The Diocesan Dilemma: How an Asset Dispute in a Diocesan Bankruptcy Created a Crucial Question in Modern Bankruptcy Law

Editor’s Note: The following article, “The Diocesan Dilemma: How an Asset Dispute in a Diocesan Bankruptcy Created a Crucial Question in Modern Bankruptcy Law,” won the prize for third place in the Ninth Annual ABI Bankruptcy Law Student Writing Competition. Mr. Fehr is a recent graduate of UC Davis School of Law and will begin working with the U.S. Trustee Program this fall. 

Since 2004, thirteen Catholic dioceses have filed for bankruptcy protection. Although several dioceses filed before 2004, filings since then have been driven by mounting sexual abuse claims against the dioceses. In response to these filings, claimants are assembling formidable unsecured creditors’ committees. For the most part, these diocesan bankruptcies have resulted in settlements. However, adversary proceedings have drawn out several of these bankruptcies. The ownership of church assets has led to many disputes over what belongs to the entities being sued and what belongs to other separate organizations. Therefore, while the bankruptcy process has helped these religious organizations with protection from impending liabilities, it has also provided sexual abuse claimants with a venue to build substantial creditors’ committees and challenge the availability of assets.

The most interesting of these drawn-out ordeals was in the Archdiocese of Milwaukee’s bankruptcy case. This case (as well as subsequent federal court decisions) has become significant for both diocesan bankruptcy cases and bankruptcy law’s interaction with other bodies of federal law. What was initially a dispute over the allocation of the Archdiocese’s assets became a debate over bankruptcy law’s place in the hierarchy of federal law.

On Nov. 13, 2015, nearly five years after its initial filing in January 2011, the Archdiocese of Milwaukee had its chapter 11 plan confirmed. The extraordinary length of this process was largely due to ongoing adversarial litigation regarding the Archdiocese’s $55 million transfer to the Archdiocese of Milwaukee’s Catholic Cemetery Perpetual Care Trust.

Early in the bankruptcy proceedings, the unsecured creditors’ committee asserted that it wanted to pursue the Cemetery Trust as a part of the estate.[1] Before the unsecured creditors filed a complaint attempting to access the funds, the Cemetery Trust filed its own complaint against the unsecured creditors’ committee, requesting a declaration from the court that the trust was not part of the estate. This complaint marked the beginning of five years of proceedings and appeals, culminating in a Seventh Circuit Court of Appeal's decision in favor of the creditors. As in a majority of the other diocesan bankruptcy cases, the debtor, the Cemetery Trust, and the unsecured creditors negotiated a settlement “at arm’s length.”[2]

Although the case itself settled typically, the Seventh Circuit decision did more than just rule in favor of the creditors’ committee. As the case rose through the courts, its significance to the bankruptcy system grew. What began as a dispute over assets evolved into a question of whether enforcement of the Bankruptcy Code could infringe on religious rights granted by the U.S. Constitution. Although the district court found that religious rights were protected against the Bankruptcy Code, the Seventh Circuit overturned this ruling and took its determination a step further. The court found that although there may be interference with religious practice, upholding and maintaining a proper bankruptcy system is a compelling governmental interest.

The Cemetery Trust Litigation

In June 2011, the Cemetery Trust filed a complaint in the Archdiocese’s case against the unsecured creditors’ committee. As trustee of the Cemetery Trust, Archbishop Jerome Listecki requested a declaration that neither the Cemetery Trust nor the funds deposited into the trust were property of the Archdiocese’s bankruptcy estate. The Cemetery Trust’s initial complaint asserted that the Archdiocese did not have a legally recognizable interest in the Cemetery Trust because it is a charitable trust under Wisconsin law.[3] Ultimately, the core of this dispute arose in the Archbishop’s amended complaint.[4]

The Cemetery Trust argued that the Bankruptcy Code could not be applied in the case because doing so would violate the Religious Freedom Restoration Act of 1993.[5] Although the Bankruptcy Code is obviously the main source of law in bankruptcy matters, bankruptcy courts are still subject to nonbankruptcy laws. Often, especially in property dispute matters, the Bankruptcy Code will defer to state property law to rule on whether an asset is property of the estate. Thus, federal laws like RFRA may be asserted and contested in relation to bankruptcy matters. The committee filed a motion for summary judgment, contesting that RFRA was inapplicable in this bankruptcy suit for three reasons.

First, the committee said that RFRA only applies in suits that involve the government. The Cemetery Trust argued that the committee acted under the “color of law,” meaning that it became a state actor when it was appointed by the U.S. Trustee.[6] Second, the committee argued that RFRA could not be applied to invalidate state law. Since Wisconsin law governed the trust, as stated in the complaint, RFRA would need to bar state law claims.[7] Third, the committee argued that the Bankruptcy Code did not violate the Free Exercise clause of the First Amendment. If the law is neutral and generally applicable, it does not qualify for relief based on religious practice.[8] The Cemetery Trust argued that the Bankruptcy Code is not neutral or generally applicable law because it contains several exceptions and exemptions.[9]

The Bankruptcy Court’s Decision Ruling RFRA Inapplicable

The bankruptcy court found that RFRA was inapplicable to protect the Cemetery Trust from the Bankruptcy Code. [10] The bankruptcy court determined that the committee was not a government actor as it did not act under the “color of law.” The committee was not compelled by the government to act in a certain way and did not act jointly with the government in any capacity. Rather, the U.S. Trustee merely monitors the committee.[11]

To the second point, the bankruptcy court determined that RFRA would indeed have to be applied to Wisconsin state law governing the trust and that RFRA is inapplicable in these sorts of matters. The bankruptcy court acknowledged that § 541 of the Bankruptcy Code governs what is property of the estate; however, Wisconsin law governs the validity of the trust.[12]

Finally, in regard to the claim that the Bankruptcy Code is not a neutral or generally applicable law in light of the First Amendment, the bankruptcy court determined that the Bankruptcy Code provisions in connection with this case are neutral, generally applicable law. Although the Bankruptcy Code contains certain exceptions and exemptions, the examples the Cemetery Trust relied upon to negate neutrality do not target religion or religious activity.[13]

Reversal in the District Court in Favor of the Cemetery Trust

After the bankruptcy court’s decision, the Cemetery Trust immediately filed for leave to appeal in the U.S. District Court for the Eastern District of Wisconsin. The district court focused its analysis on whether the committee acted under the “color of law” when pursuing claims. Ultimately, the district court found in favor of the Cemetery Trust. The district court found that by allowing the committee to pursue claims on behalf of the bankruptcy estate, the bankruptcy court had involved itself in the committee’s conduct.[14]

Unlike the bankruptcy court, the district court made its determination primarily based on the Cemetery Trust’s contention that the Committee’s pursuit of funds violated RFRA. The district court focused its analysis on whether the committee acted “under color of law” as defined by RFRA.[15] The district court overruled the bankruptcy court’s decision that the Cemetery Trust was governed by Wisconsin state trust law, stating that “the ultimate issue of whether or not that property can be brought into the bankruptcy estate is governed solely by the Bankruptcy Code.”[16] Therefore, with RFRA’s potential interference with state law ruled out, the RFRA contention became dispositive of whether the Bankruptcy Code was applicable.

RFRA protects individuals, and entities, from the government “substantially burdening” the exercise of religion unless “it is in furtherance of a compelling governmental interest.”[17] To establish that a nonobvious entity is a “government” actor as defined by the statute, a litigant may contend that the entity is “acting under color of law.”[18]

In Lugar v. Edmondson, the U.S. Supreme Court outlined a process for examining whether a private actor is “acting under color of law” and therefore subject to RFRA.[19] The court first required that deprivation be caused by a right or privilege created by the government and, second, that “the party charged with the deprivation must be a person who may fairly be said to be a state actor.”[20] In this appeal, the committee contested only the second prong regarding whether the committee could be considered a “state actor.”[21]

To test whether the committee is a state actor and acted under color of law, the district court analyzed whether there was a government “delegation of a public function.”[22] In its analysis, the district court delved extensively into the function of creditors’ committees and whether their actions are “a traditional public function,” indicating that they are a state actor.[23] The district court determined that bringing claims on behalf of the estate is a “public function” that the bankruptcy court delegated to the committee.[24] Thus, the district court concluded that the committee was given typically governmental power to pursue claims on behalf of the estate, and therefore acts under color of law when pursuing claims against the Cemetery Trust.

Since the district court classified the committee as a government actor, RFRA requires that the committee’s actions do not “substantially burden” the Cemetery Trust’s right to free exercise of religion under the First Amendment.[25] The district court resolved that removing funds from the Cemetery Trust would burden the Archdiocese by requiring it to violate church doctrine. By obeying the court and removing funds from the Cemetery Trust, the Archdiocese would be acting contrary to “the central and sacred nature of cemeteries to the Catholic faith.”[26] Therefore, placing Cemetery Trust funds into the bankruptcy estate would be substantially burdensome on the Archdiocese’s and the Cemetery Trust’s exercise of religion.

In conclusion, the district court found that the bankruptcy court’s interest in reclaiming funds for the bankruptcy estate was not a compelling interest under RFRA. Previous decisions similarly found that the tenets of the bankruptcy system were not on par with other interests considered compelling, like maintaining the tax system or maintaining national security.[27] Therefore, since there was no countervailing reason justifying the substantial burden, the district court reversed the bankruptcy court’s decision.[28]

The Seventh Circuit Court of Appeals’ Ruling in Favor of the Committee

On appeal, the Seventh Circuit took a different direction. In stark contrast to both the predominantly neutral decision by the bankruptcy court and the church-favoring reversal from the district court, the Seventh Circuit Court of Appeals painted an unflattering picture of the Archdiocese and the Cemetery Trust. Within the first paragraph of her opinion, Judge Williams criticized the Archdiocese for filing bankruptcy when “[f]acing financial problems and lawsuits from victims of sexual abuse.”[29] The panel opinion also directly linked the transfer to the desire to avoid sexual abuse claims.[30]

The appeals court’s decision began by overruling the district court’s central determination that the committee acted as the government under RFRA.[31] The court of appeals stated that committees of unsecured creditors are entirely composed of private actors and engage in private decision-making.[32] They do not represent the government. Instead, they represent “the larger interests of the unsecured private creditors” and that further, “[e]ach is a private, individual creditor who was sexually abused by the clergy.”[33] Thus, the committee is not accountable to a government actor.

The appeals court agreed with the district court that this area of the law does not have a uniform legal test but rather is based on fact- and case-specific analysis to determine whether a party is a state actor.[34] The appeals court used one Supreme Court case in particular to substantiate its decision that the committee was not a government actor. In Polk County v. Dodson, the Supreme Court assessed whether public defenders were state actors.[35] The court found that because public defenders act to advance the interests of their clients rather than on behalf of the government, they are not government actors.[36] The same logic applies to unsecured creditors’ committees. There may be some “governmental and court supervision,” although this is incidental to their primary goals and accountabilities are subject to the private unsecured creditors.[37] Thus, the appeals court determined that RFRA was inapplicable in defending against the committee’s claim.

However, the appeals court delved heavily into whether the Archdiocese’s or the Cemetery Trust’s right to free exercise was infringed. While RFRA claims are limited to government actors, First Amendment Free Exercise Clause protections are still applicable in private suits.[38] On these grounds, the Archdiocese asserted that the claims under relevant provisions of the Bankruptcy Code may impinge on their right to free exercise. The appeals court evaluated whether Code provisions that establish the breadth of the estate under 11 U.S.C. § 541 define voidable transfers under § 544, allow for the avoidance of preferential transactions under § 547, and further define fraudulent transfers under § 548 were each, or collectively, of “general or neutral applicability.”[39] The appeals court determined that each of these provisions were of general and neutral applicability since they are applied indiscriminately across all entities.[40] Since they do not single out religious beliefs, they do not qualify for Free Exercise Clause protections.

The most significant aspect of this decision may be the appeals court’s determination that the Bankruptcy Code, and the protection of creditors, “is a compelling governmental interest that can overcome a burden on the free exercise of religion.”[41] As was stated in the district court’s decision, not all laws advance a compelling governmental interest. The Supreme Court has stated that statutes providing public education, maintaining the tax system, enforcing participation in the Social Security system and maintaining national security compel government interests “of the highest order.”[42] Here, the Seventh Circuit Court of Appeals firmly states that the Bankruptcy Code should be in this highest tier of legal importance.

In its assessment of the Bankruptcy Code and creditor rights, the appeals court compared the Bankruptcy Code to other legal systems that deem to compel the highest order of governmental interest. Most significantly, the decision compared the Bankruptcy Code’s interests to those of Social Security.[43] Harkening to a deep history in the American legal system, the appeals court stated, “Both the Code and the social security system ensure the financial stability of the citizenry.”[44]

The appeals court also defended the Bankruptcy Code’s application and practicality against the Archdiocese’s proposed solutions. The Bankruptcy Code’s broad application is integral to the rights of both debtors and creditors. In support of its decision, the appeals court quoted the Archdiocese’s original chapter 11 reorganization statement that emphasized that the bankruptcy system ensured that all parties would be treated equitably.[45]

Finally, the appeals court closed its defense of the Bankruptcy Code by illustrating that religious exceptions would be a “logistical nightmare for the court.”[46] The bankruptcy system works best because of its unified application. A “piecemeal” approach allowing sects to “pick and choose” Bankruptcy Code sections would irrevocably harm the system. The bottom line is that the Bankruptcy Code is in effect “so that creditors can obtain maximum relief” and that it does so in a way where the burden religious freedom is merely incidental.

Although the Seventh Circuit clearly ruled that RFRA did not supersede bankruptcy law, it did not address whether there was actually a fraudulent, avoidable or preferential transfer into the Cemetery Trust. The court left this decision to further proceedings in the bankruptcy court, which ultimately resulted in the final settlement of the case.

Analysis

If affirmed on appeal, the district court’s decision could have completely inundated unsecured creditors’ committees attempting to include funds from fraudulent transfers or alter egos. All adversary actions brought by these committees would not only have been subject to RFRA, but would have had to contest against this potentially influential precedent. Unsecured creditors’ committees would potentially have to re-litigate this issue in typically standard bankruptcy proceedings. Every adversary proceeding brought by unsecured creditors’ committees would have to argue that its claim did not burden the free exercise of religion.

For even more long-term consequences, this decision suggests significant implications for bankruptcy courts and the application of the Bankruptcy Code in cases where the debtor is a religious entity or has some sort of religious affiliation. By determining that unsecured creditors’ committees are acting “under color of law,” the district court established that in any matter, constitutional law could potentially apply and restrict these committees. For example, with the government acting as a potential “joint participant” with the committee, unsecured creditors’ committees at large could be subject to the entire spectrum of constitutional challenges that are usually inapplicable to private parties.[47] However, the Seventh Circuit Court of Appeals issued an unambiguous reversal of the district court’s ruling. More importantly, it wrote one of the most resounding supports of the U.S. Bankruptcy Code in recent years.

Although it was not a Supreme Court decision, the Listecki decision established the benchmark principle for why the Bankruptcy Code upholds compelling governmental interests of the highest order. The opinion complimented existing Supreme Court precedent. As stated in Listecki, Supreme Court precedent still weighs in favor of case-by-case assessments of whether a law imposes an unconstitutional burden on the free exercise of religion.[48] In parallel to this continuing standard, the Listecki decision creates unequivocally worded case law establishing creditor protection as a compelling state interest. As discussed above, the appeals court used numerous pages of its opinion to reflect on the history of the Bankruptcy Code and analogize it to other statutes considered to advance compelling government interests.[49]

In United States v. Crystal Evangelical Free Church (In re Young), the Eighth Circuit found that the Bankruptcy Code did not present a compelling government interest.[50] In Listecki, the appeals court responded that the Eighth Circuit found against the Bankruptcy Code “without reason” and issued a “cursory analysis.”[51] It seems that the appeals court presented such a thorough support of the Bankruptcy Code in order to force itself into the discussion whenever the Bankruptcy Code’s importance to governmental interests is discussed in the future. Although the Listecki appeal was not granted cert by the Supreme Court, there is a significant chance that these words will be considered in the next Supreme Court case regarding the structure and application of bankruptcy courts in the U.S.

Conclusion

What began as a potential contest over estate assets evolved into a resounding statement in favor of the Bankruptcy Code’s importance in the U.S. A significant decision within the scope of diocesan bankruptcies became significant for bankruptcy law as a whole. At the core of the Listecki decision, the Seventh Circuit Court of Appeals made a clear and compelling argument that RFRA does not bar creditors’ committees from asserting claims. This conclusion was a substantial step toward treating religious organizations in bankruptcy just like any other entity that has filed a petition. However, the most significant aspect, and what may end up being discussed by the U.S. Supreme Court, was the Seventh Circuit’s determination that the Bankruptcy Code constitutes a compelling government interest. If the Supreme Court shares this view, the Bankruptcy Code could gain substantial traction when weighed against the priorities of other federal laws.