law counterclaim does not “ste[m] from the bankruptcy itself,” ante, at 34, it would not “necessarily be resolved in the claims allowance process,” ibid., and it would require the debtor to prove damages suffered by the lessor’s failures, the extent to which the landlord’s representations to the housing court were untrue, and damages suffered by improper recovery of possession of the premises, cf. ante, at 33-33. Thus, under the majority’s holding, the federal district judge, not the bankruptcy judge, would have to hear and resolve the counterclaim.

Why is that a problem? Because these types of disputes arise in bankruptcy court with some frequency. See, e.g., In re CBI Holding Co., 529 F. 3d 432 (CA2 2008) (statelaw claims and counterclaims); In re Winstar Communications, Inc., 348 B. R. 234 (Bkrtcy. Ct. Del. 2005) (same); In re Ascher, 128 B. R. 639 (Bkrtcy. Ct. ND Ill. 1991) (same); In re Sun West Distributors, Inc., 69 B. R. 861 (Bkrtcy. Ct. SD Cal. 1987) (same). Because the volume of bankruptcy cases is staggering, involving almost 1.6 million filings last year, compared to a federal district court docket of around 280,000 civil cases and 78,000 criminal cases. Administrative Office of the United States Courts, J. Duff, Judicial Business of the United States Courts: Annual Report of the Director 14 (2010). Because unlike the “related” non-core state law claims that bankruptcy courts must abstain from hearing, see ante, at 36, compulsory counterclaims involve the same factual disputes as the claims that may be finally adjudicated by the bankruptcy courts. Because under these circumstances, a constitutionally required game of jurisdictional ping-pong between courts would lead to inefficiency, increased cost, delay, and needless additional suffering among those faced with bankruptcy.

Dissent, pp. 16-17.

What Does It All Mean?

The difficulty with the Stern opinion is that it is a narrow opinion with a very broad rationale. While the holding merely invalidates 28 U.S.C. §157(b)(2)(C), it does so with a broad reading of the importance of the Article III judiciary and a narrow reading of the public rights exception. Lying underneath the opinion, there is a palpable feeling that Congress has gone too far in giving power to non-Article III adjuncts. To paraphrase a song, the majority’s lips say no, no, no (practical effect), but their eyes say yes, yes, yes.

Here are a few conclusions that can be drawn:

1. The opinion is about placement of jurisdiction rather than jurisdiction itself. The Supreme Court never said that the Bankruptcy Court lacked jurisdiction to "hear" the case; rather, it said that it lacked jurisdiction to enter a final judgment. It was the District Court which had jurisdiction to enter a final judgment. Because the District Court judgment came after the Probate Court judgment, the Probate Court judgment was entitled to full faith and credit and took precedence over the later District Court judgment.

2. The opinion will have its greatest impact on adversary proceedings. Contested matters, such as plans of reorganization and motions to lift stay would not be affected.

3. State law causes of action against non-debtor parties are non-core proceedings even if the other party has filed a proof of claim.

4. Fraudulent conveyance actions, even those arising under Section 548, may prove to be non-core.

5. Preference actions remain as core proceedings.

6. Even Justice Scalia would probably allow the Bankruptcy Court to determine an objection to claim on a good day.

For more opinions about what all this means, tune in to the State Bar of Texas’s Webinar, Stern v. Marshall: Handling State Claims After the Supremes Make It All Clear on July 12, 2011 at 10:00 a.m. Speaking will be Gerrit Pronske, former judge and law professor Glen Ayers and yours truly.

Editor's Note: The original version used the words "tortuous" and "tortuously" instead of "tortious" and "tortiously." This was an automatic correction made by Microsoft Word that I did not catch in proofing the article. According to Dictionary.com, "tortious" means "of the nature of or pertaining to a tort." It derives from the Middle English "torcious" from the period 1350-1400. On the other hand, "tortuous" means "full of twists, turns or bends." It also derives from the Middle English of 1350-1400.

To correctly use the two words:

Vickie Lynn's tortious intereference claim took a tortuous trip through the court system.

Hat tip to Barbara Barron for pointing out use of the wrong word.