The Supreme Court Holds Unconstitutional a Key Provision of the Bankruptcy Code

07/05/2011

On June 23, 2011, the Supreme Court handed down a 5-4 decision in the Stern v. Marshall case,1 holding that a bankruptcy court’s exercise of statutory jurisdiction was unconstitutional when it adjudicated a counterclaim relating to a purely state law cause of action.  This decision will make it more difficult for debtors and others to sue third parties in the bankruptcy court and will allow defendants to have cases tried in a potentially more favorable forum.  This decision is of particular importance to lenders, investment funds, investment banks, and others who are often the targets of suits by debtors.

The proper bounds of bankruptcy court jurisdiction have remained somewhat of an open issue since Congress amended the jurisdiction of bankruptcy courts in 1984 to comply with the Supreme Court’s Northern Pipeline2 decision finding the jurisdictional provisions unconstitutional as they were created in 1978.  The tension regarding bankruptcy court jurisdiction arises because bankruptcy judges are Article I judges, lacking certain characteristics of Article III judges, such as life tenure and salary protection.  Bankruptcy judges can, therefore, only exercise powers available under Article I of the Constitution, as opposed to Article III of the Constitution, which grants the core judicial powers to the judicial branch of the federal government.  As the Supreme Court observed in this case, “Article III could neither serve its purpose in the system of checks and balances nor preserve the integrity of judicial decision making if the other branches of the Federal Government could confer the Government’s ‘judicial power’ on entities outside Article III.”

Factual Background

At its heart, the substance of this case revolved around a will dispute.  The saga began when Vickie Lynn Marshall (aka Anna Nicole Smith)3 married billionaire J. Howard Marshall II about a year before his death and did not receive the gift she expected in his will when he died.  Vickie sued the deceased’s son, E. Pierce Marshall,4 in state court, alleging that he fraudulently induced his father, J. Howard, to sign a living trust that did not include Vickie.  Later, when Vickie filed for bankruptcy, Pierce filed a complaint in Vickie’s bankruptcy case (and a related proof of claim) seeking damages for Vickie’s allegedly defamatory statements accusing Pierce of engaging in fraud to acquire his father’s wealth.  Pierce also asked the bankruptcy court to find that his defamation claim was nondischargable because the defamatory statements were willful and malicious.  As a counterclaim (the “Counterclaim”), Vickie asked the bankruptcy court to find Pierce liable on the bases alleged in the state court action that Vickie had previously filed against Pierce (i.e., that Pierce tortiously interfered with Vickie’s expectancy of a gift from J. Howard).

Procedural Background

The bankruptcy court first ruled against Pierce on his defamation claim against Vickie and then, nearly a year later, held a bench trial and ruled in favor of Vickie on the Counterclaim against Pierce.  On appeal to the district court, Pierce argued that the bankruptcy court lacked jurisdiction to enter a final order on the Counterclaim.  The district court disagreed with Pierce’s reasoning, but agreed that the Counterclaim was not a “core” proceeding before the bankruptcy court as defined in 28 U.S.C. § 157.  As a result, the district court chose to treat the bankruptcy court’s judgment as proposed, rather than final, and conducted an independent review before entering a judgment in favor of Vickie.  Before the federal district court entered its judgment, however, the state court in which Vickie had filed a lawsuit based on the same theories of recovery conducted a jury trial and issued a ruling in favor of Pierce, but the district court decided not to give preclusive effect to that judgment.  The Ninth Circuit Court of Appeals agreed with the district court that the Counterclaim was a non-core proceeding, but also held that the district court was required to give preclusive effect to the state court’s prior judgment.

The Issues

The Supreme Court recognized two issues in this case.  First, did the bankruptcy court have the statutory authority to enter a final order on Vickie’s Counterclaim?  Under the jurisdictional statute, the bankruptcy court could enter a final order only if the matter were a “core” bankruptcy matter; otherwise, the bankruptcy court had to enter proposed findings of fact and conclusions of law for the district court.  Second, if the bankruptcy court was authorized by statute to enter a final order on this compulsory Counterclaim, is that statute unconstitutional?  Both the majority opinion and the dissenting opinion agreed that 28 U.S.C. § 157(b)(2)(C) plainly authorized the bankruptcy court to adjudicate the Counterclaim as a core proceeding,5 but the majority opinion also held that the statute itself was unconstitutional.

The Majority’s Analysis

In analyzing the constitutionality of the statute giving bankruptcy courts the authority to finally adjudicate all counterclaims by the estate against persons filing claims against the estate, the Court looked to its own precedent in which it has recognized a category of rights referred to as “public rights,” which Congress could constitutionally authorize non-Article III courts to adjudicate.  Public rights were found to include “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,” but the rule was later broadened to include actions in which the Government is not directly a party.  In other words, for the rights to be public rights, they would need to derive from a federal regulatory scheme or be completely dependent upon adjudication of a claim integrally related to particular federal government action.  In stark contrast, the Counterclaim was a cause of action derived from state law and “not necessarily resolvable by a ruling on the creditor’s proof of claim in bankruptcy.”  The Court distinguished its prior holdings in Granfinanciera, S.A. v. Nordberg6 and Langenkamp v. Kulp,7 which involved fraudulent transfer actions and preference actions by the bankruptcy estate against creditors who had filed proofs of claim, because in those types of actions, section 502(d) of the Bankruptcy Code requires a determination of the preference or fraudulent transfer allegation as part of the claims allowance process.  The dissent failed to make this distinction.

The Court also analyzed whether Pierce gave the bankruptcy court jurisdiction to rule on the Counterclaim because he filed a proof of claim in the bankruptcy case.8  Even though the parties agreed that Vickie’s tortious-interference Counterclaim was a compulsory counterclaim to Pierce’s defamation claim filed in the bankruptcy case, the Court noted that the Counterclaim was in no way derived from or dependent upon bankruptcy law and did not need to be resolved in order to address the defamation claim that Pierce filed against the bankruptcy estate.  In addition, the Court was convinced that Pierce had nowhere else to go to recover on his claim, and that he could not be said to have waived his constitutional right to adjudication of the Counterclaim by an Article III court simply because he was forced to bring his claim in the bankruptcy proceeding.  The Court also held that the bankruptcy court was not an “adjunct” of the district court since the bankruptcy court can enter final judgments.9

The Concurrence

The concurring opinion by Justice Scalia comments on the “factors” that the majority opinion uses to determine “public rights” as having entered the jurisprudence “almost randomly.”  This observation holds true for many of the “factors” that now seem to dominate briefing and court rulings.  Scalia then takes a narrow view of the authority of Article I courts and limits it to territorial courts, courts-martial, true “public rights” cases (presumably arising between the government and others), and possibly adjudications by federal administrative agencies.

The Dissent

The dissent argued in favor of a “more pragmatic” approach to the constitutional question and would strike down the statutory bankruptcy scheme only if it presented a “genuine and serious threat” to the separation of powers.  The dissent found no such serious threat, citing factors such as the common factual issues involved in the defamation claim and tortious-interference Counterclaim and the supervisory role Article III judges have over bankruptcy cases through appeals to the district court and through the district court’s ability to withdraw the reference.  The dissent surprisingly compared the bankruptcy judges to law clerks and the Judiciary’s administrative officials (along with the somewhat more apt comparison with magistrate judges) in an attempt to minimize the importance of the lifetime appointment and salary protection afforded to Article III judges.  The dissent also seems to contend that Pierce did not need to file a proof of claim and could have litigated the nondischargeability of his claim in a state or federal court after the bankruptcy, apparently overlooking the requirements of section 523(c)(1) of the Bankruptcy Code and Bankruptcy Rule 4007, which require a determination of dischargeability by the bankruptcy court.  More defensible is the argument by the dissent that the ability of the district court to withdraw the reference under 28 U.S.C. § 157(d) satisfies the Article III requirement.  According to the dissent, the Stern ruling would prevent bankruptcy judges from finally determining numerous matters that they currently decide, citing as an example the claim of a landlord for unpaid rent and a counterclaim by the tenant/debtor for breach of the lease and improper recovery of possession of the premises.

This hypothetical may not be universally applicable if a determination of the debtor’s counterclaim would be required to determine the validity and amount of the landlord’s claim under the terms of the lease and the applicable state law and therefore be part of the claims resolution process to be heard by an Article I court, even under the holding of the majority. 

Takeaways

Ultimately, the Court emphasized that the relevant question is whether the action at issue stems from the bankruptcy itself and would necessarily be resolved in the claims allowance process.  While the four dissenting justices urge a “pragmatic” approach to evaluating the constitutionality of Congress vesting adjudicatory authority in a non-Article III court, a majority of the Court rejected this approach.  The dissenting justices apparently believed that the delegation of authority in this case represented a de minimis intrusion into the power granted to the Judicial Branch, if any, but the majority opinion took a stricter approach to interpreting the Constitution and noted that “[s]light encroachments create new boundaries from which legions of power can seek new territory to capture.”

The result in this case may have been different if the bankruptcy court had concluded that in order to resolve the Pierce claim for defamation, it was required to simultaneously determine Vickie’s counterclaim for tortious interference.  If Vickie was right that Pierce had cheated her, then there would be no claim for defamation.  It could then have been argued that determination of the Counterclaim was part of the claim adjudication process permissible under Granfinanciera and Langenkamp.  This apparently was not the case since Pierce’s claim was denied on summary judgment almost a year prior to the trial of Vickie’s Counterclaim on questions relating to Vickie’s knowledge and approval of statements by her attorneys.  The dissent recognizes that determination of a claim might require the resolution of a counterclaim but seems to ignore that Pierce’s claim was independently determined.

Adjudication of disputes involving setoff remains unclear.  To the extent that a counterclaim of the debtor affords the creditor a right of setoff, section 506 of the Bankruptcy Code treats the creditor as a secured creditor, which may implicate the determination of the counterclaim in the claims resolution process, thus bringing the entire dispute into the jurisdiction of the bankruptcy court.

Footnote 7 of the majority opinion seems to leave open to discussion whether the restructuring of debtor-creditor relations is a public right, and the concurrence of Justice Scalia says that he states no position on the issue.  If the collective bankruptcy process that is constitutionally authorized involving an equitable distribution of the property of a bankrupt estate is not a public proceeding involving public rights, then what is it?  Are we potentially back to the in rem and summary/plenary jurisdictional arguments that existed prior to the enactment of the current Bankruptcy Code in 1978? 

The bankruptcy system will survive Stern v. Marshall.  However, many hours and dollars will be spent divining whether or not a bankruptcy court may constitutionally make a final determination of particular matters in bankruptcy cases.  Parties may seek withdrawal of the reference under 28 U.S.C. § 157(d) in order to eliminate the possibility of a retrial if the matter cannot constitutionally be heard by the bankruptcy court.  If a final judgment can only be rendered by an Article III court, such court may delegate to the bankruptcy court preliminary matters and may have the bankruptcy court make proposed findings and conclusions for the district court.  Possibly, the bankruptcy court may be more likely to abstain from hearing certain matters if jurisdiction is questionable.  A legislative fix may be proposed.  In any event, the jurisdictional issues should be addressed at the beginning of a proceeding.
 

For more information, please contact any of the lawyers listed below. You may also view the alert in the PDF linked below.

 

Robin Phelan
214.651.5612
robin.phelan@haynesboone.com

 

Scott Everett
214.651.5053
scott.everett@haynesboone.com

 

Lenard Parkins
212.659.4966
lenard.parkins@haynesboone.com 

Kenric Kattner
713.547.2518
kenric.kattner@haynesboone.com

 

Stephen Pezanosky
817.347.6601
stephen.pezanosky@haynesboone.com

 

 

 

 

 

 

 

___________________
1 564 U.S. ___ (2011).
2 Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982).
3 Vickie is now deceased, and the action was carried on by her estate.  For simplicity, the term “Vickie” refers to the estate of Vickie Lynn Marshall.
4 E. Pierce Marshall is also now deceased, and the action was carried on by his estate.  For simplicity, the term “Pierce” refers to the estate of E. Pierce Marshall.
5 In making this determination, the Court concluded that all core proceedings either arise in a Title 11 case or arise under Title 11.
6 492 U.S. 33 (1989).
7 498 U.S. 42 (1990).
8 Pierce had consented to a determination of his defamation claim notwithstanding the dictates of 28 U.S.C. § 157(b)(5), which provides that personal injury claims should be tried in the district court.  The Court acknowledged that 28 U.S.C. § 157(b)(5) is not jurisdictional. 
9 No reference is made in the opinion to 28 U.S.C. § 151, which formerly referred to the bankruptcy court as an “adjunct” of the district court but now refers to the bankruptcy court as a “unit” of the district court.

PDF - Weathering_Bankruptcy_Code.pdf

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