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Litigation: A Stern gift that keeps on giving

Supreme Court case continues to wreak havoc on the jurisdiction of federal bankruptcy courts.

In Stern v. Marshall, the Supreme Court held that a non-Article III court, such as a bankruptcy court, may only constitutionally determine “public rights,” such as the resolution of a proof of claim filed in a bankruptcy, and not private rights, such as those to augment the estate.

Stern clarifies that private rights may be adjudicated only to the extent that they are “necessarily resolvable” in the context of determining the public rights. Supplementing prior case law, Stern held that a federal bankruptcy court cannot enter final findings of fact with respect to a debtor’s state law counterclaim against a creditor despite the creditor having filed a proof of claim in the bankruptcy estate.

Since Stern, many litigants have asserted and numerous courts have analyzed whether bankruptcy courts may enter final judgments in fraudulent conveyance and preferential transfer actions. The rulings in the following cases run the gamut of interpretations.

1. Heller Ehrman LLP v. Arnold & Porter, LLP. In this case, the trustee sued to recover a fraudulent transfer from defendants who had not filed proofs of claim in the bankruptcy case. Contending that under Stern, bankruptcy judges do not have authority to hear and determine fraudulent transfer actions, defendants moved to withdraw the reference and have the matter heard by the district court,

The bankruptcy judge formally recommended that the district court deny the motion to withdraw the reference and provide that any final determination beyond constitutional competence be treated as proposed findings of fact and conclusions of law. In making his recommendation, the judge noted that although Stern’s reasoning was broad, its conclusion that “Congress could not constitutionally assign resolution of [a] fraudulent conveyance action to a non-Article III court” was dicta that did not expand Stern’s holding to fraudulent transfer actions.

Applying 9th Circuit law, the bankruptcy judge reasoned that fraudulent transfer actions cannot exist but for the debtor’s insolvency and its inability to pay debts as they become due or unreasonably small capital conditions that often lead to bankruptcy. The bankruptcy judge concluded that he may hear and determine the action. On review, the federal district court held that only district court judges can enter final judgments on state law counterclaims like these fraudulent transfer suits.

2. In re Fairfield Sentry Limited In contrast, defendants in this case moved to remand avoidance actions arising under state and foreign laws from the bankruptcy court to state court, or have the bankruptcy court abstain from hearing the matters due to its lack of subject matter jurisdiction. The underlying bankruptcy was an ancillary proceeding under Chapter 15 of the Bankruptcy Code arising from a foreign liquidation proceeding pending in the British Virgin Islands. The debtor plaintiffs were funds that had invested with Bernard Madoff who became insolvent as a result of Madoff’s fraud.

Prior to the commencement of the foreign liquidation proceeding, the funds brought an action in state court for money had and received, unjust enrichment, constructive trust and other related claims. Once the ancillary proceeding was commenced, the state court actions were removed, additional actions were filed and the state court claims were amended to add various avoidance claims.

Denying remand, the bankruptcy court found it had core jurisdiction over the avoidance claims and the remainder of the claims as those claims impacted the court’s core bankruptcy functions. The district court reversed, holding that the bankruptcy court lacked core jurisdiction because the claims did not arise under a Title 11 case and the assertion of subject matter jurisdiction by an Article I court “contravenes the principle of separation of powers enshrined in Article III of the Constitution.” The district court specifically found that the claims asserted were non-core, matters of private right, and existed independent of the bankruptcy.

3. Coudert Brothers bankruptcy case. The Stern decision has also had far reaching effect on cases that have been pending years prior to Stern. Coudert Brothers filed its Chapter 11 bankruptcy case in 2006. Six months later, a trust, comprised of retired partners, commenced a state court action against other partners and the law firms those partners joined. The trust asserted breach of contract and tortuous interference claims against the partners and the successor law firms and sought to impose successor liability on the law firms.

The law firms removed the trust’s action to the district court, which in turn referred the matter to the bankruptcy court to be heard in conjunction with Coudert’s bankruptcy case. After a liquidation plan was confirmed, the law firms moved to dismiss the trust’s action. The court dismissed holding that the trust had no standing to pursue such claims as standing vested solely with the plan’s administrator.

The trust appealed to the district court. During briefing, Stern was decided. Applying Stern, the trust moved to dismiss the appeal and remand the matter to state court. The district court held that the trust’s claims involved private rights and so could not be finally determined by the bankruptcy court.

The district court went on to analyze whether the bankruptcy court possessed final adjudicative authority through implied consent of the parties. The district noted that although Stern confirmed that consent can be a sufficient basis for Article I final adjudication, it also created confusion regarding the consent analysis and opined that while a creditor consents to all actions necessarily resolved in ruling on a proof of claim, the creditor’s consent does not extend to claims not resolved by the proof of claim.

Applying this analysis, the district court reasoned that because not all of the issues raised by the claims would be resolved in ruling on the trust’s proof of claim, the trust’s consent did not extend to actions beyond the proof of claim proceedings. The procedural quandary left the district court with no alternative but to vacate the bankruptcy court’s dismissal of the trust’s action. The district court, however, avoided the procedural nightmare that would have ensued by vacating the dismissal by treating the bankruptcy court’s ruling as a report and recommendation of dismissal.

Stern’s impact on the breadth and scope of the federal bankruptcy court’s jurisdiction and authority to make final determinations is in its infancy. No doubt litigants who find themselves in bankruptcy proceedings will attempt to broaden and narrow Stern’s application to their benefit.

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Randye Soref

Randye B. Soref is a shareholder and administrative chair of Buchalter Nemer’s Insolvency and Financial Solutions  practice group. She focuses her practice on bankruptcy and...

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