Rocking the Boat on Bankruptcy Court Authority: The U.S. Supreme Court

The U.S. Supreme Court has, for four decades, been rocking the boat [that’s Justice Blackmun’s metaphor] on bankruptcy court authority. First, they almost killed the Code, coming within one vote of declaring the entire Bankruptcy Code unconstitutional. Then, they limit and mess with it some more. Now, finally, it seems they are focused on making bankruptcy court authority work, rather than trying to restrain it.

Notably, all of these Supreme Court cases have something to do with fraud-type claims.

1898 Bankruptcy Act

This story begins with Congress enacting The National Bankruptcy Act of 1898. Under the 1898 Act, U.S. district courts are our bankruptcy courts. They appoint bankruptcy receivers to handle bankruptcy issues, in much the same ways they appoint magistrates and special masters to handle other issues. The Bankruptcy Act works for 80 years.

Bankruptcy Code

Then, in 1978, Congress enacts an entirely new bankruptcy law. Its formal name is the Bankruptcy Reform Act of 1978. We call it the Bankruptcy Code. It creates bankruptcy courts, complete with bankruptcy judges appointed for 14-year terms, and grants them extensive judicial authority over bankruptcy cases.

Northern Pipeline

The U.S. Supreme Court gets its first say on the new Bankruptcy Code in 1982 with Northern Pipeline Construction Co. v. Marathon Pipe Line Co.[1] The Supreme Court’s Northern Pipeline ruling was a debacle: It threw bankruptcy practitioners and judges into uncertainty and chaos. Here’s what happened.

Northern Pipeline filed bankruptcy in 1980 and then sued Marathon Pipe Line in bankruptcy court, asserting fraudulent misrepresentation and other tort and contract claims. The defendant has no other connection to the bankruptcy case. The question before the Supreme Court was whether bankruptcy courts have authority to decide such cases.

The Justices in Northern Pipeline were all over the place (there are four separate opinions), with varying views on how the case should be decided. Here is a nose count on how the 9 Justices voted:

·      Four: These Justices (Brennan, Marshall, Blackmun and Stevens) wanted to declare the entire Bankruptcy Code unconstitutional based on, they contended, an excessive grant of judicial authority to bankruptcy courts. These four Justices, in their plurality opinion, cited a doctrine commonly used to justify grants of judicial-type authority to administrative agencies (i.e., “public rights” doctrine, with its reference to cases in the courts at Westminster).

·      Two: These Justices (Rehnquist and O’Connor) agreed that bankruptcy courts have no jurisdiction over a case like this, but they didn’t want to throw out the entire Bankruptcy Code.

·      Three: These Justices (White, Burger and Powell) wanted to affirm the bankruptcy court’s authority to handle such cases.

The final result of Northern Pipeline is that bankruptcy courts are prohibited from handling fraud-type claims and related disputes against a third party.

Chief Justice Burger wrote a separate dissenting opinion to emphasize that the impact and effect of Northern Pipeline would be “limited” to “a relatively narrow category of claims” and that such claims can be handled by routing to the district courts. Justice Burger’s “limited” view has proven, over time, to be accurate. But no one knew it — or believed it — back then. Yet the four Justices’ use of the public rights doctrine, in their Northern Pipeline effort to kill the Bankruptcy Code, has stayed with us well into the next millennium.

1984 Bankruptcy Code Amendments

Congress amended the Bankruptcy Code in 1984 to address Northern Pipeline issues.[2] This amendment says that bankruptcy courts may (1) decide “core” proceedings and (2) hear “non-core” but “related to” proceedings and provide “proposed findings of fact and conclusions of law” to the district court. This amendment also contained a nonexhaustive listing of “core” proceedings.[3]

Granfinanciera

The U.S. Supreme Court got its first crack at the 1984 amendments in Granfinanciera S.A. v. Nordberg,[4] a fraudulent conveyance case. The question was whether the defendant was entitled to a jury trial under the U.S Constitution’s Seventh Amendment. The Supreme Court answered this Granfinanciera question in the affirmative, relying in part on Northern Pipeline’s public rights doctrine.

At first glance, Granfinanciera looks like another erosion of bankruptcy court authority. After all, five Granfinanciera Justices (Brennan, Rehnquist, Marshall, Stevens and Kennedy) in a footnote[5]:

1.     described the Bankruptcy Code as making “sweeping changes” and “radical reforms” to the U.S. bankruptcy system; and

2.     suggested that the Senate must have “overlooked” the Seventh Amendment jury trial issue entirely in adopting the 1984 amendment.

A second look, however, reveals this important fact: One of the four “entirely unconstitutional” Justices from Northern Pipeline flipped. Justice Blackmun abandoned his Northern Pipeline position of unconstitutionally and replaced it, in his Granfinanciera dissent, with these practical views[6]:

·      Congress must be allowed to establish a “modern bankruptcy system” that places bankruptcy cases in the hands of “an expert equitable tribunal”;

·      The Granfinanciera majority decision “throws Congress into still another round” of bankruptcy reform “without compelling reason”; and

·      “There was no need for us to rock the boat in this case.”

Never again is the essential constitutionality of the Bankruptcy Code called into question. But the U.S. Supreme Court isn’t yet finished rocking the boat.

Stern v. Marshall

Fast-forward a quarter century to Anna Nicole Smith’s Stern v. Marshall case,[7] involving fraud-type claims against a third party — just like Northern Pipeline. But a crucial distinction is this: The Stern v. Marshall defendant filed a proof of claim in the bankruptcy case, against which the debtor’s fraud-type claims were being asserted as counterclaims. And, of course, such counterclaims are listed as “core” proceedings in 28 U.S.C. § 157(b)(2)(C).

So the bankruptcy court in Stern v. Marshall makes a final ruling on the counterclaims. Does a bankruptcy court have authority to do such a thing? That is the question in Stern v. Marshall. “No, No, No!” was the Supreme Court’s answer [I’m paraphrasing, of course]. “You can’t do that. Congress may have authorized it, but they were wrong. The Constitution forbids this!”

This time, a five-Justice majority (Roberts, Scalia, Kennedy, Thomas and Alito), like the Northern Pipeline four-Justice plurality, referenced such things as “public rights” and “the stuff of the traditional actions at common law tried by the courts at Westminster in 1789” [the year the U.S. Constitution became effective].

This Stern v. Marshall ruling seemed (back in 2011) like a reprise of the 1982 debacle that was Northern Pipeline. And fears over the ultimate effect of Stern v. Marshall are real, despite the majority’s assurance that Stern v. Marshall deals with and affects only “one isolated” situation.[8]

Two Recent Cases

Stern v. Marshall is the last Supreme Court case (so far) to declare any part of the Bankruptcy Code unconstitutional. Supreme Court rulings on judicial authority in two subsequent cases have been geared toward making the Bankruptcy Code work instead of limiting its use. Here are the two subsequent cases.

In 2014, the Supreme Court addressed another fraudulent transfer case: Executive Benefits v. Arkison.[9] In this case, the Supreme Court assumed (but did not declare) that fraudulent transfers are Stern v. Marshall claims. Then it declared that a bankruptcy court can decide such claims as long as the ruling is appealed to the U.S. district court and reviewed do novo. Since that’s precisely what happened in the Executive Benefits case, the Supreme Court affirmed in a unanimous opinion.

In 2015, the Supreme Court took on the question of whether a Stern v. Marshall claim can be decided by a bankruptcy court on consent of the parties. The case is Wellness International v. Sharif,[10] and the answer is this: “Yes, and consent need not be express; it can be implied by conduct.” [I paraphrase, again.] This is a five-Justice majority (Sotomayor, Kennedy, Ginsburg, Breyer and Kagan) with an additional Justice (Alito) concurring. Moreover, the three dissenters (Roberts, Scalia and Thomas) also wanted to approve the ruling-plus-de novo-review that happened in this case. But they wanted to do so on different grounds: by holding on to the public rights doctrine of the past. The majority opinion, by contrast, doesn’t even mention “public rights.”

Conclusion

So, the U.S. Supreme has had its fling at rocking the boat on bankruptcy court authority.  And that fling always seems to center on fraud-type cases. The boat rocking fling progressed like this:

·      The Supreme Court starts in 1982 with a nearly successful effort to declare the entire Bankruptcy Code unconstitutional, based on the grant of judicial authority to newly created bankruptcy courts. But, as it turns out, the 1982 case does nothing more than declare that fraud-type and related claims against a third party cannot be resolved by a bankruptcy court.

·      The Supreme Court moves in 1989 to declare that a fraudulent transfer defendant is entitled to a jury trial under the U.S. Constitution’s Seventh Amendment. But the Court still uses some of the public-rights and “courts-at-Westminster” rationale of the 1982 plurality opinion.

·      Then, in 2011, the Supreme Court reiterates that fraud-type claims cannot be resolved by a bankruptcy court. The boat continues rocking, however, because the Supreme Court is still giving lip service to the public-rights and “courts-at-Westminster” arguments of 1982.

·      Since 2014 and 2015, the Supreme Court has been allowing bankruptcy courts to resolve all sorts of claims, including fraud-type claims, on a variety of grounds. Public rights and “courts-at-Westminster” language appears to be gone.

Now, the Supreme Court’s rocking the boat fling is spent. The U.S. Supreme Court appears to be focusing (even in fraud-type claims) on how to make bankruptcy court authority work, rather than trying to restrain it.

And that’s a good thing!