On June 23, 2011, the Supreme Court of the United States issued the decision of Stern v. Marshall, debatably the most important case on bankruptcy court jurisdiction in the last 30 years. The 5-4 decision, written by Chief Justice Roberts, established limits on the power of bankruptcy courts to enter final judgments on certain state law created causes of action.

Although the Supreme Court stated that Stern concerned a “narrow” issue and found that bankruptcy courts had been granted excessive authority only “in one isolated respect,” we have identified scores of cases where these issues have been raised in the last two months. See sidebar titled “Cases Citing Stern,” at p. 5. While grappling with the parameters of a Supreme Court ruling always takes some time to work through, this preliminary evidence suggests that some parties may be using Stern as part of their litigation strategy and, whether the case or not, some additional burden may now be layered on case parties who are forced to grapple with the difficult issues raised by Stern. This article reviews Stern and its implications.

Setting the Stage: A Tale of Dueling Courts

Stern v. Marshall originated when Vickie Lynn Marshall, more famously known as Anna Nicole Smith, filed for bankruptcy. Vickie was married to octogenarian oil magnate J. Howard Marshall, one of the richest men in Texas. As J. Howard’s health declined, Vickie discovered that J. Howard’s living trust made no provision for her, even though — Vickie alleged — J. Howard intended to leave Vickie half his property. Accordingly, Vickie sued J. Howard’s son, Pierce Marshall, in Texas probate (state) court alleging that Pierce fraudulently induced his father to exclude Vickie from his estate. J. Howard died before Vickie’s Texas suit was resolved.

After J. Howard’s death, Vickie filed for bankruptcy in California bankruptcy (federal) court. Pierce filed a lawsuit within the bankruptcy case against Vickie where Pierce alleged that he was defamed by Vickie and sought a declaration that the defamation damages he sought could not be excused as part of any bankruptcy discharge that Vickie might receive. Importantly, Pierce also filed a proof of claim in the bankruptcy case to recover damages on account of the defamation lawsuit. Vickie responded by filing a counterclaim against Pierce in bankruptcy court, alleging tortious interference with her expected testamentary gift from J. Howard. By counterclaiming while her suit was still pending in probate court, Vickie set essentially identical lawsuits on parallel litigation tracks, one in bankruptcy (federal) court and one in probate (state) court.

In the course of subsequent litigation, Pierce argued that the bankruptcy court lacked jurisdiction to enter a final order on Vickie’s tortious interference counterclaim because it was a “non-core matter” under the relevant Federal jurisdictional grant (28 U. S. C. §157). The bankruptcy court disagreed and, in December 2000, ruled in Vickie’s favor and entered a judgment awarding her $475 million in damages. However, and this is where the somewhat confusing jurisdiction issues first began, on appeal of the bankruptcy court’s judgment, the district court found that the counterclaim was not within the jurisdiction of the bankruptcy court. As such, the district court concluded that it could not give the bankruptcy court’s ruling preclusive effect but had to independently review the record. Ultimately, the district court ruled on the defamation claim and came to the same conclusion as the bankruptcy court; that is, the court found that Pierce interfered with Vickie’s expectancy. Although ruling in Vickie’s favor, the district court still reduced the damages to about 10% of the prior award. This was not, however, the end of the story.

On appeal to the Ninth Circuit Court of Appeals, the District Court’s ruling was reversed. In turn, on further appeal, the Supreme Court reversed the Court of Appeals ruling and remanded the matter back to the Court of Appeals for further proceedings. This last Supreme Court ruling was made in 2006. The Court of Appeals subsequently ruled again, making a second review by the Supreme Court — which review is the subject of this article — possible.

Importantly, as of the entry of the bankruptcy court’s final order and before the above-noted federal appeals had been heard, the Texas probate court had yet to resolve Vickie’s identical state-court claim. Roughly one year later, in December 2007, the probate court entered a final judgment in Pierce’s favor and denied Vickie any legal claim to J. Howard’s estate. Because of the series of appeals taken from the bankruptcy court’s order, the Texas probate court’s ruling was the earliest final judgment entered in these disputes.

The Supreme Court’s View of Bankruptcy Court Jurisdiction

As summarized in a short “primer” on bankruptcy jurisdiction that has been included in this issue of NewsWire, see page 3, the fact that there are questions about the exact parameters of a bankruptcy court’s jurisdiction under the Constitution was not a surprise to Congress or the Supreme Court. The most recent “fix, ” which divided what are purported to be traditional or “core” bankruptcy matters (over which bankruptcy courts should have complete control) from “non-core” matters (over which bankruptcy courts act essentially as assistants to the District Court) was, in fact, promulgated after the Supreme Court’s last serious review of bankruptcy jurisdictional issues in the seminal case of Northern Pipeline vs. Marathon Oil, 458 U.S. 50 (1982). That “fix” was required because of an inherent Constitutional problem with the structure used to create bankruptcy court jurisdiction. The Stern decision provided some background on these issues.

Under Article III of the Constitution, “[t]he judicial Power of the United States, shall be vested in one Supreme Court, and in such inferior Courts as the Congress may from time to time ordain and establish.” The same section provides that Article III judges “shall hold their Offices during good Behavior, and shall, at stated Times, receive for their Services a Compensation which shall not be diminished during their Continuance in Office.” The Supreme Court noted that Article III is meant to ensure that the judiciary is independent from the other two branches of government. Accordingly, “Congress may not ‘withdraw from judicial cognizance [by Article III courts] any matter which, from its nature, is the subject of a suit at the common law, or in equity, or admiralty.’” Stern, 131 S. Ct. at 2609. Such lawsuits are also described as “the stuff of the traditional actions at common law tried by the courts at Westminster [England] in [the year the Constitution was created of] 1789.” Stern, 131 S. Ct. at 2609.

Bankruptcy courts are created by Congress under Article I of the Constitution. As such, bankruptcy courts are not Article III tribunals and bankruptcy judges do not enjoy the same protections as Article III judges. It is suggested that Congress is allowed to create such courts under what is called the “public rights exception.” Such courts are allowed to administer, among other things, “cases in which the claim at issue derived from a federal regulatory scheme.” The Supreme Court itself acknowledged, however, that its discussion of the public rights exception in prior cases has not been entirely consistent. Stern, 131 S. Ct. at 2611. What is clear to the Supreme Court, however, is that where administration of an issue in a bankruptcy case becomes too close to traditional state law rights that are wholly independent of the bankruptcy case, it may be entertaining “the stuff of Westminster” and must be specifically reserved for adjudication by Article III tribunals.

To allow bankruptcy courts to operate in as sensible a fashion as possible despite their apparent inherent jurisdictional constraints, a division of labor was created in the new bankruptcy jurisdiction statute after Northern Pipeline. The relevant statute, 28 U.S.C. § 157(b)(2), lists sixteen types of matters that are defined as “core” proceedings, including claims and “counterclaims by [a debtor’s] estate against persons filing claims against the estate.” The bankruptcy court has been granted full and final statutory authority over such “core” matters because they are alleged to be traditional bankruptcy powers that are not included within “the stuff of Westminster.”

The Stern Ruling

After reviewing the historical background on bankruptcy court jurisdiction, the Supreme Court turned to the two issues at hand: (1) whether bankruptcy courts were statutorily authorized to address the counterclaim at issue; and (2) even if statutorily authorized, was the statutory grant consistent with the Constitution. Turning to the first question, the Supreme Court rather quickly concluded that the bankruptcy court had statutory authority to enter a final judgment on Vickie’s counterclaim. This was not incredibly surprising. The statute, 28 U.S.C. § 157(b)(2), explicitly says that. The court next turned to the more difficult question of whether the statute itself was constitutional.

Following completion of an exhaustive (and, at times, somewhat convoluted) analysis, the Supreme Court concluded that although 28 U.S.C. 157(b)(2)(C) purported to grant the bankruptcy court authority to enter a final decision on Vickie’s counterclaim, the statute violated the Constitution by allowing an Article I court to improperly exercise powers reserved for Article III Courts. Citing several relatively recent cases, the Court noted that bankruptcy courts, as non-Article III courts, lacked authority to decide a state law contract claim and a fraudulent conveyance claim against an entity that was not “otherwise part of the bankruptcy proceedings.” Similarly, the Court concluded that Vickie’s right to relief did not flow from a federal (bankruptcy) statutory scheme and was based instead solely on a state law right. As such, the Court reasoned, the “experts” at resolving common law counterclaims such as Vickie’s were Article III courts and such experts are required to resolve those matters in this case.

Vickie sought to distinguish prior cases on the grounds that Pierce, unlike the defendants in the prior cases, had filed a proof of claim, thereby making himself “part of the bankruptcy proceedings.” Vickie, in fact, cited to several of the Supreme Court’s decisions that held that creditors subject themselves to the bankruptcy court’s equitable jurisdiction, including the claims allowance and disallowance process, by filing a proof of claim.1 The Stern Court, however, suggests that such an interpretation of its prior case law was not correct.

The Court found that Pierce did not, by filing a proof of claim, automatically consent to bankruptcy court jurisdiction over all related matters, no matter how tangential. Indeed, the Supreme Court stated, in an apparent break with its prior decisions, that “it is hard to see why Pierce’s decision to file a claim should make any difference with respect to the characterization of [Vickie’s] counterclaim.” Stern, 131 S. Ct. at 2616. Having concluded that the mere submission of a proof of claim did not resolve the question at issue, the Supreme Court undertook a two-part analysis to determine whether resolution of Vickie’s counterclaim nevertheless fell within the bankruptcy court’s purview.

First, the court examined whether Vickie’s counterclaim stemmed directly from her bankruptcy. After distinguishing certain prior cases on the grounds that they involved rights of recovery created by federal bankruptcy law, the Supreme Court found that Vickie’s tortious interference counterclaim, which arose under Texas tort law, was “in no way derived from or dependent upon bankruptcy law . . . .” Stern, 131 S. Ct. at 2618. Accordingly, the court concluded that the bankruptcy court could not exercise jurisdiction over the counterclaim as a matter “stemming from the bankruptcy itself.”

Second, the Court examined whether Vickie’s claim required findings of fact that would necessarily be resolved in the course of deciding whether to allow or disallow Pierce’s claim. After reviewing the record, the Court concluded that while Vickie’s counterclaim for tortious interference would share some underlying facts with Pierce’s claim for defamation, Vickie’s “‘counterclaim raise[d] issues of law entirely different from those raise[d] on [Pierce’s] defamation claim.’” Stern, 131 S. Ct. at 2617. Accordingly, the court found that Vickie’s claim was not necessarily resolved as part of the claim’s allowance process.

The Impact of Stern

In the Stern case, Vickie also argued that ruling in Pierce’s favor “will create significant delays and impose additional costs on the bankruptcy process.” The Stern Court disagreed, stating that its “narrow” ruling will not “meaningfully change[] the division of labor in the current statute.” Stern, 131 S. Ct. at 2620.2 So far, the ruling appears to have had more substantial impact than the majority imagined.As can be seen in our sidebar on a sampling of recent cases citing Stern, see page 5, scores of courts are now in the middle of, as Justice Breyer predicted in his dissent, a game of “jurisdictional ping-pong.” This is not always an easy game for the courts administering the cases to play. One court explained: “My frustration with Stern is that it offers virtually no insight as to how to recalibrate the core/non-core dichotomy so that I can again proceed with at least some assurance that I will not be making the same constitutional blunder with respect to some other aspect of authority [under] section 157(b)(2).” Meoli v. Huntington Nat’l Bank (In re Teleservices Group, Inc.), 2011 WL 3610050, at *3 (Bankr. W.D. Mich. Aug. 17, 2011). Not surprisingly, litigants are using such uncertainty to their advantage. As explained in a recent decision from a New York bankruptcy judge, “Stern v. Marshall has become the mantra of every litigant who, for strategic reasons, would rather litigate somewhere other than the bankruptcy court.” See In re Ambac Financial Group, Inc., 2011 WL 4436126 at *6 (Bankr. S.D.N.Y. Sept. 23, 2011).

 While it is difficult to see what lessons will ultimately be learned from Stern, especially as circuit courts of appeal have, at least so far3, declined to interpret Stern and thus provide guidance to the district and bankruptcy courts on these issues, a few themes and approaches are worthy of note.

First, ignoring a jurisdictional issue in the hope that it will go away is not a safe approach. In fact, some courts have been considering the impact of Stern “sua sponte” (that is, on their own motion) because it is a well-settled doctrine of law that the question of a court’s jurisdiction may be raised at any time, including on appeal. Accordingly, parties should be considering Stern regardless of whether or not the other side has raised the jurisdictional issues.

Second, when bankruptcy courts do hold that they have authority to issue final judgments on matters, many courts are nevertheless couching their decisions with the express reservation that should a district court disagree with the bankruptcy court’s jurisdictional decision under Stern, the bankruptcy court’s opinion should be treated as a report and recommendation to the district court. This approach suggests a simplified alternative to a bankruptcy court completely removing itself from hearing a contested matter and referring it to the district court. To the extent possible, parties may want to encourage a court to take this approach.

It is too soon to tell whether this flood of disputes regarding jurisdiction will continue. However, it is evident that, if the cases logically progress and litigants continue to do what they do (litigate in their best interests), Stern’s impact on bankruptcy court jurisdiction could easily be more significant than the Supreme Court majority contemplated when it issued its “narrow” decision on Vickie Lynn Marshall’s state law counterclaim. Stay tuned.

An Introduction to Bankruptcy Court Jurisdiction

While the Constitution allows Congress to “establish uniform laws on the subject of bankruptcy,” Congress chose not to exercise the power to establish such laws for nearly 100 years of this Country’s history. At such times, creditors and debtors were left to resolve insolvency-related disputes under applicable state laws. Starting during the second half of the 19th century, however, Congress took greater control of insolvency matters by enacting bankruptcy law in one form or another. For the most part, these laws established the federal district court (the trial-level court in the federal system) as the court that was to administer bankruptcy cases, but Congress allowed that court to refer such matters to “referees” or, subsequently, “bankruptcy judges” for administration. Bankruptcy referees and judges administered such cases as best they could but, without consent by case parties, could not address matters that fell outside their mandate; that is, if the matter did not involve a debtors’ property (the bankruptcy “estate”), the matter could not be resolved without the involvement of the federal district court or a state court. This limitation was, at the very least, inconvenient.

The division between traditional bankruptcy matters and matters that were less closely related to a bankruptcy case was based on the above-cited Constitutional provision. That provision permitted Congress to administer bankruptcy matters in anyway Congress deemed appropriate, whether by a bankruptcy judge or by a referee or by whomever. In such cases, Congress was creating an “Article I” court; that is, a court created by Congress, the first of the three branches of government and the branch established under Article I of the Constitution. However, if a case involved non-bankruptcy matters, the judicial power of the United States was (at least debatably) being exercised. Consistent with other provisions of the Constitution, the judicial power of the United States can only be exercised by so-called “Article III” courts; that is, courts established by Article III of the Constitution as the third branch of government and imbued with certain attributes. These attributes ensure that Article III judges do not fall under the influence of either the legislature or executive branches, and can make independent decisions using the judicial power of the United States. Article III judges are appointed with life tenure and cannot have their salaries reduced. Bankruptcy courts, as Article I tribunals were not presided over by Article III judges.

In the 1970’s, as part of the creation of the new bankruptcy law (what is referred to as the “Bankruptcy Code”), Congress recognized the Constitutional issue and, seeking to resolve the conflict and make bankruptcy case administration more sensible, contemplated making bankruptcy judges Article III judges. However, given objections by various parties including sitting Article III judges, a compromise solution was reached: bankruptcy courts were made “adjuncts” of the Federal District Court and the bankruptcy court was automatically referred all bankruptcy matters, including more “traditional” bankruptcy matters as well as matters only tangentially related to a bankruptcy case. Within a short time after the enactment of the new Bankruptcy Code and the new jurisdictional provisions, a Constitutional challenge arose. In the now seminal case of Northern Pipeline Constr. Co. v. Marathon Pipe Line, 458 U.S. 50 (1982), the Supreme Court found that a state law for contract lawsuit was not based on “traditional” bankruptcy law matters that required adjudication by an Article III court. Thus, the Supreme Court found that Congress’s purported jurisdictional grant to bankruptcy courts was unconstitutitonal.

Following the imposition of a stop-gap measure to deal with the immediate operational problems of not having bankruptcy courts, Congress enacted a law in 1984 which, among other things, clearly granted jurisdiction over all bankruptcy cases and bankruptcy related matters to federal district courts but allowed the district courts to refer — but did not automatically refer — such matters to bankruptcy courts. (Following the enactment of the 1984 law, each of the 98 Federal Court Districts referred all bankruptcy matters to bankruptcy courts by a standing order.) To ensure that the Constitutional limits are otherwise satisfied, a relevant jurisdictional statute was also created to divide the allowed bankruptcy-related jurisdiction into two categories: “core” and “non-core” matters.

“Core matters” could be described as traditional bankruptcy matters in a bankruptcy case that could be fully administered by a bankruptcy judge under the Constitution. The statute, 28 U.S.C. § 157(b), lists sixteen types of matters that are considered core proceedings, including case administration, property of the estate issues, confirmation matters and, importantly, “counterclaims by [a debtor’s] estate against persons filing claims against the estate.” In contrast, “noncore” matters that are otherwise related to a bankruptcy case may also be heard by the bankruptcy judge but, in such instances, the bankruptcy judge cannot issue “final” orders but instead can only issue proposed findings of fact and conclusions of law that are reviewed in their entirety by the district court (and thus do not become fully binding until the District Court judge approves them). See 28 U.S.C. § 157(c).

For the most part, until the Stern decision was issued, the division of labor between the District Court and the bankruptcy court was not seriously disputed.

A Sampling of Cases Citing Stern

In the last several months, Stern has been raised in scores of bankruptcy cases. A sampling of those cases follows:

  • Buffets, Inc. v. California Franchise Tax Board (In re Buffets Holdings, Inc.), No. 09-50894, 2011 WL 3607825 (Bankr. D. Del. Aug. 15, 2011) (bankruptcy court held that it had jurisdiction over debtors’ state tax claims under Stern because they “essentially involve[d] the allowance of the [Franchise Tax Board’s proof of claim for unpaid franchise taxes]”).
  • In re Fairfield Sentry Ltd, No. 11-MC-224, 2011 WL 4359937 (S.D.N.Y. Sept. 19, 2011) (district court held that bankruptcy court did not have jurisdiction over a foreign representatives’ state and foreign law avoidance claims because they more closely “resemble state law contract claims brought by a bankrupt corporation to augment the bankruptcy estate,” similar to those at issue in Stern and Granfinanciera).
  • Miller v. Greenwich Capital Fin. Prods., Inc. (In re American Business Financial Services, Inc.), No. 06-50826, 2011 WL 3240596 (Bankr. D. Del. July 28, 2011) (bankruptcy court held that it had jurisdiction over chapter 7 trustee’s avoidance and state law tort claims because they were integrally related to a section 363 sale, and thus, the bankruptcy itself under Stern).
  • In re Salander O’Reilly Galleries, No. 07-30005, 2011 WL 2837494 (Bankr. S.D.N.Y. July 18, 2011) (bankruptcy court held that it had jurisdiction over liquidating trustee’s avoidance claim under Stern because, despite questions of state law being involved, action implicated the determination of a proof of claim).
  • In re Bearingpoint, Inc., No. 09-10691, 2011 WL 2709295 (Bankr. S.D.N.Y. July 11, 2011) (bankruptcy court granted trustee’s motion seeking relief from a plan and confirmation order which required certain non-core litigation to be brought exclusively in the bankruptcy court because, in a post-Stern environment, case efficiency motivations were nullified where the bankruptcy court judge could not render a final judgment.
  • Samson v. Blixseth (In re Blixseth), No. 10-00088, 2011 WL 3274042 (Bankr. D. Mont. Aug. 1, 2011) (bankruptcy court reviewed its jurisdiction sua sponte and held that, under Stern, it did have jurisdiction over trustee’s preference, related tort and equitable subordination claims but it did not have jurisdiction over the fraudulent transfer claims; court provided the parties time to file motion to withdraw the reference before it dismissed the fraudulent transfer claims).
  • Springel v. Prosser (In re Innovative Commc’n Corp.), No. 08-3004, 2011 Bankr. LEXIS 3040 (Bankr. D. V. I. Aug. 5, 2011) (bankruptcy court held that it had jurisdiction over trustee’s fraudulent conveyance claims to recover postpetition transfers under Stern but, should the district court disagree, the bankruptcy court’s opinion would constitute its report and recommendation to the district court).
  • In re Okwonna-Felix, No. 10-31663, 2011 WL 3421561 (Bankr. S.D. Tex. Aug. 3, 2011) (bankruptcy court reviewed its jurisdiction sua sponte and held that it had authority to approve a settlement of breach of insurance contract claims under Stern because the contested matter involved Bankruptcy Rule 9019 which has no equivalent in state law).
  • Kurz v. EMAK Worldwide, Inc., No. 11-CV-375, 2011 WL 4048966 (D. Del. Sept. 9, 2011) (district court held that the bankruptcy court must adjudicate plaintiff’s state law contract claims under Stern because plaintiff also filed a proof of claim in defendant’s bankruptcy which “contain[s] the same legal question, whether the [a]greement entitles Plaintiff to fees and expenses”).
  • In re Ambac Financial Group, Inc., No. 10-15973, 2011 WL 4436126 (Bankr. S.D.N.Y. Sept. 23, 2011) (bankruptcy court held that it had jurisdiction to approve a settlement affecting plaintiff’s securities litigation claims pending in state and district court because those claims became property of the debtor’s estate upon filing for bankruptcy and approving a settlement under Bankruptcy Rule 9019 does not implicate Stern).
  • Retired Partners of Coudert Brothers Trust v. Baker & Mackenzie LLP (In re Coudert Brothers LLP), No. 11-2785, 2011 U.S. Dist. LEXIS 110425 (S.D.N.Y. Sept. 23, 2011) (district court held that bankruptcy court did not have authority to render final judgment over fraudulent transfer and state law tort claims under Stern and Granfinanciera but treated the bankruptcy court’s final judgment as a report and recommendation that would be subject to its de novo review).
  • In re Washington Mutual, Inc., No. 08-12229, 2011 WL 4090757 (Bankr. D. Del. Sept. 13, 2011) (bankruptcy court held that it had jurisdiction to approve a global settlement of the estate’s fraudulent conveyance, federal intellectual property and state law tort claims because approving a settlement under Bankruptcy Rule 9019 is a “firmly established historical practice” of bankruptcy courts and “a court does not have to have jurisdiction over underlying claims in order to approve a compromise of them”).