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

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The Boat

By: Donald L. Swanson

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 kill the Code—coming within one vote of declaring the entire Bankruptcy Code unconstitutional. Then they limit and mess with it some more. And 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. And 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. It’s formal name is 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. The case is Northern Pipeline Construction Co. v. Marathon Pipe Line Co., 458 U.S. 50, 102 S.Ct. 2858, 73 L.Ed.2d 598 (1982).

The Supreme Court’s Northern Pipeline ruling is a debacle: it throws bankruptcy practitioners and judges, back then, into a chaos of uncertainty. Here’s what happened.

Northern Pipeline files bankruptcy in 1980 and then sues 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 is whether bankruptcy courts have authority to decide such cases.

The Justices in Northern Pipeline are 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 nine Justices voted:

Four — these Justices (Brennan, Marshall, Blackmun and Stevens) want to declare the entire Bankruptcy Code unconstitutional, based on, they contend, an excessive grant of judicial authority to bankruptcy courts. These four Justices, in their plurality opinion, cite 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) agree that bankruptcy courts have no jurisdiction over a case like this, but they don’t want to throw out the entire Bankruptcy Code.

Three — these Justices (White, Burger and Powell) want to affirm the bankruptcy court’s authority to handle such cases.

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

Chief Justice Burger writes a separate dissenting opinion to emphasize that the impact and effect of Northern Pipeline is “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 public rights doctrine, in their Northern Pipeline effort to kill the Bankruptcy Code, stays with us well into the new millennium.

1984 Bankruptcy Code Amendments

Congress amends the Bankruptcy Code in 1984 to address Northern Pipeline issues (see 28 U.S.C. § 157). This amendment says bankruptcy courts may, (i) decide “core” proceedings, and (ii) hear “non-core” but “related to” proceedings and provide “proposed findings of fact and conclusions of law” to the district court. This amendment also contains a non-exhaustive listing of “core” proceedings (see 28 U.S.C. § 157(b)(2)).

Granfinanciera

The U.S. Supreme Court gets its first crack at the 1984 amendment in Granfinanciera, S.A. v. Nordberg492 U.S. 33, 109 S.Ct. 2782, 106 L.Ed.2d 26 (1989).

It’s a fraudulent conveyance case. And the question is whether the defendant is entitled to a jury trial under the U.S Constitution’s Seventh Amendment. The Supreme Court answers 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 footnote 16:

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

2) suggest 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 in Northern Pipeline has flipped. Justice Blackmun abandons his Northern Pipeline position of unconstitutionally and replaces it, in his Granfinanciera dissent, with these practical views :

–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 case of Stern v. Marshall, 564 U.S. 462, 131 S.Ct. 2594, 180 L.Ed.2d 475 (2011), involving fraud-type claims against a third party—just like Northern Pipeline. But a crucial distinction is this: the Stern v. Marshall defendant has filed a proof of claim in the bankruptcy, against which the debtor’s fraud-type claims are 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!” is 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!”

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

This Stern v. Marshall ruling seems (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.

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 are geared toward making the Bankruptcy Code work, instead of limiting its use. Here are the two subsequent cases.

In 2014, the Supreme Court addresses another fraudulent transfer case: Executive Benefits v. Arkison573 U.S. ___, 134 S. Ct. 2165, 189 L.Ed2d 83 (2014). In this case the Supreme Court assumes (but does not declare) that fraudulent transfers are Stern v. Marshall claims. Then it declares 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 affirms in a unanimous opinion.

In 2015, the Supreme Court takes 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, 575 U.S. ___, 135 S. Ct. 1932, 191 L.Ed.2d 911 (2015), 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 want to approve the ruling-plus-de novo-review that happened in this case. But they want to do so on different grounds: they want to hold on to 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. The 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 declares in 1989 that a fraudulent transfer defendant is entitled to a jury trial under the U.S. Constitution’s Seventh Amendment. And the Court relies upon 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.

–By 2014 and 2015, the Supreme Court is 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.

The Supreme Court’s rocking the boat fling is now spent. It 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!

**  If you find this article of value, please feel free to share.  If you’d like to discuss, let me know.

Footnote: This article was originally published in the American Bankruptcy Institute’s Commercial Fraud Committee Newsletter on September 25, 2017.

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