The United States Supreme Court recently ruled in Stern v. Marshall1 that a bankruptcy court lacks constitutional authority to render a final judgment on a bankruptcy estate’s counterclaim against a creditor based on state common law, despite an express statutory grant of jurisdiction. This ruling is the most significant decision regarding bankruptcy court jurisdiction since the Court’s 1982 decision in Northern Pipeline v. Marathon2 and it could significantly affect the administration of bankruptcy cases.

Root of the Constitutional Problem

Under the Bankruptcy Reform Act of 1978,3 Congress established bankruptcy courts that were characterized as "adjuncts" of the federal district courts with broad jurisdiction and authority to render final decisions in all proceedings arising under the Bankruptcy Code (Code) and proceedings arising in or related to cases filed under the Code. Bankruptcy judges were appointed by the President for 14-year, renewable terms. In Northern Pipeline, the Supreme Court held that the broad subject matter jurisdiction granted to the bankruptcy courts under the 1978 Act was unconstitutional as violative of Article III of the U.S. Constitution.

Congress’ Attempt at Remedial Legislation

After an intervening period of uncertainty and confusion during which the bankruptcy court system operated under "emergency rules" promulgated by the Article III courts, Congress enacted the Bankruptcy Amendments and Federal Judgeship Act of 1984,4 which established the regime under which bankruptcy courts have since operated.

In order to address the constitutional infirmities identified by the Supreme Court in Northern Pipeline, the 1984 legislation created a structure under which bankruptcy jurisdiction was vested in the federal district courts, who were authorized to "refer" that jurisdiction to bankruptcy judges subject to withdrawal of the reference.5 In addition, the statute authorizes bankruptcy courts to enter final judgments in all core proceedings arising under the Code or arising in a case under the Code, but not in non-core proceedings, in which bankruptcy courts may only make proposed findings of fact and conclusions of law.6 Thus, in cases in which a bankruptcy court rules on a core matter, a district court will review the decision under traditional appellate standards. By contrast, when a bankruptcy court rules on a non-core issue, the district court will review any finding or conclusion to which a litigant objects de novo.

The Constitutional Problem Resurfaces in Stern v. Marshall

The efficacy of Congress’s attempt to remedy the jurisdictional problems identified in Northern Pipeline was tested in the Supreme Court’s recent decision in Stern v. Marshall. In that case, the Court considered whether a bankruptcy court had the statutory and constitutional authority to enter a final judgment on a counterclaim based on a state common law claim asserted by the debtor’s estate against a creditor who had filed a proof of claim against the estate. In a 5-4 decision, the Court held that the bankruptcy court lacked jurisdiction to enter a final judgment on such a counterclaim, which was a claim for tortious interference, because bankruptcy judges are not appointed under Article III of the Constitution. In his opinion for the majority, Chief Justice Roberts illuminated the obscure, but nonetheless important, boundaries of bankruptcy court jurisdiction, while at the same time limited the matters upon which bankruptcy judges are authorized to render final judgments. The opinion also raised a number of issues that the Court did not resolve.

The Background of Stern v. Marshall

In Stern, Vickie Lynn Marshall (commonly known as Anna Nicole Smith) sued Pierce Marshall (the son of Vickie’s deceased husband) in Texas state probate court, arguing that Pierce had fraudulently induced his father into signing a living trust that did not permit Vickie to share in her husband’s estate. After Vickie filed for bankruptcy protection, Pierce filed an adversary proceeding in the bankruptcy court asserting that Vickie was liable to him for defamation and seeking a declaration that Vickie’s liability to him was nondischargeable. Pierce also filed a proof of claim asserting a claim for damages based on the alleged defamatory conduct. Vickie objected to Pierce’s proof of claim and filed a counterclaim against Pierce, asserting a claim for tortious interference with the gift she had expected from her husband. The bankruptcy court disallowed Pierce’s claim and entered a final money judgment in favor of the estate and against Pierce on the counterclaim.

On appeal to the district court, Pierce argued that the bankruptcy court lacked the authority to enter the judgment because the counterclaim was not a core proceeding. The district court agreed, determining that it was required to treat the bankruptcy court’s judgment as proposed, rather than final. In the meantime, the Texas state probate court had entered judgment in favor of Pierce on the same causes of action that were considered by the bankruptcy court. Nevertheless, the district court engaged in an independent review of Vickie’s counterclaim and, like the bankruptcy court, found that Pierce had tortiously interfered with the gift at issue and awarded Vickie a several million dollar judgment. On appeal, the Ninth Circuit reversed. The court of appeals agreed with the district court that the counterclaim at issue was not a core proceeding and held that, accordingly, the state court’s judgment should have been given preclusive effect and the district court should not have entered a judgment that contravened it.

On appeal from the Ninth Circuit’s decision, the Supreme Court was presented with the issues of whether the bankruptcy court had the statutory authority – as well as the constitutional authority – to enter a final judgment on the counterclaim. Importantly, the Court found that bankruptcy courts cannot, consistent with Article III of the Constitution, exercise subject matter jurisdiction over this type of counterclaim.

The Bankruptcy Court Had Jurisdiction Under the Statute

Before reaching the constitutional question, the Court addressed the issue of whether the bankruptcy court had the statutory authority to enter a final judgment on the counterclaim. Section 157(b)(1) of Title 28 provides that bankruptcy judges may enter final judgments in core proceedings arising under the Code or arising in cases filed under the Code. Section 157(b)(2)(C) identifies (without limitation) 16 different types of matters that constitute core proceedings, including "counterclaims by [a debtor’s] estate against persons filing claims against the estate." The Court ruled that, under the plain language of the statute, Vickie’s counterclaim asserting tortious interference was a core proceeding. The Court also rejected Pierce’s contention that the bankruptcy court lacked jurisdiction because Vickie’s counterclaim arose neither under the Code nor in the bankruptcy case but was merely "related" to the case, instead finding that Vickie’s counterclaim was clearly a core proceeding as specifically set forth in the statute.

The Bankruptcy Court Did Not Have Jurisdiction Under the Constitution

Even though the bankruptcy court had the statutory authority to render final judgment on Vickie’s counterclaim, the Court held that the exercise of such jurisdiction was not constitutionally permissible. Because bankruptcy courts are not Article III courts, they may not exercise "the judicial power of the United States." Rather, such power is specifically reserved for Article III courts, whose judges are appointed by the President with lifetime tenure and salaries that cannot be diminished by Congress. Entering a final judgment on a counterclaim purely grounded in state common law, where such judgment was not necessary to adjudicate a creditor’s proof of claim, involved the exercise of judicial power possessed only by an Article III judge.

The Court began its constitutional analysis by explaining the purpose of Article III, which "both defines the power and protects the independence of the judicial branch."7 The federal judiciary is an independent and co-equal branch of the federal government that exists both to counterbalance the respective powers of the legislative and executive branches, as well as to protect individual liberty from encroachment by the excesses of such powers. To ensure their independence, the Constitution provides lifetime appointments to Article III judges and places restrictions upon the other branches’ ability to impair their tenure or salaries. In this manner, the judge’s evaluation of the merits of a case will not be influenced by personal considerations. However, the judiciary cannot be truly independent, nor effectively serve its constitutional functions, if the other branches are able to authorize entities other than Article III judges (who do not enjoy the requisite tenure and salary protections) to exercise Article III powers. As stated by the Court, "Article III could neither serve its purpose in the system of checks and balances nor preserve the integrity of judicial decisionmaking if the other branches of the Federal Government could confer the Government’s ‘judicial power’ on entities outside Article III."

Thus, Article III prohibits Congress from, among other things, authorizing entities other than Article III courts (even other federal courts such as the bankruptcy courts) to exercise authority over any matter that is the subject of a suit at common law.8 That is, in cases in which a matter is within the bounds of federal jurisdiction, and it is "the stuff of the traditional actions at common law" (which Vickie’s counterclaim was), then deciding such suit is the exclusive province of Article III judges in Article III courts.9 Bankruptcy courts, while federal courts, are not Article III courts because they lack the tenure and salary guarantees of Article III. As such, bankruptcy courts cannot, consistent with Article III of the U.S. Constitution, enter final judgments on common law counterclaims. Succinctly stated by the Court in Stern, the "... Bankruptcy Court below lacked the constitutional authority to enter a final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim." Because adjudicating Vickie’s counterclaim required the exercise of the "judicial power of the United States," and because such litigation was not necessary to resolve Pierce’s proof of claim, a final judgment could only be entered by an Article III court.

The Court expressly rejected the contention that bankruptcy courts are empowered to enter final judgments on claims such as Vickie’s because they are "adjuncts" of district courts, distinguishing this case from Crowell v. Benson,10 the landmark case on administrative agency jurisdiction. The Court also found that the "public rights" exception recognized by the plurality in Northern Pipeline did not apply to Vickie’s counterclaim because that exception only extends to claims "integrally related to a particular Federal Government action." Notably, the Court holds that by filing a proof of claim, a creditor does not thereby consent to the adjudication of all related counterclaims by the bankruptcy court – a holding likely to surprise many experienced bankruptcy practitioners.

In arriving at its decision, the Supreme Court relied upon Northern Pipeline and its earlier decision in Murray’s Lessee v. Hoboken Land & Improvement Co.11 and distinguished its decisions in Katchen v. Landy12 and Langenkamp v. Culp.13 The Court found that, in deciding Vickie’s counterclaim, the bankruptcy court made several factual findings and legal determinations it did not need to make to dispose of the objections to Pierce’s proof of claim. Both Katchen and Langenkamp were distinguishable on the additional grounds that the claims asserted by the estate in those cases, unlike Vickie’s, were "rights of recovery created by federal bankruptcy law."

Majority Rejects ‘Pragmatic’ Approach to Non-Article III Courts’ Adjudicatory Authority

Centralizing and resolving all disputes involving a debtor’s estate in the bankruptcy court clearly would be more efficient than litigating in multiple venues. However, the Stern majority concluded that "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."14 Because the bankruptcy court’s final judgment lacked the requisite jurisdictional foundation, the Ninth Circuit’s decision was affirmed.

In an opinion authored by Justice Breyer, the dissent expressed the concern that the majority’s decision will result in "a constitutionally required game of jurisdictional ping-pong between courts [that] would lead to inefficiency, increased cost, delay, and needless additional suffering among those faced with bankruptcy."15

Some Unanswered Questions

The Supreme Court’s decision in Stern raises a number of issues and leaves several questions either unanswered or unclear. For example:

  • if, in an action involving a counterclaim based upon state common law, the bankruptcy court makes proposed findings of fact and conclusions of law with the final determination to be made by the district court, will that be sufficient to overcome any constitutional objections based on Article III?
  • reading Stern and Granfinanciera together with Section 502(d) of the Code, does a bankruptcy court have the power to finally decide a fraudulent transfer counterclaim against a creditor who filed a proof of claim? Does it matter whether the estate’s claim is brought under Section 544(b) or 548?
  • will amendments to the Code or the Federal Rules of Bankruptcy Procedure be adopted to address the effects of the Stern decision?

We will have to await future developments in Congress and the courts to gain answers to these and other questions raised by Stern.

Conclusion

The majority opinion in Stern suggests that the impact of its holding on the administration of bankruptcy cases will be modest, and of course, only time will tell in terms of the opinion’s real impact. However, in the immediate wake of Stern, it seems likely that practitioners will be spending more time battling over whether a claim properly belongs before the bankruptcy court or a district court instead. Without question, the ruling in Stern curbs the power of bankruptcy courts to render final decisions on a number of counterclaims that they previously have adjudicated. If the bankruptcy court’s inability to rule on state law counterclaims causes confusion, waste or delay, the ability of bankruptcy courts to serve as efficient engines to dispose of complex insolvency matters may be impaired. It is also unclear whether the federal district courts can efficiently handle the increased volume of cases that Stern might bring to their dockets. Therefore, one cannot help but wonder whether Stern’s real impact will be to extend the bankruptcy process or, as a practical matter, will cause debtors to pursue state law claims in some other forum.

Moreover, there will most assuredly be a great deal of creative lawyering in terms of whether a counterclaim falls squarely within the "public rights" exception. The high Court’s decision could also trigger some interesting contests as to the validity of previous rulings for which a bankruptcy court may have lacked the requisite constitutional jurisdiction.