Jurisdiction of Bankruptcy Courts to Enter Final Judgment on “Stern Claims” Based on Consent of Parties Affirmed

The U.S. Supreme Court in Wellness Int’l Network, Ltd. v. Sharif1 explicitly affirmed the jurisdiction of Article I bankruptcy courts to issue final decisions on claims for which litigants are constitutionally entitled to Article III adjudication if the parties consent to the bankruptcy court adjudicating such claims.

In Wellness, a bankruptcy court entered a final order in an adversary proceeding that the 7th Circuit found to include a “Stern claim.”2 The so-called Stern claim was in reference to the Supreme Court’s previous decision wherein it held:

Article III [of the U.S. Constitution] prevents bankruptcy courts from entering final judgment on claims that seek only to augment the bankruptcy estate and would otherwise exist without regard to any bankruptcy proceeding.3

Accordingly, on appeal, the 7th Circuit reversed the bankruptcy court’s decision on the Stern claim because it found that the bankruptcy court lacked constitutional authority to enter a final judgment on the claim.

In reversing the 7th Circuit, the Supreme Court held that “Article III permits bankruptcy courts to enter final judgment on Stern claims submitted to them by consent.”4 Such consent need not be expressly given. It can be implied as long as it is knowingly and voluntarily given. “[T]he key inquiry is whether ‘the litigant or counsel was made aware of the need for consent and the right to refuse it, and still voluntarily appeared to try the case’ before” the non-Article III bankruptcy court judge.5 The Supreme Court then remanded the case to the 7th Circuit to determine, based on the facts of the case, whether the litigants in Wellness had sufficiently consented to the bankruptcy court entering a final judgment on the Stern claim.

Structured Dismissals that Violate Absolute Priority Rule Approved

The U.S. Court of Appeals for the 3rd Circuit in In re Jevic Holding Corp.6 affirmed a bankruptcy court’s discretion to approve structured dismissals of Chapter 11 reorganization cases that do not adhere to the priority in distribution rules that would otherwise apply under the Bankruptcy Code. 

In Jevic Holding, the Official Committee of Unsecured Creditors, on behalf of a debtor’s Chapter 11 bankruptcy estate, brought a fraudulent conveyance action against the debtor’s secured lenders, alleging that a leveraged buyout funded by the secured lenders hastened the debtor’s decline and saddled the debtor with debts that it could not service. 

After years of litigation, the committee, the debtor, and the debtor’s secured lenders reached a settlement in connection with the fraudulent conveyance action. As part of the settlement, the debtor’s remaining cash on hand ($1.7 million) would be used to pay tax and administrative creditors first, and then the general unsecured creditors on a pro-rata basis. Additionally, the debtor’s bankruptcy case would be dismissed.  Thus, “[t]he parties’ settlement [] contemplated a structured dismissal, a disposition that winds up the bankruptcy with certain conditions attached instead of simply dismissing the case and restoring the status quo ante."7

A group of WARN Act claimants (and the United States Trustee), who were not a party to the proposed settlement, objected to the settlement and the structured dismissal because it failed to provide any payment for the WARN Act claimants “even though they held claims of higher priority than the tax and trade creditors’ claims” that would receive a distribution under the settlement and structured dismissal.8 The WARN Act claimants argued that the bankruptcy court had no authority to approve a structured dismissal to the extent that it deviates from the priority scheme provided for in the Bankruptcy Code.

Disagreeing with the objectors, the 3rd Circuit first decided the issue of whether structured dismissals are ever permissible under the Bankruptcy Code.  As the 3rd Circuit stated, “absent a showing that a structured dismissal has been contrived to evade the procedural protections and safeguards of the plan confirmation or conversion process, a bankruptcy court has discretion to order” a structured dismissal.9 The 3rd Circuit went on to recognize that “[s]ettlements that skip objecting creditors in distributing estate assets raise justifiable concerns about collusion.”10 Nonetheless, structured dismissals that deviate from the priority scheme of the Bankruptcy Code may be approved if the bankruptcy court finds “specific and credible grounds to justify [the] deviation.”11

In Jevic Holding, the 3rd Circuit found that deviation from the priority scheme of the Bankruptcy Code was justified, because the bankruptcy judge made sound findings of fact that there was no prospect of a plan being confirmed and conversion to Chapter 7 would have resulted in the secured creditors taking all that remained of the estate in short order.

Takeaways

The Wellness decision issued by the Supreme Court has definitively authorized litigants’ ability to consent to the jurisdiction of bankruptcy courts to decide so-called Stern claims. Litigants should understand that they may be deemed to have consented to the bankruptcy court’s jurisdiction if they proceed to litigate such claims in bankruptcy court without objection.  However, the exact parameters of when a party will be deemed to have consented to the jurisdiction of the bankruptcy court is yet to be determined.

With respect to the Jevic Holding decision, the 3rd Circuit has provided express authority for structured dismissals as a viable strategy for debtors to consider in determining how best to exit bankruptcy. In fact, structured dismissals may offer a more flexible approach than more traditional routes for Chapter 11 debtors that want to maintain some control over their exit, but a confirmable plan is not feasible under the circumstances. Nonetheless, the limits of structured dismissals and their attendant conflicts with the Bankruptcy Code leave structured dismissals as a potentially risky strategy for exiting bankruptcy.

Although the two decisions decide completely separate issues, both should be viewed as affirmation that bankruptcy courts are well equipped to decide a wide range of matters within the context of bankruptcy cases.