LAW-Chapter 11 Litigation After 'Stern v. Marshall'-The NY Law Journal

The following information is used for educational purposes only.

Chapter 11 Litigation After 'Stern v. Marshall'

George A. Zimmerman and Mark A. McDermott


11-14-2011


On June 23, 2011, the U.S. Supreme Court issued its highly controversial decision in Stern v. Marshall.1 The Court ruled that bankruptcy judges could not constitutionally enter final rulings in a class of cases that bankruptcy judges and practitioners had long understood to be the proper domain of the bankruptcy courts. Although the decision purported to address only one narrow aspect of bankruptcy judges' authority, the potential implications of the Court's ruling are far broader in scope, and have raised fundamental questions concerning bankruptcy judges' authority to determine matters that bankruptcy courts historically have handled as a matter of course without any question of their authority to do so.

Indeed, since Stern was decided, courts around the country have struggled with the meaning of the decision and its potentially profound implications. The decision also is dramatically impacting the litigation strategies and budgets of debtors, their creditors, their owners, their directors and officers and others who become involved in bankruptcy cases and related litigation, as they struggle to formulate appropriate strategies to deal with Stern's ramifications.

This article provides a brief overview of bankruptcy court jurisdiction and authority, the holding in Stern, and finally, some of the litigation and related strategies that litigants now must consider in light of the confusion that Stern has engendered.

Jurisdiction and Authority

The statutes governing bankruptcy court jurisdiction and authority create three groups of bankruptcy-related matters. The first is comprised of "cases under title 11."2 That phrase refers to the bankruptcy case of a debtor: the process by which a debtor is either liquidated or reorganized. That basic category of matters is not implicated by Stern.

However, the second and third categories of bankruptcy matters are implicated by Stern. These matters are referred to as "core" and "non-core" proceedings. Core proceedings are those that either "arise under title 11" or that "arise in a case" under title 11.3 The Bankruptcy Code contains a non-exclusive list of 16 types of proceedings that are core.4 For example, actions to recover preferences and fraudulent conveyances are core.5

"Non-core" matters, on the other hand, are those that could exist outside of bankruptcy, but that nonetheless have some effect on the bankruptcy.6 This would include, for example, a debtor's or litigation trustee's claim against former officers and directors for breach of fiduciary duty.

Federal district courts have jurisdiction over all three categories of bankruptcy matters.7 However, the district courts have, by local rules, referred all bankruptcy matters to the bankruptcy judges of their respective districts.8 Bankruptcy judges can hear and enter final orders in core matters.9 However, with respect to non-core matters, a bankruptcy judge may only "submit proposed findings of fact and conclusions of law to the district court," with any final order or judgment entered by the district court after de novo review.10 Notwithstanding this general rule, if all parties to a non-core proceeding consent, the bankruptcy judge may enter a final judgment in the non-core proceeding.11

As noted above, all federal district courts have referred bankruptcy matters to the bankruptcy judges of their districts. However, a litigant may request a district court to "withdraw the reference," i.e., to hear a particular bankruptcy matter, by filing a request with the district court.12 One of the important criteria in assessing whether to withdraw the reference is whether a proceeding is non-core.13 Since Stern was decided, that has been an exponential increase in the number of motions to withdraw the reference that have been filed.

A 'Stern' Decision

In Stern, a creditor filed a proof of claim in a debtor's bankruptcy proceeding alleging that the debtor had defamed the creditor pre-petition by accusing the creditor of fraudulently inducing debtor's husband to exclude the debtor from his will. The debtor filed a counterclaim, alleging the creditor had tortiously interfered with her inheritance. Under the Bankruptcy Code, the debtor's counterclaim fit squarely within one of the 16 categories of matters that are listed as "core claims": those involving "counterclaims by the estate against persons filing claims against the estate."14

While the Supreme Court concluded that there was no question that the debtor's counterclaim against the creditor constituted a core proceeding as defined by the statute,15 it nonetheless found the statute to be unconstitutional insofar as it authorized the Bankruptcy Court to issue a final ruling on the counterclaim. According to the Supreme Court, bankruptcy judges do not have the power under the Constitution to enter final orders on a debtor's state law counterclaim unless the debtor's counterclaim "stems from the bankruptcy itself" or adjudication of the debtor's counterclaim "necessarily" would resolve the creditor's proof of claim.16

The Stern ruling came as a shock to the bankruptcy system. Bankruptcy judges and practitioners have long assumed, without question, that the statutory distinction between core and non-core proceedings properly delineated the respective roles and authority of district courts and bankruptcy judges; and that as a result, bankruptcy judges could hear and finally determine state law or other actions by a representative of a bankruptcy estate that are designed to augment the estate for creditors' benefit by recovering money damages for breach of contract claims, fraudulent transfer claims, preference claims, and claims against former officers and directors for breach of fiduciary duty, to name a few standard bankruptcy type litigation matters.

That is no longer the case. Under Stern, it now appears that these cases can only be decided by Article III courts, not Article I bankruptcy judges, at least where the putative defendant did not file a proof of claim that would necessarily require a determination of such state law claims. As these types of matters routinely have been litigated to finality in Bankruptcy Courts for decades—indeed, they are staple litigations in most bankruptcy cases—Stern has turned conventional bankruptcy practice and strategy on its head, as evidenced by the fact, among others, that post-Stern litigants in thousands of cases around the country have been filing motions to withdraw the reference of such formerly routine bankruptcy matters to the federal district courts—with inconsistent results. Some of the novel issues raised by Stern are discussed below.

Issues Presented

Does 'Stern' implicate subject matter jurisdiction? There is considerable confusion over whether Stern implicates bankruptcy courts' subject matter jurisdiction. The decision itself arguably is not clear on the point. While the decision states that it does not implicate subject matter jurisdiction, if a bankruptcy judge nonetheless may not constitutionally enter a final order in a core matter, then it cannot fulfill its central judicial function of deciding cases; and if it cannot decide cases, one could argue that this is simply another way of saying that the court has no subject matter jurisdiction.

Most bankruptcy courts post-Stern have said, with little or no analysis, that they do not believe that the decision implicates bankruptcy courts' subject matter jurisdiction.17 However, a small number of bankruptcy judges have carefully analyzed the issue in the context of fraudulent transfer litigation—and they have arrived at different conclusions. Some bankruptcy judges have ruled post-Stern that they can still hear fraudulent transfer litigation—but they must proceed as if such litigation is a non-core matter.18 The litigants' consent, therefore, is required before a bankruptcy court may actually enter a final ruling in the matter. Absent such consent, a bankruptcy judge may only make proposed findings of fact and conclusions of law for de novo consideration by a federal district court.

However, some courts have ruled that Stern deprives bankruptcy courts of subject matter jurisdiction over fraudulent conveyance actions—meaning that they cannot act at all in such matters, and that the parties therefore must withdraw there the reference of such matters to the district courts.19

The implications of this confusion are considerable. Because subject matter jurisdiction can be raised at any time, parties could litigate a matter to judgment before a bankruptcy court, only for the loser to then claim that there was no subject matter jurisdiction to begin with and that the judgment therefore is void ab initio. As noted above, the Supreme Court's opinion in Stern is long and complicated and arguably is internally inconsistent on the subject matter jurisdiction point. Accordingly, until higher courts—federal district courts or federal courts of appeals—definitively speak to this issue, doubt over subject matter jurisdiction will linger.

What constitutes binding consent? One of the other controversies surrounding Stern is the type of consent necessary to evidence a party's agreement to entry of final orders by a bankruptcy judge. While the creditor in Stern chose to participate in the debtor's bankruptcy case in several significant ways, the Supreme Court said that the creditor had not effectively consented to adjudication of the debtor's counterclaim, emphasizing that the filing of a proof of claim is not "true" consent because the creditor had no choice but to do so in order to preserve his right to a distribution from the estate.20

The Court's ruling raises an obvious question: If participation in litigation before the bankruptcy court does not suffice for consent, then what sort of consent should bankruptcy judges and litigants insist upon in order to foreclose later assertions by a party that its consent was not effective or was given under some type of duress? U.S. Bankruptcy Judge Robert E. Gerber in the Southern District of New York probably best captured the exasperation over Stern's lack of clarity on this point:

[I]t's fair to assume that it will now be argued, that consent, no matter how uncoerced and unequivocal, will never again be sufficient for bankruptcy judges to issue final judgments on non-core matters. That huge uncertainty presages litigation over that issue with the potential to tie up this case, and countless others, in knots. It also would at least seemingly invite litigants to consent, see how they like the outcome, and then, if they lose, say their consents were invalid.21

In an effort to bring some clarity to the issue of consent, U.S. Bankruptcy Judge James M. Peck, also of the Southern District of New York, entered an order in one of the Lehman adversary proceedings requiring either that parties explicitly state whether or not they consent to each and every claim asserted in the complaint, or that they seek withdrawal of such claims to the district court.22 While this may resolve the question of whether or not the parties' consent was truly free and uncoerced, it does not resolve the more fundamental issue of a bankruptcy court's subject matter jurisdiction because, as noted above, parties cannot by their consent confer subject matter jurisdiction upon a court that does not otherwise have such jurisdiction.

Should a potential defendant file a proof of claim? While one possible implication of Stern is that bankruptcy judges no longer can enter final orders in fraudulent transfer and preferential transfer litigation, at least absent the parties' consent, it is clear that if a defendant has filed a proof of claim in the related bankruptcy proceedings, then a bankruptcy court constitutionally may adjudicate a fraudulent or preferential transfer action against the defendant to final judgment.23

This begs the question whether a creditor should consider not filing a proof of claim if it believes it may later be sued for a fraudulent or preferential transfer. Some creditors may choose to forgo filing a claim and participating in any distribution from the estate if they think that they may be sued for a fraudulent or preferential transfer and they wish to preserve their options to attempt to have the litigation heard in a forum other than the bankruptcy court.

Issues Post-'Stern'

The Bankruptcy Code specifies that proceedings to determine the validity, extent, and priority of a lien are core proceedings.24 Because Stern throws into doubt the efficacy of the statutory designation of a matter as core, the matter is not entirely clear as a constitutional matter because lien determination actions ultimately turn on questions of state law. Accordingly, some bankruptcy judges have concluded post-Stern that they may enter final orders in such actions,25 but others have suggested that they must treat such actions as if they are non-core matters as to which they may only submit proposed recommended findings and conclusions to the district court.26

There should be no question under Stern that a bankruptcy court can enter a final order adjudicating a creditor's proof of claim, even though the claim may be based on state law. The Bankruptcy Code specifically states that matters related to the allowance or disallowance of claims are core proceedings,27 and the Supreme Court and several courts post-Stern have confirmed that the adjustment of creditor claims is central to the bankruptcy process, and that bankruptcy courts have the constitutional authority to issue final orders in the claims resolution process, even though claim disputes may turn on questions of state law.28

Similarly, there should be no question that bankruptcy judges may enter final orders confirming plans of reorganization and approving settlements of estate claims. Such matters have long been the province of bankruptcy judges. However, Stern has created such confusion that these fundamental principles have been questioned in several cases, with the bankruptcy courts in each case ultimately affirming their authority to enter final orders.29

It is clear that the dust has not yet settled on any of these or myriad other issues raised by Stern v. Marshall. Reorganizing debtors, their stakeholders, and bankruptcy and other judges will be unwinding these issues for many years to come. Accordingly, bankruptcy litigants will be required to make careful assessments of their litigation strategies, as even seemingly innocuous decisions like whether to file a proof of claim could have significant consequences.

George A. Zimmerman is a partner at Skadden, Arps, Slate, Meagher & Flom and head of the firm's New York litigation practice. Mark A. McDermott is a partner the firm's corporate restructuring practice.

Endnotes:

1. 131 S.Ct. 2594 (2011).

2. 28 U.S.C. §§157(a), 1334(a).

3. 28 U.S.C. §§157(b)(1), 1334(b).

4. 28 U.S.C. §157(b)(2).

5. 28 U.S.C. §157(b)(2)(F), (H), and (J).

6. In re Salander O'Reilly Galleries, 2011 WL 2837494, at *5 (Bankr. S.D.N.Y. July 18, 2011).

7. 28 U.S.C. §1334(a).

8. 28 U.S.C. §157(a).

9. 28 U.S.C. §157(b)(1).

10. 28 U.S.C. §157(c)(1).

11. 28 U.S.C. §157(c)(2).

12. 28 U.S.C. §157(d).

13. Orion Pictures Corp. v. Showtime Networks Inc. (In re Orion Pictures Corp.), 4 F.3d 1095, 1101 (2d Cir. 1993).

14. 28 U.S.C. §157(b)(C).

15. Stern, 131 S. Ct. at 2608.

16. Id. at 2620.

17. See, e.g., In re Oxford Expositions, LLC, 2011 WL 4054872, at *7 (Bankr. N.D. Miss. Sept. 12, 2011) ("There are some students of bankruptcy lore who are concerned that Stern implicates the subject matter jurisdiction of the bankruptcy courts. This court does not believe that is the case at all").

18. See, e.g., In re Coudert Brothers LLP, 2011 U.S. Dist. LEXIS 110425 (S.D.N.Y. Sept. 23, 2011).

19. In re Blixseth, 2011 WL 3274042 (Bankr. D. Mont. Aug. 1, 2011).

20. Stern, 131 S. Ct. at 2615, n.8.

21. In re Bearingpoint Inc., 2011 WL 2709295 at *8, n.37 (Bankr. S.D.N.Y. July 11, 2011).

22. Lehman Brothers Holdings Inc. v. JPMorgan Chase Bank, N.A. (In re Lehman Brothers Holdings Inc.), Adv. No. 10-03266 , Docket No. 93 (Bankr. S.D.N.Y. Aug. 15, 2011); see also In re Coudert Brothers LLP, 2011 U.S. Dist. LEXIS 110425, at *33 (S.D.N.Y. Sept. 23, 2011) ("Following Stern, it is doubtful whether mere participation in litigation is enough to imply consent").

23. Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989); Langenkamp v. Culp, 498 U.S. 42 (1990).

24. 28 U.S.C. §157(b)(2)(K).

25. See, e.g., In re Hudson, 2011 WL 3583278 (Bankr. W.D. Mich. Aug. 16, 2011) (acknowledging that lien avoidance action under 11 U.S.C. §544 involved issues of state law, court nonetheless said that it "cannot envision a core proceeding that is more 'core' than lien avoidance").

26. In re South Louisiana Ethanol, LLC, 2011 WL 3047805 (Bankr. E.D. La. July 25, 2011) (noting that "[t]o the extent this Court does not have subject matter jurisdiction over this [action by a debtor to determine the validity of a lien pursuant to [Stern]], this Opinion will be considered a Report and Recommendation….") (emphasis added).

27. 28 U.S.C. §157(b)(2)(B).

28. See, e.g., In re Salander O'Reilly Galleries, 2011 WL 2387494 (Bankr. S.D. N.Y. July 18, 2011).

29. See, e.g., In re Washington Mutual Inc., 2011 WL 4090757 (Bankr. D. Del. Sept. 13, 2011).