Originally appeared in the August 2014 issue of The Bankruptcy Strategist.
After a reprieve of more than 20 years, the United States Supreme Court has in the past several years delved into the world of bankruptcy court jurisdiction in a big way. In 2011, the Supreme Court introduced newfound uncertainty into bankruptcy practice and procedure when it issued its landmark decision in Stern v. Marshall, which limited the constitutional authority of bankruptcy judges to issue final decisions with respect to state law counterclaims. At the time, many observers worried that the decision could lead to a dramatic overhaul of the bankruptcy court system. With the Supreme Court’s June 9, 2014 decision in Executive Benefits Insurance Agency v. Arkison, the Supreme Court had its first opportunity to consider the implications of Stern. Ultimately, the Supreme Court’s decision in Executive Benefits endorsed the new procedures that the bankruptcy courts have been following in the wake of Stern. Again, the Supreme Court left several questions open in Executive Benefits, and the decision’s main lesson to bankruptcy practitioners seems to be: “Stay tuned.” With the Supreme Court’s decision of
July 1, 2014 to grant certiorari in Wellness International Networks, Inc. v. Sharif, the court now has an opportunity to address questions expressly left open in Executive Benefits.
Stern dealt directly with the authority of bankruptcy judges to enter final orders on state law counterclaims. Although Congress had designated such counterclaims as “core” bankruptcy matters, 28 U.S.C. § 157(b)(2), and had granted bankruptcy judges the statutory authority to issue final rulings on those claims, 28 U.S.C. § 157(b)(1), the Supreme Court ruled that bankruptcy judges, as Article I judges, did not have the constitutional authority to enter a final ruling on a state law counterclaim unless that counterclaim “stem[med] from the bankruptcy itself” or determination of the counterclaim was necessary to resolve a creditor’s proof of claim.
The Supreme Court’s holding in Stern was based on the court’s longstanding distinction between cases involving “public rights,” which may be removed from the jurisdiction of Article III courts, and cases involving “private rights,” which may only be adjudicated by Article III courts. Public rights are those rights that stem from or depend on a federal statutory scheme,
like the Bankruptcy Code, while private rights are those derived from common law or state law causes of action. The counterclaim at issue in Stern was a common law claim for tortious interference; accordingly, the Supreme Court held that Congress had violated Article III by designating such a counterclaim as a “core” matter to be adjudicated with finality by a bankruptcy court.
Although Stern dealt only with the state-law counterclaim, the decision opened the door for litigants to question whether bankruptcy courts had the constitutional authority to issue final orders for other matters that were statutorily “core.” To address Stern, many district courts amended their standing orders of reference to the bankruptcy courts to provide that when a bankruptcy court addresses a nominally “core” matter that might be beyond its constitutional authority to adjudicate, the decision of the bankruptcy court would be treated as proposed findings of fact and conclusions of law to be reviewed de novo by the district court, as is the case with non-core proceedings. 28 U.S.C. § 157(c)(1).
“Although Stern dealt only with the state-law counterclaim, the decision opened the door for litigants to question whether bankruptcy courts had the constitutional authority to issue final orders for other matters that were statutorily ‘core.’”
In view of the many questions remaining in the aftermath of Stern, the bankruptcy community eagerly awaited the Supreme Court’s decision in Executive Benefits, the court’s first follow-up to Stern. Executive Benefits addressed the authority of a bankruptcy court to hear and determine a fraudulent transfer claim. Prior to Stern, fraudulent transfer claims were commonly and statutorily recognized as falling within the core jurisdiction of the bankruptcy courts. 28 U.S.C. § 157(b)(2)(H). In Executive Benefits, the chapter 7 trustee alleged that the debtor had fraudulently transferred assets to Executive Benefits Insurance Agency (EBIA). The bankruptcy court granted summary judgment to the trustee, and the district court, following de novo review on appeal, affirmed the bankruptcy court’s decision. EBIA appealed to the Ninth Circuit Court of Appeals. Before the Ninth Circuit ruled, the Supreme Court issued its decision in Stern.
EBIA then argued, for the first time, that the bankruptcy court did not have the constitutional authority to issue a final order on the fraudulent transfer claim. The Ninth Circuit agreed with EBIA that the fraudulent transfer claim was a “Stern claim” (i.e., a proceeding that is defined as “core” under 28 U.S.C. § 157(b) but may not, as a constitutional matter, be adjudicated as such) but held that EBIA had implicitly consented to entry of a final order by the bankruptcy court. The Ninth Circuit also observed that the bankruptcy court’s judgment could be treated as proposed findings of fact and conclusions of law subject to de novo review by the district court.
On June 9, 2014, the Supreme Court unanimously affirmed the Ninth Circuit’s decision in a narrow ruling. The case brings clarity to the procedure that bankruptcy courts should follow when dealing with “Stern claims.” To the relief of the bankruptcy community, the Supreme Court held that bankruptcy courts could continue to issue proposed findings of fact and
conclusions of law for Stern claims. Thus, the Supreme Court validated the coordinated approach that bankruptcy courts and district courts have generally been following since Stern. Although the Supreme Court acknowledged that the 1984 statute that codified the core/non- core distinction did not give bankruptcy courts the express authority to issue findings with respect to core matters (as opposed to non-core matters, see 28 U.S.C. § 157(c)(1)), the Supreme Court held in Executive Benefits that the proper approach to Stern claims is for the bankruptcy court to treat the claims as non-core and submit proposed findings of fact and conclusions of law to the district court.
Although Executive Benefits presented other opportunities for the Supreme Court to bring clarity to the impact of Stern, the court expressly declined to answer other questions raised by the case. For example, the Supreme Court declined to rule on whether the fraudulent transfer claims at issue were Stern claims. Although the Ninth Circuit had found that the fraudulent transfer claims were Stern claims, the Supreme Court declined to affirm this portion of the lower court’s decision. Instead, it expressly assumed without deciding that the fraudulent transfer claims were Stern claims.
The Supreme Court’s refusal to hold that bankruptcy courts have the constitutional authority to enter final judgments on matters as fundamental to bankruptcy cases as fraudulent transfer claims injects further uncertainty into the post-Stern bankruptcy world. The Supreme Court’s creation of a class of claims to be known as “Stern claims” opens the door for litigants to contend that bankruptcy courts cannot enter final orders in other types of statutorily core matters, such as preference actions, actions to force the turnover of estate property, or disputes over the validity of a lien.
“The Supreme Court’s refusal to hold that bankruptcy courts have the constitutional authority to enter final judgments on matters as fundamental to bankruptcy cases as fraudulent transfer claims injects further uncertainty into the post-Stern bankruptcy world.”
The Supreme Court in Executive Benefits also expressly declined to consider whether a bankruptcy judge may enter a final order on a Stern claim if the parties consent and, if so, whether a party’s consent may be implied by conduct. Although the Ninth Circuit concluded that EBIA had implicitly consented to the bankruptcy court’s jurisdiction, the Supreme Court sidestepped the consent issue by holding that, because the district court had reviewed the bankruptcy court’s order de novo and entered its own judgment, EBIA had received all due process to which it was constitutionally entitled.
While the Supreme Court declined to address the consent questions in Executive Benefits— instead deciding to “reserve that question for another day”—it now appears that the Supreme Court may intend to resolve this issue in the near term. On July 1, 2014, the Supreme Court
granted certiorari for an appeal of the Seventh Circuit Court of Appeals’ decision in Wellness International Networks, Inc. v. Sharif. That decision arose from the chapter 7 bankruptcy case of Richard Sharif, who filed for bankruptcy protection after a judgment was entered against him by a federal district court. Wellness International Network (Wellness), the judgment creditor, commenced an adversary proceeding in the bankruptcy court seeking both to block Sharif’s bankruptcy discharge and also for a declaratory judgment, pursuant to Section 541 of the Bankruptcy Code, that certain assets purportedly held in trust were actually part of Sharif’s bankruptcy estate. The bankruptcy court granted a default judgment in favor of Wellness, denied Sharif a discharge and found that the assets held in trust were part of Sharif’s bankruptcy estate.
On appeal to the district court, Sharif did not initially challenge the bankruptcy court’s constitutional authority to enter a final judgment. After briefing was complete, Sharif moved for leave to file a supplemental brief to raise a Stern challenge, but the district court denied the motion and affirmed the decision of the bankruptcy court. The district court, in reviewing the decision of the bankruptcy court, applied a deferential standard of review and considered whether the bankruptcy court’s entry of a default judgment was an abuse of discretion and whether its factual findings were clearly erroneous.
The Seventh Circuit affirmed the district court’s decision denying Sharif a discharge, finding that the relevant claims stemmed from federal law and were thus in the nature of public rights. With respect to the assets held in trust, however, the Seventh Circuit reversed the lower court’s ruling, holding that the bankruptcy court did not have constitutional authority to declare that the trust assets were part of Sharif’s bankruptcy estate because that declaration required the resolution of state-law alter ego issues. The Seventh Circuit further held that a constitutional objection based on Stern was not waivable and, therefore, Sharif could not implicitly or explicitly consent to final adjudication of the state-law issue by the bankruptcy court.
The Supreme Court granted certiorari to address two questions raised by Wellness on appeal. First, the Supreme Court will consider whether the presence of a subsidiary state law issue in a Section 541 action to determine whether property is part of a bankruptcy estate means that the action does not “stem from the bankruptcy itself” (as the Supreme Court expressed in Stern), and thus a bankruptcy court does not have the constitutional authority to enter a final order. Second, the Supreme Court will consider whether bankruptcy courts may enter final orders with respect to Stern claims if the parties consent and, if so, whether a party may implicitly consent through its conduct.
Bankruptcy practitioners and scholars expect that the Supreme Court’s answer with respect to these questions will help to bring greater clarity to bankruptcy jurisprudence post-Stern. A determination by the Supreme Court that the state-law alter ego claim is not a Stern claim would be the first clear signal from the Supreme Court that its ruling in Stern was truly intended to be narrow, and bankruptcy courts could retain their authority to issue final orders in more traditional bankruptcy matters.
If, on the other hand, the Supreme Court determines that the state-law alter ego claim at issue in Wellness Networks is a Stern claim, it appears that the court may need to resolve the consent question that it declined to rule on in Executive Benefits. In contrast to the district court in Executive Benefits, which had reviewed the bankruptcy court’s decision de novo, the district court in Wellness Networks applied a more deferential standard of review to the bankruptcy court’s decision. For this reason, Sharif may be able to demonstrate an actual deprivation of rights if the Supreme Court determines that the bankruptcy court was without constitutional authority to render a final order with respect to the alter ego claim.
By virtue of its decision in Executive Benefits and its grant of certiorari in Wellness International, the Supreme Court has demonstrated that any further clarification of its decision in Stern will come slowly and deliberately. Observers should not look to any one decision as a panacea for the continuing panoply of thorny and complicated issues of bankruptcy jurisdiction. While the Supreme Court may address the important question of consent when it rules in Wellness Networks, the Supreme Court appears to be willing to have the lower courts continue to work through the myriad of questions raised directly or indirectly by Stern, stepping in only occasionally to provide answers.