Bankruptcy Courts Cannot Decide Debtors’ Common Law Claims

June 29, 2011 Author: Zack A. Clement

Stern Holding

In Stern v. Marshall, ___ U.S. ___, 2011 WL 2472792 (June 23, 2011), issued on June 23, the Supreme Court declared for the third time that a bankruptcy court does not have authority under the Constitution to issue a final judgment in a lawsuit arising solely under state common law seeking to bring assets into a debtor's bankruptcy estate.  The Court held that the bankruptcy court lacked constitutional authority to enter a final judgment on a counterclaim filed by Vickie Lynn Marshall, more commonly known as Anna Nicole Smith, alleging interference with expected inheritance against her late husband's son, Pierce Marshall, after he filed a proof of claim in her Chapter 11 case alleging damages for defamation.

Previously, the Supreme Court had held that a bankruptcy court lacks the power to enter a final judgment on a debtor's state law contract claim against a non-debtor third party, Northern Pipeline Const. Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982), and that a bankruptcy court lacks such power concerning a debtor's fraudulent conveyance claim against a non-debtor party who had not filed a proof of claim,Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989).

In Stern, the Supreme Court ultimately held that, even though Congress has listed in 28 U.S.C. §157(b)(2)(C) to be a matter of "core" bankruptcy jurisdiction a counterclaim against a party that has filed a proof of claim,[1] the bankruptcy court in Vickie Marshall's case "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."  Stern, at *27. 

Action in Response to Stern

The Stern decision gives parties defending against debtor claims (or counterclaims) arising under state common law a substantial reason to file a motion under 28 U.S.C. §157(d) asking the district court to withdraw reference of that cause of action from the bankruptcy court to have the issue heard by a district court.  Even parties who wish to have such a claim tried in the bankruptcy court, but do not want the expense of a re-trial, now have reason to ask the district court for an early declaration under 28 U.S.C. §157(d) whether such a case should continue in the bankruptcy court and, if so, under what rules for district court review.

Relatedness of a Claim to Another Core Matter

Stern affirmed the circuit court's holding that "a counterclaim under §157(b)(2)(C) is properly a 'core' proceeding 'arising in a case under' the [Bankruptcy] Code only if the counterclaim is so closely related to [a creditor's] proof of claim that the resolution of the counterclaim is necessary to resolve the allowance or disallowance of the claim itself."  Stern, at *8.  Stern held that Vickie Marshall's counterclaim did not meet that standard.

Here 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.  Northern Pipeline and our subsequent decision in Granfinanciera, 492 U.S. 33 . . . rejected application of the 'public rights' exception in such cases.

Id. at *16.

Public Right Versus Common Law

Stern held that Vickie Marshall's counterclaim did not meet the "public right" exception to the general rule that an Article III court (i.e., a district court) must adjudicate a "matter which, from its nature, is the subject of a suit at the common law, or in equity or admiralty."  Id. at *2.  When Congress creates a right that did not exist as a private right among citizens under the common law, it can assign that public right to a non-Article III court.  According to Stern,  the Supreme Court "has continued, however, to limit the [public right] 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," neither of which it found to be present in the Stern case.  Id. at 3.

Stern noted that the Supreme Court had held in Granfinanciera that the bankruptcy court lacked power to enter judgment on a debtor's fraudulent conveyance claim against a party that had not filed a creditor claim because "if 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 *19.  In Granfinanciera, the court held 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.

Stern found Vickie Marshall's counterclaim to be similar to the fraudulent conveyance claims in Granfinanciera.  It was not a claim created by Congress but "is instead one under state common law between two private parties.  It does not depend on the will of Congress."  Id. at 19.

Filing a Proof of Claim Does Not Necessarily Equal Submission to Bankruptcy Court Jurisdiction

Stern held that Pierce Marshall's filing of a proof of claim in the bankruptcy case alleging defamation did not, by itself, give the bankruptcy court jurisdiction over Vickie Marshall's counterclaim for tortious interference.  First, Stern found that "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."  Id. at 20. 

Stern thus appears on the surface to have overruled in Katchen v Landy, 382 U.S. 323 (1966) which had held that a creditor who filed a proof of claim had submitted to the summary jurisdiction of the bankruptcy court over a counterclaim against it.  Stern, however, distinguished Katchen because the central bankruptcy function of allowing and paying the creditor's claim could not be completed there until the preference counterclaim was resolved and the preference cause of action was contained in the federal bankruptcy statute.  Moreover, Stern ruled that, even though the courts below had concluded that Vickie Marshall's counterclaim was compulsory, "there was never any reason to believe that the process of adjudicating Pierce's proof of claim would necessarily resolve Vickie's counterclaim."  Id. at 23. 

The New Rule From Stern

Ultimately, Stern distinguished Katchen and extended Granfinanciera to Vickie Marshall's case in which the creditor had filed a proof of claim and the lower courts had found her counterclaim to be  compulsory.  In essence, Stern held that the "public law" exception would be extended to counterclaims based on state law where the resolution of the counterclaim (1) is necessary to resolution of the bankruptcy case or (2) so intertwined with claims allowance that it will necessarily be decided in connection with claims allowance.

Granfinanciera's distinction between actions that seek 'to augment the bankruptcy estate' and those that seek 'a pro rata share of the bankruptcy res' . . . reaffirms that Congress may not bypass Article III simply because a proceeding may have some bearing on a bankruptcy case; the question is whether the action at issue [1] stems from the bankruptcy itself or [2] would necessarily be resolved in the claims allowance process.

Id. at 24 (emphasis added). 

Conclusion and Actions to Take

Stern appears to apply only to a debtor's efforts to use a state common law cause of action to bring assets into the bankruptcy estate. 

When such a case is presented, or is arguably presented, it makes sense to start as soon as possible a collaboration between the bankruptcy court and the district court about which court will conduct the trial and which court will enter final judgment, subject to what kind of review.

28 U.S.C. §157(d) gives the district court the power to withdraw reference of a lawsuit from the bankruptcy court on its own motion or the motion of a party.  As a practical matter, most districts have procedures similar to Southern District of Texas Local Rule 5011-1 providing that "unless the district court orders otherwise, the [withdrawal of reference] matter will first be presented to the bankruptcy judge for recommendation."

Filing a motion to withdraw reference under 28 U.S.C. 157(d) will serve as a mechanism to find out in greater depth (1) what the parties think are the issues in the lawsuit, (2) how much they are intertwined with other issues that are core to the bankruptcy process (including claims allowance and distribution issues), (3) whether the bankruptcy court believes it should keep the case, and (4), finally, possibly establishing in advance the rules for district court review of the bankruptcy court's findings if the case is to be tried by the bankruptcy court.  

In the wake of Stern, whether a party's goal is to maximize or minimize the bankruptcy court's role in such a lawsuit, it makes sense to start the debate promptly about how the case should proceed.

This article was prepared by Zack A. Clement, Partner (zclement@fulbright.com or 713 651 5434) in Fulbright's Bankruptcy and Insolvency Practice Group. Fulbright's Bankruptcy and Insolvency Practice Group represents secured and unsecured creditors, committees (both official and ad hoc), bondholders, asset purchasers, equity sponsors, debtors, trustees and other parties involved in financial restructuring transactions and cases, both in and out of court. For further information or questions regarding Fulbright's Bankruptcy and Insolvency Practice, please contact Louis R. Strubeck, Partner (lstrubeck@fulbright.com or 214 855 8040), national chair of the group.

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[1] 28 U.S.C. §157(b)(1) provides that "bankruptcy judges may hear and determine [enter a final judgment on] all [main bankruptcy] cases arising under title 11 [the Bankruptcy Code] and all core proceedings [lawsuits] arising under title 11 [the Bankruptcy Code] or arising in a [bankruptcy] case under title 11."  As to "proceedings" (lawsuits) that are merely related to a bankruptcy case because they might affect the size of the bankruptcy estate, the bankruptcy court can only issue proposed findings subject to de novo review by the district court. 28 U.S.C. §157(c).  28 U.S.C. §157(b)(2) provides that core matters include, but are not limited to a list of sixteen items, including "counter-claims by the estate against persons filing claims against the estate." 28 U.S.C. §157(b)(2)(C).