State Sovereign Immunity Bars Adversary Proceeding Concerning Tax Refunds

Before litigating an adversary proceeding or contested matter against a state or its agencies, plaintiffs would be wise to consider whether the state entity has a colorable sovereign immunity defense.[1] In In re La Paloma Generating Co.,[2] Delaware Chief Bankruptcy Judge Christopher S. Sontchi determined that California’s sovereign immunity barred the liquidating trustee’s motion for a determination of tax liability — specifically the right to property tax refunds — under Bankruptcy Code § 505 against the California State Board of Equalization (SBE).[3]

State Sovereign Immunity

The Eleventh Amendment to the U.S. Constitution states that “[t]he Judicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by Citizens of another State, or by Citizens or Subjects of any Foreign State.”[4] This immunity nonetheless can be waived “either if the State voluntarily invokes [federal court] jurisdiction,… or else if the State makes a ‘clear declaration’ that it intends to submit itself to [such] jurisdiction.”[5] State sovereign immunity is also waived for “proceedings brought pursuant to ‘Laws on the subject of Bankruptcies,’”[6] on the theory that states consented to waive their sovereign immunity in connection with certain bankruptcy-related matters in ratifying the U.S. Constitution.[7]

Voluntary Waiver Through Litigation Acts

Federal courts are reluctant to find a wavier through a state entity’s litigation acts. Only a narrow set of litigation actions constitute a waiver, such as where “a State … submits its rights for judicial determination … and unequivocally invokes the jurisdiction of the federal courts.”[8] Actions by a state that invoke federal court jurisdiction include when a state files a claim, joins in a cause of action, or successfully seeks to remove a state or federal law cause of action.[9]

In La Paloma, Judge Sontchi rejected several arguments that the SBE had waived its sovereign immunity defense.[10] Pointing to precedent holding that a state could raise a sovereign immunity defense for the first time on appeal, Judge Sontchi found that the SBE had not waived sovereign immunity by waiting until the “eve of trial” to first raise the sovereign immunity defense or by entering into a stipulation concerning the tax dispute that conceded that the bankruptcy court had jurisdiction.[11] “The crucial fact remains that SBE ‘never chose to litigate this suit in a federal forum.’”[12]

Waiver Under Ratification-by-Consent Doctrine

The vast majority of bankruptcy litigation against state entities relies on the exception to the Eleventh Amendment immunity set forth in Central Virginia Community College v. Katz, 546 U.S. 356, 377 (2006), in which the Supreme Court found that by ratifying the U.S. Constitution, states waived their sovereign immunity as to “adjudications of rights in the res” of the bankruptcy estate and “order[s] … ancillary to and in furtherance of the court’s in rem jurisdiction, [which] might involve in personam process.”[13] As to the former, there is no state sovereign immunity in connection with “the three critical in rem functions of bankruptcy courts: [1] the exercise of exclusive jurisdiction over all of the debtor’s property, [2] the equitable distribution of that property among the debtor’s creditors, and [3] the ultimate discharge that gives the debtor a ‘fresh start’….”[14]

Applying Katz, Judge Sontchi held that the SBE maintained its sovereign immunity because determining the tax refund did not involve any of the critical in rem functions of bankruptcy courts because “[w]hat La Paloma contests here is nothing more than a state law claim for a sum of dollars.”[15] The fact that the taxed property was property of the estate was not enough,[16] nor could the liquidating trustee even argue that its suit against SBE was to get specific money back that it was overpaid by the debtor pre-petition, as the entity who was paid the taxes pre-petition was a California county, not SBE.[17] This fact pattern contrasted with tax disputes involving the “payment of post-petition funds” or “unpaid tax assessments,” which Judge Sontchi indicated would invoke the bankruptcy court’s in rem jurisdiction.[18]

Judge Sontchi likewise ruled that the tax dispute was not ancillary to in rem jurisdiction.[19] The two factors he considered were “(1) whether the relevant law applies uniform treatment between state and private creditors, and (2) then whether the activities constitute core aspects of bankruptcy administration through either its history or effect on the estate.”[20] While the first factor applied, the second did not.[21] The ability to seek a tax determination in bankruptcy court only had a short history, going back “sixty years, a far cry from the history used to support preference and fraudulent transfer actions.”[22] Nor did the tax dispute “functionally serve the administration of the res … by connect[ing] to one of the core in rem processes of the bankruptcy court.”[23] Administration over the tax dispute was unnecessary, because the liquidating trustee could pursue litigation in California Superior Court.[24] Moreover, seeking a money judgment against SBE “seemingly goes beyond the realm of ‘ancillary orders’” and “is ‘too remote’ to create the necessary nexus to the bankruptcy’s administration.”[25]

Additional Problems in Litigating Against States

Other factors bear on the decision of whether or not to sue a state or its agency. Even if the federal court finds a waiver of sovereign immunity and refuses to dismiss litigation against a state entity, the state entity has an immediate right of appeal from the decision.[26] Unless the appeal is “facially defective” or “frivolous,” the court is “obliged to grant” a state entity’s motion for stay pending appeal.[27] Because such interlocutory appeals can take many months or years, the more expedient course for litigating against a state entity may be to use a nonfederal forum. Finally, even if there is a waiver of sovereign immunity, there is a risk that the bankruptcy court may abstain from deciding the dispute anyway.[28]