The Consent Trap

A new decision from the Fifth Circuit holds that implied consent cannot overcome a formal denial of consent to entry of a final judgment by a magistrate judge, even when the objecting party expressly consented.  PNC Bank v. Ruiz, Case No. 20-50255 (5th Cir. 3/3/2021), which can be accessed here.  The decision is of interest to bankruptcy lawyers because the issue of consent is common to the actions of both bankruptcy judges and magistrate judges.

Third Circuit Allows Third Party Release on "Exceptional" Facts

Third party releases have long been a controversial feature of certain chapter 11 plans. They are neither specifically allowed nor prohibited by the plain language of the Bankruptcy Code. This has led courts to reach differing results. There are two important principles at play in these cases. On the one hand, bankruptcy exists to provide relief to debtors. On the other hand, bankruptcy plans are intended to provide the greatest possible return to creditors. If granting releases makes the plan possible, this is in the best interest of creditors.

The Third Circuit waded into this debate to answer a very limited question:  does Article III permit non-consensual third party releases? The Court's answer, at least in the specific case before it, was yes. In re Millenium Holdings II, LLC, 945 F.3d 126 (3rd Cir. 12/19/19). 

Did Gorsuch Expand Bankruptcy Court Referral Power?

Newly minted Supreme Court nominee Neil Gorsuch sat on the Tenth Circuit for ten years.  During that time, he signed on to eleven opinions regarding bankruptcy, which means that he wrote about bankruptcy around once a year.    None of his opinions are particularly well-known.  (In contrast, fellow finalist Thomas Hardiman authored the opinion in Official Committee of Unsecured Creditors vs. CIT Group/Business Credit, Inc. (In re Jevic Holding Corp.), 787 F.3d 173 (3rd Cir. 2015) which is currently before the Supreme Court).    However, these opinions demonstrate his crisp writing style and offer some insights into his judicial thinking.   I am going to look at one of his opinions in depth and follow up with a separate post on his remaining decisions.

Wellness Case Brings Healing for Bankruptcy Court Authority

Resolving an issue left open by two prior decisions, the Supreme Court ruled that the right to entry of a final judgment by an Article III court, like the right to trial by jury, is a personal right which can be waived or consented away (subject to supervision by an Article III Court).    The decision left Chief Justice Roberts, whose broad language in Stern v. Marshall spawned a plethora law review articles, in the minority, while Justice Sotomayor wrote for the six justices in the majority.   Wellness International Network, Ltd. v. Sharif, No. 13-935 (5/26/15).    

The Stern Problem

Article III of the Constitution states that the judicial power is vested in courts created under that Article, which is to say, judges appointed by the President, confirmed by the Senate and enjoying life tenure.    Over the years, Congress created many other judges, such as U.S. Magistrate Judges, Administrative Law Judges and Bankruptcy Judges, to help with the workload of the federal courts.   These judges were not appointed by the President or confirmed by the Senate and did not enjoy life tenure.    While they were under the supervision of Article III Judges, some of these legislatively created judges enjoyed great levels of independence.   

In Stern v. Marshall, 564 U.S. ___, 131 S.Ct. 2594 (2011), the Court said that Congress did not have unlimited power to create adjuncts to assist the Article III judges.   Specifically, the Court said that the Bankruptcy Court did not have the power to enter a final judgment on a state law counterclaim brought by a debtor against a creditor.    Judges, practitioners and academics alike wondered whether the system of independent Article I Bankruptcy Judges could survive this ruling.    This uncertainty was engendered by the narrow scope of the actual issue decided and the sweeping language used by Chief Justice Roberts to support it.   Taken to its fullest extent as suggested by the dissenting justices in that case, it could have meant that Bankruptcy Court's lacked the power to decide anything that could have been decided by courts of law in 1789 and parties lacked the authority to consent to a different result.   

 Life After Stern

The sky did not fall following Stern and the Bankruptcy Courts continued to operate.   However, there was a split of authority as to whether parties could consent to entry of a final judgment by a Bankruptcy Court in a Stern case.    Last year, in Executive Benefits Ins. Agency v. Arkison, 134 S.Ct. 2165 (2014), the Court ducked the consent issue.   Instead, it found that regardless of the Bankruptcy Court's authority to enter a final judgment, it could hear cases within its jurisdiction and submit a report and recommendation to the District Court which could review it on a de novo basis. This was important because the Bankruptcy Court decision was a summary judgment which the District Court was bound to review on a de novo basis in any event.   As a result, even if the Bankruptcy Court lacked authority to enter a final judgment, the District Court's ruling on appeal was the functional equivalent of entry of a final judgment by that court.  

This ruling preserved the ability of Bankruptcy Courts to hear disputes in the first instance.   However, it left open the question of whether Bankruptcy Courts could issue final orders in all matters with consent or by waiver.   The consent issue had enormous practical significance.    If parties could not give valid consent, they could have an advisory trial in the Bankruptcy Court and then request a do-over in the District Court if they didn't like the result.    There was also the possibility (although I am not aware of this actually happening) of a party agreeing to litigate in Bankruptcy Court and ignoring the result on the basis that it had never been approved by the District Court.    

The issue split the circuit courts.   The Fifth, Sixth and Seventh Circuits nixed consent while the Ninth Circuit permitted it.   Today's decision resolved that split and established that parties can consent to entry of a final judgment by a Bankruptcy Judge.   The decision also acknowledges the practical reality that without legislatively created courts, "the work of the federal court system would grind nearly to a halt."   Opinion, p. 2.   In a footnote, the Court noted that the 349 Bankruptcy Judges hear twice as many cases as all of the District and Circuit judges combined.    

What Happened

Sharif was a distributor for Wellness International Network, a manufacturer of health and nutrition products.    Sharif sued Wellness but wound up owing $650,000 in attorneys' fees after he failed to comply with discovery and other litigation obligations.    When Sharif filed bankruptcy, Wellness wanted to know about the $5 million in assets he had listed on a loan application in 2002.   Sharif glibly admitted that he had lied about owning the assets and said that they really belonged to a trust which he administered for his mother and sister.    

Wellness filed an adversary proceeding against Sharif seeking to deny his discharge and establish that the trust was an alter ego.   Sharif answered and conceded that these claims were core proceedings.   Once again, Sharif failed to provide responsive discovery answers.   As a result, the Bankruptcy Court entered default judgment against him and denied his discharge.   The Bankruptcy Court also found that the trust was his alter ego because the Debtor "treats [the Trust's] assets as his own property."    

Sharif appealed to the District Court.   While his case was pending, the Stern decision came out.   He asked to supplement his briefing to assert that the District Court should treat the Bankruptcy Court's ruling as a report and recommendation.   The District Court denied the request for additional briefing as untimely and affirmed the Bankruptcy Court.

The Seventh Circuit affirmed in part and reversed in part.  It upheld denial of the discharge as something that the Bankruptcy Court had the authority to grant.   However, it reversed the ruling on the alter ego claim.   It held that not only did the Bankruptcy Court lack authority to enter a final judgment, but that it might have lacked authority to even hear the case in the first place.   (The latter ruling was based on the fact that 28 U.S.C. Sec. 157 did not authorize Bankruptcy Courts to issue reports and recommendations in core proceedings.   In Executive Benefits, the Supreme Court clarified that Bankruptcy Courts could issue a report and recommendation in any case in which it could not issue a final judgment, thereby eliminating the so-called statutory gap).

The Majority Ruling

Justice Sotomayor began her discussion of consent by stating, "(a)djudication by consent is nothing new."    Opinion, p. 8.    After discussing cases, the Court held that the right to an Article III tribunal is both a personal one which may be waived and a structural one that must be respected.  Justice Sotomayor wrote:

The entitlement to an Article III adjudicator is “a personal right” and thus ordinarily “subject to waiver,” (citation omitted). Article III also serves a structural purpose, “barring congressional attempts ‘to transfer jurisdiction [to non-Article III tribunals] for the purpose of emasculating’ constitutional courts and thereby prevent[ing] ‘the encroachment or aggrandizement of one branch at the expense of the other.’” Id., at 850 (citations omitted). But allowing Article I adjudicators to decide claims submitted to them by consent does not offend the separation of powers so long as Article III courts retain supervisory authority over the process.

Opinion, pp. 11-12.    In reaching this formulation, Justice Sotomayor resolved a question which had been dividing commentators for years:   was the right to an Article III Court personal and thus waivable or was it structural and therefore immutable?   Although the Court answered "both," it did so in a way that set a low bar for satisfying the structural concerns of the Constitution.   So long as the Article III judiciary retained "supervisory authority" over the legislatively created courts, separation of powers was not violated.    Stated another way, Congress can create judicial helpers for the Article III Courts but cannot create an entire independent system out of whole cloth.

Under this standard, it is clear that Bankruptcy Courts are under the supervisory authority of the Article III Courts.   Bankruptcy Judges are appointed by Article III judges and may be removed by them.   They are a unit of the District Court and enjoy their authority by virtue of an order of reference from the District Courts.   The District Courts also have the power to withdraw that reference.   Indeed, if a District Court wished to do so, it could revoke the order of reference completely and decide all bankruptcy matters.    Decisions of Bankruptcy Courts are reviewed by either the District Courts or by Bankruptcy Appellate Panels (with consent).   However, Bankruptcy Appellate Panels only exist if created by the Court of Appeals.   

The Court further noted that the Bankruptcy Courts do not possess "free-floating authority to decide claims traditionally heard by the Article III Courts" but instead may hear "a narrow class of common law claims" which are incidental to their primary bankruptcy powers.   Finally, the Court noted that Bankruptcy Courts were not created by Congress "to aggrandize itself or humble the Judiciary."   Instead, the Court noted the practical benefit to the Article III Judiciary from having Bankruptcy Courts:

Congress could choose to rest the full share of the Judiciary’s labor on the shoulders of Article III judges. But doing so would require a substantial increase in the number of district judgeships. Instead, Congress has supplemented the capacity of district courts through the able  assistance of bankruptcy judges. So long as those judges are subject to control by the Article III courts, their work poses no threat to the separation of powers.

Opinion, pp. 14-15.    

Having ruled that consent was possible, the Court ruled that it need not be express. 

Nothing in the Constitution requires that consent to adjudication by a bankruptcy court be express. Nor does the relevant statute . . . mandate express consent; it states only that a bankruptcy court must obtain“the consent”—consent simpliciter—“of all parties to the proceeding” before hearing and determining a non-core claim.

Opinion, p. 18.    

Thus, the Court remanded the case to the Seventh Circuit to decide the question of whether consent had indeed been given.    

The majority opinion was joined in by Justices Kennedy, Ginsberg, Breyer and Kagan. Justice Alito concurred in the judgment with the demurrer that he would not have reached the issue of whether consent could be implied.   

The Chief Justice and Justices Scalia and Thomas dissented.

The Dissents

At thirty-nine pages, the dissents are nearly twice as long as the majority opinion.    The dissenting justices (each of whom was in the majority in Stern) did not agree that supervisory authority satisfied separation of powers.   The Chief Justice expressed his preference that the Court would have once more avoided deciding the consent issue.   He warned that by deciding the larger issue, the Court was descending a slippery slope.

By reserving the judicial power to judges with life tenure and salary protection, Article III constitutes “an inseparable element of the constitutional system of checks and balances”—a structural safeguard that must “be jealously guarded.”(citation omitted).

Today the Court lets down its guard. Despite our precedent directing that “parties cannot by consent cure” an Article III violation implicating the structural separation of powers, (citation omitted), the majority authorizes litigants to do just that. The Court justifies its decision largely on pragmatic grounds. I would not yield so fully to functionalism. The Framers adopted the formal protections of Article III for good reasons, and “the fact that a given law or procedure is efficient, convenient, and useful in facilitating functions of government, standing alone,will not save it if it is contrary to the Constitution.” (citation omitted).

The impact of today’s decision may seem limited, but the Court’s acceptance of an Article III violation is not likely to go unnoticed. The next time Congress takes judicial power from Article III courts, the encroachment may not be so modest—and we will no longer hold the high ground of principle. The majority’s acquiescence in the erosion of our constitutional power sets a precedent that I fear we will regret. I respectfully dissent.

Roberts, C.J., Dissenting, pp. 1-2.    The Chief went on to quote significant amounts of his opinion from Stern.  He effectively established that despite his protestations to the contrary, he never intended for Stern to be a narrow ruling.   Instead, he sought to interpose the Article III Judiciary as a bulwark against Congressional interference in the bankruptcy arena no matter how difficult or impractical this might be.   His dire sermon concluded with an allusion to the Bible.

Ultimately, however, the structural protections of Article III are only as strong as this Court’s will to enforce them. In Madison’s words, the “great security against a gradual concentration of the several powers in the same department consists in giving to those who administer each department the necessary constitutional means and personal motives to resist encroachments of the others.”The Federalist No. 51, at 321–322 (J. Madison). The Court today declines to resist encroachment by the Legislature.  Instead it holds that a single federal judge, for reasons adequate to him, may assign away our hard-won constitutional birthright so long as two private parties agree. I hope I will be wrong about the consequences of this decision for the independence of the Judicial Branch. But for now, another literary passage comes to mind: It profits the Court nothing to give its soul for the whole world . . . but to avoid Stern claims?

 Roberts, C.J., Dissenting, p. 20.    

Justice Thomas complained that both the majority and the Chief Justice had failed to answer the question of "whether a violation of the Constitution has actually occurred."    Justice Thomas does not appear to answer this question either.   Instead, he appears to conclude that the parties did not brief the proper issues and that those issues "merit closer attention by this Court."   As a result, Justice Thomas would have decided the case on the narrow ground of whether an alter ego claim is in fact a Stern claim.  

What It Means

This case has two main impacts:  the practical and the political.    

On a practical level, Wellness has brought healing to the uncertainty wreaked by Stern.   We now have a pretty solid flow chart for knowing what Bankruptcy Courts should do with matters brought before them.

1. Is there jurisdiction under 28 U.S.C. Sec. 1334?   If yes, proceed to #2.   If no, stop.
2. Has the District Court withdrawn the reference?  If yes, stop.  If no, proceed to #3.
3. Must or should the Court abstain?  If yes, stop.   If no, proceed to hear the matter.
4.  Is the claim one which could have been heard by the courts of law in England in 1789?  If no, proceed to enter a final judgment.  If yes, proceed to #5.
5. Have the parties consented to entry of a final judgment, either expressly or implicitly?  If yes, proceed to enter a final judgment.   If no, enter a report and recommendation

While I may be oversimplifying this, I think it captures the general idea of where we are today.

On a political level, Justices Breyer, Ginsberg, Sotomayor and Kagan have made the journey from  the dissent in Stern to the majority in Wellness.   They were able to make this transition because Justices Alito and Kennedy changed positions.  While this is rank speculation, it is entirely possible that Justices Alito and Kennedy could see the harm in giving the Bankruptcy Courts unlimited power to rule on state law counterclaims and therefore joined the majority in Stern, but did not want to jeopardize the authority of U.S. Magistrates or other consent-based mechanisms.   If the Chief  had gotten his way, the magistrate system, which operates on referral and consent, could well have fallen.

An older definition of conservative is to conserve, to observe respect for existing institutions.    In his desire to assert the dignity of the Article III Judiciary, the Chief Justice could have torn down decades of smoothly functioning institutions, jeopardizing not only Bankruptcy Judges but Magistrate Judges and possibly arbitrators as well.    Thus, Justices Alito and Kennedy could have joined both majorities out of a sense of conservatism.     

NCBJ 2014: Ethics and Supreme Debate

Saturday concluded NCBJ with ethics and the Supreme Court review.   (There was also a program on scientific studies of mindfulness which I missed).

Wait, Wait, Don’t Tell Me! An Ethics Game Show:  Retired Judge James H. Haines as Peter Segal, Christine Devine (DeMaillie & Lougee), Judge Benjamin Goldgar, Timothy Nixon (Godfrey & Kahn), Judge Neil Olack, Prof. Nancy Rapoport and Judge Erithe Smith.  

This was an entertaining quiz show style ethics panel.    For each ethical scenario, there were three answers only one of which was correct.   Here are the questions and correct answers.  

 

1.  Can law firm be sanctioned for failure to amend obvious errors in schedules?   Yes.    Section 707(b)(4)(C) and (D) and Rule 9011 require an attorney to certify that after making a reasonable inquiry, the petition, schedules and SOFA are correct and that he does not know of any information that would make them incorrect.   The specific hypothetical involved an international law firm which filed bankruptcy but failed to mention any of its international offices.

2.  Can an attorney ethically limit its representation of a chapter 7 debtor to exclude adversary proceedings when necessary to achieve the client’s goals?  No.   While unbundling can be done with full disclosure, an attorney cannot disclaim defending adversary proceedings if it is known in advance that this will be necessary to meet the client’s objectives.   In re Seare, 2014 Bankr.LEXIS 3584 (9^th Cir. BAP 2014).

3.  May CROs be employed under sections 105(a) and 363(b)(1)?  Yes.    Under what is known as the “Jay Alix Protocol,” a chief restructuring officer may be employed in the ordinary course subject to review of his fees for reasonableness.    Additionally, the CRO may only serve in one capacity.

4.  Can a Chinese Wall be used to prevent firm from being disqualified based on one attorney who is not disinterested?   The answer given was no, but that Texas follows minority rule.    An example of the majority rule is In re Essential Therapeutics, Inc., 295 B.R. 203, 211 (Bankr. D. Del. 2003), while the minority rule is illustrated by In re Cygnus Oil & Gas Corp., 2007 Bankr. LEXIS 1913 (Bankr. S.D. Tex. 2007).   I am not completely satisfied by the panel’s designation of these as majority and minority rules.  They might be worth more scrutiny.

5.  Can the same attorney be retained to represent multiple debtors with inter-company claims?    There is no per se disqualification rule.   Must decide on a case by case basis.

6.  What is appropriate sanction for undisclosed fee sharing?   Court may disqualify firm and order disgorgement of fees.   However, court should use least restrictive sanction to deter bad conduct.

7.  May an attorney withdraw when the client insists on taking a course of action that the attorney disagrees with?    Yes, but only with court permission.

8.  Can an attorney be sanctioned for “ghostwriting” a pleading for an acquaintance?  Maybe.   I think this one is too fact specific to give a definitive answer.   In the hypothetical, the attorney was asked to provide a law school acquaintance with a form claims objection which the debtor then used without modification.    In my mind, providing a form to another attorney is never “ghostwriting.”   There was some discussion that an attorney who prepares a pleading for a pro se party is required to sign it.  I am not convinced by this argument.

9.  Can a plan provide that Committee members will be able to recover their attorney’s fees?  No.  They have to justify that they made a substantial contribution.

10.  Can a firm get paid all of its fees when it obviously overstaffed the case?   No.

May You Live in Interesting Times:   The Supreme Court’s Year in Bankruptcy:   Eric Brunstad (Dechert, LLP) and Dean Erwin Chemerinsky

This panel took the form of a debate between Eric Brunstad and Erwin Chemerinsky on the subject of consent under Stern v. Marshall.   Brunstad took the position that Stern v. Marshall was correctly decided but that consent was permissible.    Chemerinsky took the position that Stern v. Marshall was wrongly decided and that if followed to its logical conclusion, consent would not be allowed.   In this section, I am referring to major Supreme Court cases by name rather than by citation.    However, they can be easily looked up on any number of free legal research sites.

Brunstad:

Brunstad argued that Article III originated from the experience in England where it was necessary to separate the judiciary from the crown.   On the other hand, the issue of who decides your case does not implicate the independence of the judiciary and can be waived.   According to Brunstad, Marathon stands for the proposition that you cannot assign a purely private dispute to an Article I tribunal.   However, in Schor, the Supreme Court indicated that the right to an Article III tribunal was a personal right which could be waived.   Granfinanciera equated the right to a jury trial and the right to an Article III tribunal.   Because a jury trial can be waived, an Article III tribunal could be as well.  

He then made the following points (which he numbered making it much easier for me to report):

1.  Schor designated the right to an Article III tribunal as a purely personal right.  Having a case decided by an Article I or an Article III judge does not implicate separate of powers concerns because separation of powers is concerned with conflicts between the judicial branch and the legislative or executive.

2.  By analogy, if you can waive your right to a jury trial, you can waive your right to an Article III judge.

3.  For hundreds of years, District Courts have relied on special masters.   With consent, a special master could make findings upon which the District Court would enter judgment.

4.  Arbitration allows decision by a non-Article III tribunal, although the arbitrator cannot enter a judgment.

5.  Bankruptcy judges are like magistrates who enjoy broad authority with consent.

6.  The consequences of not allowing consent would be detrimental to the modern administrative state.  

Chemerinsky:

According to Dean Chemerinsky, Stern v. Marshall was wrong because it misunderstood separation of powers.    He said that separation of powers is a means to an end rather than an end itself.   Separation of powers is invoked when one branch usurps or interferes in the operations of another branch.   Allowing bankruptcy courts to decide state law issues does not implicate either concern.   Therefore Stern was wrongly decided.

However, he said that once you accept that Stern adopted a formalistic approach to separation of powers rather than a functional one (which is what Dean Chemerinsky advocates), you must follow that logic to its end.   Mr. Brunstad’s arguments were functional rather than formalistic.   However, you cannot accept Stern and still take a functional approach.

Chemerinsky then argued that:

1.  Separation of powers violations cannot be overcome by consent.

2.  The authority of the federal courts cannot be changed by consent, a proposition which goes back to Marbury v. Madison.

Dean Chemerinsky went on to state that there is no good reason to distinguish between subject matter jurisdiction and authority to decide cases.    He said that under Mr. Brunstad’s logic, subject matter jurisdiction could be waived.  

While Mr. Brunstad relied on Schor, that case said that “essential attributes” are reserved to Article III courts.   

He also rejected the notion that there was a difference between personal and structural rights because all structural rights exist to protect personal liberties.   

The Dean also distinguished several of Mr. Brunstad’s analogies.   Neither a special master nor an arbitrator can issue a final judgment.   However, a bankruptcy judge can.   He said that federal magistrates are not a good comparison because their authority is still up in the air like that of bankruptcy courts.

Brunstad:

In rebuttal, Mr. Brunstad challenged Dean Chemerinsky’s contention that jurisdiction and authority to decide were similar.   He said that only Congress can create jurisdiction, but Article III does not specify the form that inferior courts must take.   Further, all Article III requires from a structural viewpoint is independence from the Executive and the Legislative branches.   By placing Bankruptcy Courts within the judicial branch, Congress insulated them from pressure by other branches.   

There are some rights which cannot be waived, such as the right against involuntary servitude.  There are other rights such as the right to a jury trial which may be waived.   The right to decision by an Article III tribunal is a right which can be waived.  

He said that Stern was decided correctly (a position he had to take since the argued for the winning side) but that it did not involve impermissible delegation of judicial powers.   He said that most things that bankruptcy courts do, such as adjudicating claims, are public rights.   Stern, on the other hand, involved a tort claim which was a purely private right.   In Stern, it was clear that Pierce Marshall did not consent to adjudication of the tort claim in bankruptcy.      

Chemerinsky:

Stern v. Marshall was decided wrongly because you should always take the functional approach to separation of powers.   Stern was wrong because there was no threat to separation of powers.  The central tension in Eric’s argument is that it takes a functional approach to a formalistic decision.   Separation of powers cannot be overcome by consent which resolves the consent issue.

Public rights are limited to suits by or against the government.   Because the government cannot be sued absent its consent due to sovereign immunity, it can allow actions to be resolved by or against it in a non-Article III tribunal.   However, most of the work of the Bankruptcy Court does not involve public rights.   Therefore, the public rights argument does not work.

Congress may create inferior courts, but it can’t give them authority beyond what Article III allows.    In Stern, Congress gave bankruptcy courts the power to decide counterclaims to proofs of claim and that authority was found to be unconstitutional.

The right to a jury trial was never structural.   Therefore it does not help on the separation of powers issue here.

Having listened to both arguments, I now have no idea how the consent issue in Wellness International will come out.  I thought that Dean Chemerinsky had the better argument in terms of consistency while Mr. Brunstad had the better argument in favor of making the system work.   Given that the Supreme Court vacillates between strict interpretation and practicalities, this one is very hard to handicap.   However, as a practitioner, the answer is easy:  bankruptcy courts need to be given as much authority as they need to do their jobs and the Constitution will still survive.

Post-script:

In the final minutes, they discussed the Court’s recent decisions.   They both observed that the court vacillates between strict statutory construction and policy concerns.   Law v. Siegel was an example of a strict statutory approach, while Clark v. Rameker (inherited IRAs are not exempt) was a practical approach.    This remains a constant tension with the court.

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.  

 

  

Supreme Court Prepares for Stern v. Marshall Round 3

When the Supreme Court struck down the Bankruptcy Reform Act's grant of authority to bankruptcy judges in 1982, it took it took them 29 years to return to the issue.    This allowed bankruptcy law to develop and mature without constantly fretting about whether the whole system would collapse.   However, since Stern v. Marshall, 131 S.Ct. 2594 (2011), the high court has shown renewed concern with how our nation's courts of financial last resort function.   While this term's unanimous decision in Executive Benefits Insurance Agency v. Arkison, No. 12-1200 (6/9/14) was notable for what it didn't decide (see my prior post here), the Supreme Court is going to try again.   On July 1, 2014, the court granted cert in Wellness International Network Limited v. Sharif, 727 F.3d 751 (7th Cir. 2013).   

What Happened

The Seventh Circuit case began when Richard Sharif sued Wellness International (WIN), claiming it was a pyramid scheme.   Sharif did not cooperate in discovery and ended up on the receiving end of a judgment for $650,000.   When he filed bankruptcy, WIN objected to his discharge and also sought a declaration that a trust was Sharif's alter ego.   After Sharif failed to fully respond to discovery once again, the Bankruptcy Court entered default judgment against him on all counts.   The Seventh Circuit affirmed the Bankruptcy Court's denial of discharge, but found that it lacked authority to enter a final judgment on the alter ego claim.  

The Issues on Cert

The Supreme Court granted cert on two points:

(1) Whether the presence of a subsidiary state property law issue in a 11 U.S.C. § 541 action brought against a debtor to determine whether property in the debtor’s possession is property of the bankruptcy estate means that such action does not “stem[] from the bankruptcy itself” and therefore, that a bankruptcy court does not have the constitutional authority to enter a final order deciding that action; and 

(2) whether Article III permits the exercise of the judicial power of the United States by the bankruptcy courts on the basis of litigant consent, and if so, whether implied consent based on a litigant’s conduct is sufficient to satisfy Article III.

What It Might Mean

If this case produces a direct answer on the issues granted (unlike Executive Benefits), it could be earthshaking.   If the Supremes find that Bankruptcy Courts lack authority to determine state law issues necessary to find whether assets are property of the estate, it would be a crippling blow to the ability of the system to function.   If the court gives a clear answer on consent/waiver, it will provide the answer missing in Executive Benefits.  

Bankruptcy practitioners will be watching with great interest and trepidation as the Supreme Court examines both whether and how our unique courts will be allowed to function  (or not) for the third time this decade.  The fact that the court is taking a second crack at the consent issue suggests that there are some justices on the court who were not satisfied with this term's non-answer.   

Supreme Court Dodges Consent Issue in Bellingham But Signals No New Challenges to Bankruptcy Court Authority

In the follow-up to Stern v. Marshall, the Supreme Court concluded that it didn’t need to answer the primary questions addressed to it, leaving open (on the surface at least) the issue of whether parties can consent to final adjudication by a bankruptcy court in situations where the court could not otherwise issue a final decision.   The Court also assumed but did not decide the question of whether a fraudulent conveyance action would violate Stern.   In fact, the only issue the Court did decide was that bankruptcy courts may issue reports and recommendations in core proceedings where they lack authority to make a final ruling.   While the decision is not as expansive as many practitioners would have liked, it doesn’t do any violence to the bankruptcy system and has some helpful subtext.  The case is Executive Benefits Insurance Agency v. Arkison (In re Bellingham Insurance Agency, Inc.), No. 12-1200 (June 9, 2014).   You can find the opinion here.

What Happened

Nicholas Palaveda and his wife owned Bellingham Insurance Agency, Inc. (BIA).   Palaveda used Bellingham’s assets to set up a new business, Executive Benefits Insurance Agency, Inc.  (EBIA).   When BIA filed bankruptcy, its trustee, Arkison, sued EBIA to recover the assets as a fraudulent transfer.   EBIA did not assert its right to a hearing before an Article III judge and either consented to adjudication by the Bankruptcy Court or waived its right to district court review.   Arkison filed a motion for summary judgment which was granted.   The District Court affirmed the Bankruptcy Court.   Because this was a review of a summary judgment, the District Court’s review was necessarily on a de novo basis.  

 The Ninth Circuit, after inviting amicus briefs, affirmed.   It found that while a fraudulent conveyance action was not within the Bankruptcy Court’s authority to enter a final decision, that EBIA had consented to the Bankruptcy Court’s authority and could not question it on appeal.   Thus, the Ninth Circuit answered two important questions:  1) did the Bankruptcy Court have final authority to rule on a fraudulent conveyance (no); and 2) could the parties consent to the Bankruptcy Court’s ability to enter a final ruling (yes).

The Supreme Court’s Ruling

Unless the contentious ruling in Stern, Bellingham was a 9-0 decision comprising a scant 13 pages of text.    The Court avoided ruling on either of the main conclusions of the Ninth Circuit, assuming without deciding that fraudulent conveyance claims violated Stern and finding that it need not reach the consent issue.   As will be discussed below, the opinion is more significant for what it implies than what it decided.

The court began with a history of bankruptcy jurisdiction, taking practitioners through the familiar history of summary vs. plenary jurisdiction under the Bankruptcy Act, the expansive but unconstitutional jurisdiction granted under the Bankruptcy Reform Act of 1979 and the core vs. non-core dichotomy enacted by the Bankruptcy Amendments and Federal Judgeship Act of 1984.  

The core vs. non-core distinction attempted to remedy the finding of unconstitutionality contained in Northern Pipeline Construction Co. v. Marathon Pipeline Co., 458 U.S. 50 (1982).    According to Justice Thomas,

The 1984 Act largely restored the bifurcated jurisdictional scheme that existed prior to the 1978 Act.   The 1984 Act implements that bifurcated scheme by dividing all matters that may be referred to the bankruptcy court into two categories: “core” and “non-core” proceedings.

Opinion, p. 6.  In a footnote, Justice Thomas noted that the “core” designation tracked language used by the plurality opinion in Northern Pipeline.

Justice Thomas summarized the current working of the bankruptcy system as follows:

Put simply:  If a matter is core, the statute empowers the bankruptcy judge to enter final judgment on the claim, subject to appellate review by the district court.   If a matter is non-core, and the parties have not consented to final adjudication by the bankruptcy court, the bankruptcy judge must propose findings of fact and conclusions of law.   Then the district court must review the proceeding de novo and enter final judgment. (emphasis added).

Opinion, p. 7.

In several brief passages, the Court addressed what the Stern decision did and did not address.  According to Justice Thomas, Stern “considered a constitutional challenge to the statutory designation of a particular claim as ‘core.’”  The answer was that “some claims labeled by Congress as ‘core’ may not be adjudicated by a bankruptcy court in the manner designated by §157(b).”    Left unanswered in Stern was “how the bankruptcy court should proceed in those circumstances.”   Id.  

This led up to the main question actually addressed by Bellingham (as opposed to the ones it granted cert on):  whether there is a gap in the statutory scheme of core vs. non-core.   BAFJA allowed entry of final orders on core matters and proposed findings in non-core.   What to do with core proceedings in which bankruptcy courts cannot constitutionally enter a final judgment?   Are these matters left in limbo, incapable of being resolved?   The sensible answer from the Supremes is no.    BAFJA, like most statutes, contains a severability clause.   The Court concluded that any matter upon which the bankruptcy courts cannot properly enter a final judgment should simply be treated as non-core.   

The plain text of this severability provision closes the so-called “gap” created by Stern claims.   When a court identifies a claim as a Stern claim, it has necessarily held “invalid” the application of §157(b)—i.e., the “core” label and its attendant procedures—to the litigant’s claim.   (citation omitted).    In that circumstance, the statute instructs that “th[e] remainder of the Act . . . is not affected thereby.  (citation omitted).   That remainder includes §157(c), which governs non-core proceedings.   With the “core” category no longer available for the Stern claim at issue, we look to §157(c)(1) to determine whether the claim may be adjudicated as a non-core claim—specifically, whether it is “not a core proceeding” but is “otherwise related to a case under Title 11.”    If the claim satisfies the criteria of §157(c)(1), the bankruptcy court simply treats the claims as non-core:  the bankruptcy court should hear the proceeding and submit proposed findings of fact and conclusions of law to the district court for de novo review and entry of judgment.

Opinion, pp. 9-10.

In the particular case, the bankruptcy court should have submitted proposed findings and conclusions to the district court which would then conduct a de novo review and enter judgment.  As Justice Thomas noted, “(a)lthough this case did not proceed in precisely that fashion, we affirm nevertheless.”    Opinion, p. 12.    When a court grants summary judgment, its order is reviewed as a matter of law, which is de novo review.   Thus, the district court did conduct a de novo review and did enter a judgment affirming the bankruptcy court.   As a result, the substance of the law was satisfied.

In light of the procedural posture of this case, however, we need not decide whether EBIA’s contentions are correct on either score.   At bottom, EBIA argues that it was entitled to have an Article III court review de novo and enter final judgment on the fraudulent conveyance claims asserted by the trustee.   In effect, EBIA received exactly that.

Opinion, p. 12.   Thus, the opinions of the lower courts were affirmed and Mr. Palaveda’s scheme remained unraveled notwithstanding the detour to the Supreme Court.

So What Did the Court Decide?

Prudentialism is the school of supreme court jurisprudence that says that the court should decide as little as possible to conserve the court’s power and prestige.  It can also be described as passive-aggressive judging. This was certainly an example of prudential review.    No doubt it is frustrating to the litigants to go all the way to the Supreme Court without receiving answers on the main questions that they briefed.   However, the Court’s non-answers to the larger questions may speak volumes.

First, the court preserved the core vs. non-core system that we have been operating under since 1984.   In the wake of Stern v. Marshall, many commentators had declared this structure to be a dead letter, since it was unconstitutionally overbroad.   Not so, says the high court.  It simply needs to be fine-tuned by our friend severability.   This should properly be viewed as a signal, although oblique, that the Supreme Court does not wish to throw out the bankruptcy system as some had feared.

Second, while the court did not expressly decide the consent issue, it did so indirectly.   By saying that core but unconstitutional matters should be treated as non-core under the statutory procedures of 28 U.S.C. §157(c), the court referred to a statutory provision which included consent.   Indeed, Justice Thomas’s discussion of the statutory scheme expressly stated that proposed findings and conclusions are only necessary where the parties have not consented.   If consent was not constitutionally viable, the Court would have been expected to at least drop a footnote stating that they were not opining on that portion of the law.    When Justice Thomas said that courts should follow §157(c), which includes consent, he was implicitly upholding consent.

Finally, while the Court did not rule on whether fraudulent conveyance claims failed the Stern test, it noted that no party had disputed this conclusion.   Thus, while it is not a direct holding, it is a clear signal.   

In my opinion, Bellingham is a signal from a unanimous Court that the BAFJA core vs. non-core system still works, although it needed to be tweaked.   The new “core” proceedings will look somewhat like the old summary jurisdiction under the Bankruptcy Act.   Proceedings intended to augment the estate which are not necessary to determination of a claim, will now be considered non-core matters regardless of how Congress classified them in 1984.

However, I do see one big issue that remains to be decided.   What happens if a Bankruptcy Court enters a final judgment on a matter that is constitutionally non-core and no party seeks de novo review from the District Court?   Is that an invalid judgment that can be collaterally attacked or does the failure to seek de novo review constitute consent?    Must there be actual de novo review or merely the opportunity for de novo review?  There are certainly other questions lingering out there as well.   This means that while the boat has not been capsized (at least for today), we have not felt the last ripples from Stern v. Marshall.

Fifth Circuit Declines to Rehear Stern Consent Issue

Recently, the Fifth Circuit has authored two opinions in which it opined that parties could not consent to entry of a final order in a case governed by Stern v. Marshall.   In one of these cases, BP RE, LP v. RML Waxahachise Dodge, LLC, 735 F.3d 279 (5th Cir. 2013), the plaintiff, having filed suit in bankruptcy court, invoked Stern v. Marshall after losing on the merits.    The previously prevailing defendants sought rehearing en banc in light of the conflict between the Fifth Circuit decision allowing consent to trial by a Magistrate Judge and BP RE.   Today the Fifth Circuit voted by the narrowest of margins to decline rehearing.    Six judges, including Chief Judge Stewart, would have granted rehearing en banc, while eight judges voted no.   You can find the opinion here.

The opinion will soon become a historical curiosity once the Supreme Court renders its own consent decision in Executive Benefits Insurance Agency v. Arkison, 702 F.3d 553 (9th Cir. 2012), cert. granted, 133 S.Ct. 2880 (2013).   Nevertheless, I thought that Judge Higginson wrote a very well reasoned dissent which I will quote in its entirety.   

I write in dissent of denial of full court rehearing to note that this case presents an enbancworthy issue—whether a bankruptcy court, consistent with its statutory authority under 28 U.S.C. § 157(c)(2), may enter final judgment in a non-core proceeding with the parties’ consent. The panel opinion holds that it cannot do so consistent with Article III of the United States Constitution.  The Supreme Court has granted certiorari and heard argument in Executive Benefits Insurance Agency v. Arkison (In re Bellingham Ins. Agency, Inc.), 702 F.3d 553 (9th Cir. 2012), cert. granted, 133 S. Ct. 2880 (2013), a case that presents the question of whether a bankruptcy court can enter judgment in a core proceeding with the parties’ consent. Hence, and speaking to the issue’s significance, the role of consent in delineating the scope of Article III is before the Supreme Court and I would be loath to anticipate its answer. I will not belabor the importance of a case that, in effect, strikes down a federal statute and whose result may disrupt the way our district and bankruptcy courts handle a large volume of routine bankruptcy business. Instead, I especially see significance to examining any rationale that might logically extend to precluding magistrate judges from entering judgment with parties’ consent.

In Technical Automation Services Corporation v. Liberty Surplus Insurance Corp., 673 F.3d 399, 407 (5th Cir. 2012), this court upheld a magistrate judge’s capacity to enter final judgment in civil cases with the parties’ consent. In the instant matter, the panel opinion asserts no conflict with Technical Automation, but it is hard to see how there is not tension between this case and Technical Automation. Both cases recognize the similarities between magistrate and bankruptcy judges. Further, the respective statutes providing a basis for entering judgment with parties’ consent are similar. Then, and even assuming BP RE’s correctness, our law after BP RE is that a magistrate  judge’s judgment is proper under 28 U.S.C. § 636(c)(1), but a bankruptcy judge’s judgment under 28 U.S.C. § 157(c)(2) is improper. Maybe there are good reasons for incongruity, but they are ones I perceive that our full court should explore.

As to BP RE’s merits, the panel opinion acknowledges that Stern announced a limited holding: “We conclude today that Congress, in one isolated respect, exceeded that limitation in the Bankruptcy Act of 1984.” Stern v. Marshall, 131 S. Ct. 2594, 2620 (2011). BP RE concludes that Stern’s reasoning requires the conclusion that Congress exceeded Article III in another respect, even though Stern did not address parties’ consent. Instead, Stern may be less decisive than CFTC v. Schor, 478 U.S. 833, 851 (1986), which noted that when “Article III limitations are at issue, notions of consent and waiver cannot be dispositive because the limitations serve institutional interests that the parties cannot be expected to protect.” But Schor has language supporting both sides of this controversy. Schor proclaims: “the parties cannot by consent cure the constitutional difficulty for the same reason that the parties by consent cannot confer on federal courts subject-matter jurisdiction beyond the limitations imposed by Article III, § 2,” id. at 851, but also that:

the decision to invoke this forum is left entirely to the parties and the power of the federal judiciary to take jurisdiction of these matters is unaffected. In such circumstances, separation of powers concerns are diminished, for it seems self-evident that just as Congress may encourage parties to settle a dispute out of court or resort to arbitration without impermissible incursions on the separation of powers, Congress may make available a quasi-judicial mechanism through which willing parties may, at their option, elect to resolve their differences.

Id. at 855. There is no determinative guidance as to the role consent plays in the Article III analysis of § 157(c)(2). It may be, as BP RE suggests, irrelevant as an impermissible cure attempt, or  alterna- tively, consent may be part of the multifactor balancing test to determine whether there is an Article III problem in the first instance. Fortunately, Executive Benefits likely will shed light on this issue. Our court will benefit from that guidance, and I write separately to note that I would usefully have incorporated such guidance into our own full court assessment of these weighty constitutional boundaries.

(emphasis added)

I give Judge Higginson (and the rest of the dissenters) kudos for understanding the importance of the issue and the contradictory reached by the Fifth Circuit with regard to  Magistrate Judges and Bankruptcy Judges.  Now we will have to wait to hear what the Supremes have to say.   

Disclosure:  I submitted an amicus brief in favor of rehearing en banc on behalf of the Commercial Law League of America.