In Patriot Coal Corp.’s second foray through chapter 11, the bankruptcy court in Richmond, Va., read Supreme Court authority on sovereign immunity to mean there was no jurisdiction to compel a state to turn over a disputed tax refund. The Nov. 22 opinion in substance says that the adoption of Section 106(a) was an unconstitutional attempt by Congress to waive sovereign immunity to the extent it was an exercise of power under Article I of the Constitution.
In the Fourth Circuit, at least, the opinion stands for the proposition that the understanding of bankruptcy powers at the time of the adoption of the Constitution delimits the waiver of sovereign immunity by virtue of inclusion of the Bankruptcy Clause in the founding document.
The opinion by Bankruptcy Judge Keith L. Phillips is a “must read” for anyone involved in a suit where the state did not waive sovereign immunity by filing a proof of claim.
The liquidating trust in Patriot’s second bankruptcy initiated a turnover action under Section 542, alleging that the trust was entitled to a refund for overpayment of coal severance taxes. Judge Phillips dismissed for lack of jurisdiction, holding that the state was entitled to sovereign immunity because the right to a refund was disputed and the state had not waived sovereign immunity by filing a claim.
The decision explains how Congress could not waive sovereign immunity even though Section 106(a) on its face waives sovereign immunity for all governmental units, including Section 542 turnover actions.
The starting point for the analysis was the 1996 Seminole Tribe decision, where the Supreme Court held that Congress could not abrogate sovereign immunity using its powers under Article I of the Constitution. However, the high court said that Congress can waive a state’s sovereign immunity using its enforcement powers under the Fourteenth Amendment.
The second pivotal case is Katz, where the Supreme Court held in 2006 that a state’s ratification of the Constitution waived sovereign immunity in the area of bankruptcy in view of the inclusion of the Bankruptcy Clause in the Constitution.
In between the two high court decisions, the Fourth Circuit’s 1997 Schlossberg decision held that the abrogation of sovereign immunity in Section 106 was unconstitutional because the statute was enacted under the Article I Bankruptcy Clause rather than through the Fourteenth Amendment.
Then the Fourth Circuit handed down NVR in 1999, recognizing that the Eleventh Amendment’s sovereign immunity protections only apply to judicial proceedings constituting a “suit.” NVR therefore created a test for deciding when federal action amounts to a suit. Generally speaking, NVR said that a proceeding in bankruptcy court that would impact the state’s treasury likely would be a suit barred by sovereign immunity.
Although the Fourth Circuit itself said in Carpenters Pension Fund in 2013 that NVR “likely does not survive” after Katz, Judge Phillips noted that Katz did not say whether the abrogation of sovereign immunity in Section 106 was constitutional. Rather, the Supreme Court held that Section 106 was unnecessary for bankruptcy courts to have jurisdiction over preference proceedings because, at the time of ratification, preference actions were understood to fall within the scope of “Laws on the subject of Bankruptcies,” thus resulting in the waiver of sovereign immunity merely by the adoption of the Constitution.
Judge Phillips therefore concluded that Schlossberg, regarding the constitutionality of Section 106(a), remains good law in the Fourth Circuit. He then analyzed whether the turnover action amounted to a suit.
Ordinarily, Judge Phillips said that sovereign immunity would be inapplicable to turnover actions under Katz where ownership of property was undisputed. In Patriot’s case, however, the trustee’s own allegations showed that the state was not in possession of undisputed estate property.
As a result, Judge Phillips said that sovereign immunity deprives the bankruptcy court of jurisdiction over a turnover action if there is a “legitimate dispute as to ownership of the property.” Since the trustee’s allegations “fall short of establishing the existence of a ‘matured debt,’” Judge Phillips dismissed the turnover action for lack of jurisdiction.
The opinion includes a twist giving the trust a ray of hope. Without deciding the issue, Judge Phillips said that the Missouri bankruptcy court in Patriot’s first bankruptcy court might have jurisdiction over the same turnover action since the state had filed claims in the prior chapter 11 case.