I. Introduction

On August 8, 2013, the United States Court of Appeals for the Fifth Circuit in Tanguy v. West (In re Davis)1 affirmed a judgment in favor of a chapter 7 trustee in an adversary proceeding to recover on a promissory note issued by the defendant to the debtor. In affirming the decisions below, the Fifth Circuit held that both the bankruptcy court and the district court had properly exercised subject matter jurisdiction over the proceedings—proceedings that involved not only the chapter 7 trustee’s garden-variety claim under Texas law to recover on the promissory note, but also certain counterclaims by the defendant for breach of contract and tortious interference by the trustee after the chapter 7 case had been filed. The Fifth Circuit explicitly rejected the argument that the United States Supreme Court decision in Stern v. Marshall2 posed a bar to the bankruptcy court’s power to enter a final judgment on any of these claims.

As noted by the Fifth Circuit, Stern held that, under Article III of the Constitution, a bankruptcy court, which is an Article I court, lacks Constitutional power to decide state-law counterclaims asserted by the bankruptcy estate against a creditor unless that counterclaim is necessarily resolved in connection with resolving the creditor’s prepetition claim against the debtor. Applying Stern narrowly, the Fifth Circuit declined to apply Stern to the case at hand because the counterclaims at issue arose postpetition based on alleged misconduct by the chapter 7 trustee in the administration of the estate and thus, unlike Stern, were not the estate’s counterclaims against a party that had filed a proof of claim. The Fifth Circuit emphasized that the Stern decision, by its own terms, should be applied narrowly. Consequently, the Fifth Circuit affirmed the Bankruptcy Court’s exercise of jurisdiction over state law claims under circumstances that were not precisely aligned with the circumstances at issue in Stern.

Significantly, the Fifth Circuit’s ruling in Davis applied to the entire proceedings before it—that is, to both the trustee’s original claim on the promissory note and the defendant’s counterclaims. The trustee’s original claim, like the counterclaim at issue in Stern, was based on state law and does not appear to have been necessarily resolved by a ruling on the defendant’s claims. Nevertheless, at least in the Fifth Circuit, it appears that Stern does not prevent a bankruptcy court from entering a final judgment on a state law action as long as that action is raised by the bankruptcy estate as an original claim rather than as a counterclaim. The Davis opinion, however, only discusses the relevance of Stern as it relates to the defendant’s counterclaims against the estate, rather than the trustee’s original claim under the promissory note. And, by not addressing the broader issue of the bankruptcy court’s power to decide the chapter 7 trustee’s state law claim, the decisions by the bankruptcy court, the district court, and the Fifth Circuit in Davis appear to contradict at least one earlier decision from the Bankruptcy Court for the Southern District of Texas, In re Heights Melrose Group, LLC, where the court held that it lacked the power to enter a final order in a proceeding based entirely on state law, rather than on rights created by the Bankruptcy Code.3

II. Background

The background of the Davis decision is relatively straightforward. Prior to his chapter 7 case, the debtor entered into an agreement to sell an aircraft to Tanguy. In exchange, Tanguy issued a promissory note in favor of the debtor that was to be repaid in monthly installments. Roughly six months after the sale transaction closed, the debtor filed a chapter 7 bankruptcy case in the United States Bankruptcy Court for the Southern District of Texas.4

After the chapter 7 filing, Tanguy and the chapter 7 trustee entered into a stipulation, acknowledging that the trustee was the lawful holder of the note and that the note remained in full force and effect. Tanguy stopped making payments on the promissory note, however, in November 2008, leaving an unpaid principal balance of approximately $1.05 million. Shortly thereafter, Tanguy repudiated all obligations under the promissory note.

The chapter 7 trustee sent a demand letter to Tanguy notifying him of his default under the promissory note and accelerating the payments due under the note. In response to the demand letter, Tanguy asserted that (1) another lawsuit had been filed against him, resulting in a temporary injunction restricting his ability to sell, encumber, transfer or relocate the aircraft at issue from the county where it was located, and (2) under the terms of the aircraft purchase agreement, the trustee was required to defend Tanguy’s title to the aircraft.

In March 2009, the chapter 7 trustee initiated an adversary proceeding against Tanguy in the bankruptcy court seeking payment of the unpaid balance on the promissory note plus interest and attorney’s fees. Tanguy answered the trustee’s complaint by asserting several affirmative defenses, as well as counterclaims for breach of the aircraft purchase agreement and tortious interference. After conducting a bench trial on the merits, the bankruptcy court ruled in favor of the trustee. Tanguy appealed the judgment against him to the United States District Court for the Southern District of Texas.

While Tanguy’s appeal was pending in the District Court the United States Supreme Court decided Stern on June 23, 2011. Based on Stern, Tanguy argued that both the bankruptcy court and the district court lacked subject matter jurisdiction over the adversary proceeding. The district court concluded, without discussion, that Stern did not apply and affirmed the bankruptcy court’s judgment on the merits. Tanguy thereafter appealed to the United States Court of Appeals for the Fifth Circuit.

III. Fifth Circuit’s Decision

The Fifth Circuit affirmed the decisions below. Significantly, the court rejected Tanguy’s argument that the bankruptcy court, the district court, and the Fifth Circuit did not have subject matter jurisdiction over the proceedings in light of Stern.

As summarized by the Fifth Circuit, the Supreme Court’s decision in Stern invalidated, under Article III of the United States Constitution, the statutory authorization for bankruptcy courts to enter final judgments on counterclaims by the estate against persons filing claims against the estate5 where the counterclaim 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. According to the Fifth Circuit, Stern’s holding, as the Supreme Court itself recognized, applies only in that "one isolated respect."6

The Fifth Circuit refused to extend Stern’s limited holding to the proceedings in Davis. The Fifth Circuit specifically highlighted that this case involved a counterclaim against a representative of the bankruptcy estate (i.e., the chapter 7 trustee) for acts that were allegedly committed during the administration of the bankruptcy case. This was not the type of counterclaim that the Stern decision held could only be decided by an Article III court instead of a bankruptcy court because it did not involve a counterclaim by the estate against a private party acting in a personal capacity. Thus, in the Fifth Circuit’s view, Stern simply did not apply to the proceedings before it.

After consideration of Tanguy’s remaining arguments on appeal, the Fifth Circuit affirmed the district court’s judgment.

IV. Conclusion

On its face, the primary focus of the Fifth Circuit’s decision in Davis rests on drawing a distinction between (1) a party pursuing counterclaims against a representative of the estate in bankruptcy court and (2) the estate pursuing counterclaims against parties acting in their personal or private capacity. In the Fifth Circuit’s view, the former type of counterclaim is not implicated by the holding in Stern.7

But in focusing on the distinction between a counterclaim filed by the defendant and a counterclaim filed by the estate, the Fifth Circuit does not analyze what is perhaps the more important question: why should it matter for purposes of Stern’s Article III analysis whether a representative of the estate files an original claim or a counterclaim in bankruptcy court? Here, the original claim asserted by the trustee under the promissory note was, like the counterclaim in Stern, a state law action independent of the federal bankruptcy law and not necessarily resolvable by a ruling on a creditor’s proof of claim in bankruptcy. There does not appear to be any meaningful distinction under Article III between the counterclaim filed in Stern and the original claim filed in Davis. In both instances, a private party is being forced to defend against a state-law claim in bankruptcy court that ordinarily would be litigated in either a state court or a United States District Court. The only distinction between Davis and Stern is that the estate filed the original claim in Davis, while in Stern the estate responded to a proof of claim by filing a counterclaim.

Arguably, the chapter 7 trustee’s state law cause of action in Davis not only ran afoul of the Article III limitations established by Stern, but also the Article III limitations established in the much earlier Supreme Court decision Northern Pipeline Construction Co. v. Marathon Pipe Line Co., where the Court held that a bankruptcy court could not adjudicate a "state-law contract claim against an entity that was not otherwise part of the bankruptcy proceedings."8 Nevertheless, the Fifth Circuit’s holding is clear: the bankruptcy court had the power to decide both the trustee’s original claim and the defendant’s counterclaims in Davis.

The Fifth Circuit has clearly staked out its view that Stern should be applied narrowly. In fact, the Davis decision follows the Fifth Circuit’s decision from last year in Technical Automation Servs. Corp. v. Liberty Surplus Ins. Corp.,9 where the court declined to hold that Stern affected a magistrate judge’s authority to enter final judgment on a state‐law counterclaim under 28 U.S.C. § 636(c)(1). Thus, at least in the Fifth Circuit, it appears that Stern does not prevent a bankruptcy court from entering a final judgment on a cause of action that is first brought by the bankruptcy estate even if that cause of action is based on state law and is unrelated to the resolution of any proof of claim filed by the defendant. Whether other Courts of Appeal adopt such a narrow application of Stern remains to be seen.10