October 20111 Bankruptcy Section Newsletter

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Stern v. Marshall And The Limits Of Bankruptcy Courts' Article III Jurisdiction

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A Look At Stern v. Marshall, 131 S. Ct. 2594 (2011)

The following article offers a look at the background behind the groundbreaking Stern v. Marshall Supreme Court case. To find out how the decision will affect the legal industry - and what attorneys and bankruptcy judges need to know - register today for our Oct. 4 Webinar on the case!

The Supreme Court, in Stern v. Marshall, a 5-4 decision, has upset the accepted rule that a bankruptcy court has jurisdiction to issue a final judgment on a counterclaim to a proof of claim, when the counterclaim, even though it might be compulsory, is a "common law tort claim." These are issues that need to be seriously considered after thorough analysis.
This is the second time these parties - the appellant, Vickie Marshall (a.k.a Anna Nicole Smith), a former Playboy model (now deceased) and the widow of the wealthy Texas oilman Howard Marshall, and appellee Pierce Marshall, the now-deceased son of Howard Marshall - appeared before the Supreme Court. To re-enforce the lengthy nature of this case, Chief Justice Roberts quoted Dickens' "Bleak House."

Vickie Marshall filed a Chapter 7 bankruptcy petition. Pierce filed a proof of claim based upon allegations that Vickie had defamed him by inducing her lawyers to tell the press that he had engaged in fraud to control his father's assets. The Chapter 7 trustee of Vickie Marshall's bankruptcy estate, in return, asserted a counterclaim that Pierce had engaged in fraud to gain control of his father's assets (although some might argue whether this counterclaim was "compulsory," there seemed to be some concession that it was).
The bankruptcy court entered final orders on the proof of claim (denying it) and the counterclaim (granting the bankruptcy estate judgment for $400 million). The final order for $400 million was appealed, raising the issue of whether the bankruptcy court had jurisdiction to enter a final judgment.

Chief Justice John G. Roberts wrote for the majority. He resolved the first issue of whether 28 U.S.C. § 157(b), authorized a final order by the bankruptcy court. Stating that §157(b)(1)'s grant to the bankruptcy courts to "hear and determine all cases under Title 11 and all core proceedings under Title 11, or arising in a case under Title 11" is "ambiguous," he concluded that §157(b)(2)(C) (which designated a core matter as a "[counterclaim] by the estate against persons tiling claims against the estate") granted statutory authority to the bankruptcy court to issue a final order.

Roberts next addressed whether the bankruptcy court lacked jurisdiction to issue a final order because §157(b)(5) provides that "[t]he district court shall order that personal injury tort and wrongful death claims shall be tried in the district court in which the bankruptcy case is pending." The chief justice determined that Pierce Marshall had consented to the bankruptcy court's resolution of his proof of claim, overriding the assignment of jurisdiction by §157(b)(5).

Chief Justice Roberts then turned to the issue of the constitutionality. Simply put, "[A]lthough [the court] conclude[s] that §157(b)(2)(C) permits the bankruptcy court to enter final judgment on Vickie's counterclaim, Article III of the Constitution does not." Roberts patiently traced the history of the independence of the judicial power as prescribed by the Constitution, and the placement of that power in judges that "shall hold their offices during good behavior" and "receive...compensation[ ] [that] shall not be diminished." Consistent with this grant of power, Roberts stated "[t]hat is why we have long recognized that, in general, Congress may not withdraw from judicial cognizance any matter which, from its nature, is the subject of a suit at the common law, or in equity, or admiralty," citing Murray's Lessee v. Hoboken Land & Improvement Co., 59 U.S. 272, 284 ,18 How. 272, 284 (1856).

Regardless of the compulsory nature of this counterclaim, Chief Justice Roberts characterized the counterclaim as "one under state common law between two private parties." Although Katchen v. Landy, 382 U. S. 323 (1966), was acknowledged as permitting adjudication by the bankruptcy court of claims after the submission of a proof of claim, this was not sufficient. Roberts distinguished Katchen because, in Katchen, the preference issue presented by the trustee was part of the process of allowing or disallowing claims of the creditor, who filed a proof of claim, leaving the creditor with no basis for resolution of the issue in an Article III court.

The chief justice then noted the Katchen court did not opine on whether the bankruptcy referee had summary jurisdiction to determine a trustee's request for affirmative relief when all of the substantial legal and factual bases for which had not been decided in ruling on the objections to the creditor's proof of claim. (Stern, 131 S. Ct. at - citing Katchen, 382 U.S. at 334 n.9.) As such, the state court claim before Chief Justice Roberts was deserving of treatment under Article III's judiciary, not an Article I court.
Justice Stephen G. Breyer wrote for the minority. He traced the earlier cases that relied upon the majority, primarily Murray's Lessee v. Hoboken Land & Improvement Co., supra. But Breyer preferred to rely upon more recent cases that he felt provided a more practical resolution: Crowell v. Benson, 285 U.S. 22 (1932), Thomas v. Union Carbide Agricultural Products Co., 473 U.S. 568 (1985) and Commodity Futures Trading Comm'n v. Schor, 478 U.S. 833 (1986). These cases, he argued, augured for a more practical approach. Further, a practical review of the present bankruptcy scheme evidenced minimal congressional intrusion in this Article I court because the judges were appointed by the courts of appeal, not Congress.

But Justice Breyer's most powerful argument was his citing of James Madison's comments in the Federalist Papers when the subject turned to Article I, §8 grant to Congress of the "power to...establish...uniform laws on the subject of bankruptcies throughout the United States" - stating:

[The] power of establishing uniform laws of bankruptcy is so intimately connected with the regulation of commerce, and will prevent so many frauds where the parties or their property may lie or be removed in to different states, that the expediency of it seems not likely to be drawn into question. - The Federalist No. 42, p. 271 (C. Rossiter ed. 1961).

Justice Breyer concludes with noting how extensive this litigation of counterclaims is present in the bankruptcy courts, and says that he foresees a problem due to the "staggering" number of bankruptcy cases (almost 1.6 million), as compared to the district court's docket of only 280,000 civil cases and 78,000 criminal cases. He also sees the jurisdictional shifting of cases leading to inefficiency, increased cost, delay and needless suffering.

As to the majority, it is disappointing that they ignore the precedence of Katchen v. Landy, a precedent that many have relied upon, including, arguably, the Supreme Court in Langenkamp v. Culp, 498 U. S. 42 (1990) (per curiam); although Chief Justice Roberts ruled that these cases did not provide for jurisdiction to resolve of all counterclaims to proofs of claims, other courts certainly have found a safe haven in these two Supreme Court cases.

Further, it seems essential that all agreed that the counter claim at issue in the case at bar was compulsory (which, under Federal Rule of Civil Procedure 13(a) means that it arises out of the transaction or occurrence that is the subject matter of the opposing party's claim) - under the majority's limited reading of Katchen, that would seem to fall into the majority's insistence of constitutional jurisdiction when "the same issue [arose] as part of the process of allowance and disallowance of claims." (But query, wasn't this really two different claims, each asserting separate claims for recovery, connected only as part of some expensive "family feud?" The majority did state that, "Vickie's claim, in contrast, is in no way derived from or dependent upon bankruptcy law; it is a state tort action that exists without regard to any bankruptcy proceeding.")

Justice Breyer's dissent suggests attention to practicality - and favoring a different result. But practicality does not require the waiver of constitutional protections - as Justice Scalia wrote when faced with the standards for admissibility of drug tests, he recognized the need for constitutional protections:

Finally, respondent asks us to relax the requirements of the Confrontation Clause to accommodate the "necessities of trial and the adversary process." Brief for Respondent at 59. It is not clear whence we would derive the authority to do so. The Confrontation Clause may make the prosecution of criminals more burdensome, but that is equally true of the right to trial by jury and the privilege against self-incrimination. The Confrontation Clause - like those other constitutional provisions - is binding, and we may not disregard it at our convenience. Melendex-Diaz v. Massachusetts, 129 S.Ct. 2527, 174 L.Ed. 2d 314 (2009).

Further, the requirement that a life-tenured judge be the arbitrator of essential legal issues is not a new one - it predates the Constitution, as the Declaration of Independence criticized King George as he "made judges dependent on his will alone, for the tenure of their offices, and the amount and payment of their salaries." (Declaration of Independence ¶11.)

Still, his citing of James Madison's perspective of bankruptcy in the Federalist Papers is refreshing - refreshing because the founding fathers were able to recognize that bankruptcy is different, requiring "expediency."

Finally, it is possible to consider this case as one protecting the due process rights of individuals. However, there is a difference, regarding due process's protection of procedural and substantive rights, and the placement of the judicial power in life-tenured appointees.

Stated another way, one does not have a right to be heard before an Article III judge; rather, only an Article III judge can issue certain final orders. If one searches the majority and supporting opinions, the phrase "due process" does not appear at all; in contrast, the phrase "due process" does appear in Justice Breyer's minority opinion, but perhaps in a way that the majority might not dispute.

While this plainly is a simplification of a complex issue that ignores the case law starting with Murray's Lessee v. Hoboken Land and Improvement Co., 58 U.S. 272, 18 How. 272 (1856), it appears that Justice Roberts is drawing a distinction between Article III jurisdiction and due process.

- By Louis S. Robin and Lawrence C. Brown
 

Earn CLE Credit At The CLLA  New York Meeting's Outstanding Bankruptcy Programs!

The Value of Everything And The Worth of Nothing: Legal And Practical Perspectives On Understanding Both

Nov. 11, 2011 - 1:00 – 6:15 p.m. (with cocktail party to follow)
Sheraton New York Hotel and Towers, New York, N.Y.


1:00 – 2:30 p.m.
Valuation: A Primer For Determining How To Determine Value And Analyzing The Numbers Alleged By Your Client (Debtor Or Creditor)

David Wall, David Wall, EP Forensic & Valuation Services LLP, Ontario, CA
               
2:45 – 3:45
Valuation From The Trustees' Perspective

Lori Lapin Jones, Principal, Lori Lapin Jones PLLC
Kenneth P. Silverman, Partner, Silverman Acampora
Gregory Messer, Principal, The Law Office of Gregory Messer

4:00 – 5:15 p.m.
Valuation From The Bench: A Panel Of Judges Comments On The "Hot Issues" They See From The "Other Side Of The Bench."

Hon. Robert D. Drain, U.S. Bankruptcy Judge, U.S. Bankruptcy Court for the Southern District of New York
Hon. Elizabeth Stong, U.S. Bankruptcy Judge, U.S. Bankruptcy Court for the Eastern District of New York
Hon. Alan S. Trust, U.S. Bankruptcy Judges, U.S. Bankruptcy Court for the Eastern District of New York

5:15 – 6:15 p.m.
Ten Bankruptcy Cases From This Year Which Affect Your Practice
Hon. Harlin "Cooter" Hale, U.S. Bankruptcy Court, Northern District of Texas, Dallas, Texas

Sua Sponte

Peter Califano, Bankruptcy Section Chair
Cooper, White & Cooper LLP
San Francisco, Calif.

Solyndra was a California-based solar-panel maker that recently filed a Chapter 11 bankruptcy case in Delaware (Case No. 11-12799). The filing has attracted national attention due to the circumstances surrounding the granting of $535 million in federal loan guarantees from federal "stimulus" monies; investigations are ongoing. The venue selection for the bankruptcy case was of particular interest to bankruptcy practitioners. The company had no employees in Delaware; its principal place of business was located in the San Francisco Bay Area, and the company was not a particularly large case - its petition indicated assets and liabilities of less than a billion dollars. Why was Solyndra's bankruptcy filed in such a remote jurisdiction?

One possible answer may have been to limit potential claims by its employees. Upon filing, the company suspended its manufacturing operations and laid off approximately 1,100 employees, triggering both federal and California Worker Adjustment and Retraining Notification Act ("WARN") claims. In addition, the California labor code places significant duties on employers when its employees are laid off, specifically with respect to salary and accrued benefits. The consequences for violations of these obligations may provide a basis for nondischargeability under 9th Circuit law. It appears that the company's employees could be disadvantaged in the Delaware forum on these matters.

This and many other similar situations helped form the need for the "Chapter 11 Bankruptcy Venue Reform Act of 2011," recently introduced by Rep. Lamar Smith and John Conyers, Jr. (H.R. 2533). The Commercial Law League of America testified in support of the bill on September 8, 2011, before a House subcommittee, maintaining that H.R. 2533 "constructively attempts to rebalance the interests of all parties in bankruptcy by making sure that the bankruptcy reorganization process remains within the regions and communities that have the most significant vested interest in the outcome."

Although there are opposing arguments, on balance, the CLLA believes that the bill represents a better approach for all interested parties regarding bankruptcy venue. You can review our submitted statement on this important issue here . Please let us know what you think about the CLLA's support for the bill.

Don't forget to sign up for our Oct. 4, 2011, Webinar concerning the meaning and impact of the recent U.S. Supreme Court decision in Stern v. Marshall. This is likely the most important bankruptcy jurisdiction case since the court's ruling in Northern Pipeline Const. Co. v. Marathon Pipe Line Co. Our panel of experts will help you quickly understand the decision and begin to plan for your pending cases.  Please sign up here.

We also hope to see you in Tampa, Fla., for the National Conference of Bankruptcy Judges (Oct. 12 -15, 2011). The CLLA will hold its annual breakfast at the conference where it will present the Lawrence P. King Award for Excellence in Bankruptcy to the Hon. Judith K. Fitzgerald (Western District of Pennsylvania). The keynote speaker at the breakfast will be television sports announcer Greg Gumbel.  In addition, the CLLA is sponsoring three excellent current development panels. This year's topics include two panels on emerging and complex Chapter 11 issues, along with a recent developments panel on bankruptcy ethics. Please sign up if you have not already done so.

Finally, at the CLLA's Annual New York Meeting (Nov. 10 -12, 2011), the Bankruptcy Section will present three separate valuation panels featuring valuation from the perspective of the debtor/creditor, the trustee and the judge. We will also have a panel that will examine the 10 most significant bankruptcy decisions from the past year that will affect your practice. During that weekend, the section's Executive Council and its subcommittees will be meeting, and we will host a dinner for the section's members and guests.  We hope you will come to New York and join us. Please sign up here.

Case Law Analysis

Eric D. Novetsky
Jaffe, Raitt, Heuer & Weiss, P.C.
Southfield, Michigan
Email: enovetsky@jaffelaw.com; Phone: (248) 351-3000
© All Rights Reserved

The Absolute Priority Rule as an Absolute Rule: The Rejection of Secured Creditor "Gifting" Under a Chapter 11 Plan of Reorganization

In Sprint Nextel Corp. v. DBSD North America, Inc. (In re DBSD North America, Inc.), 634 F.3d 79 (2nd Cir. 2011), the United States Court of Appeals for the Second Circuit reversed in part and remanded the decision of a bankruptcy court that confirmed a plan of reorganization, which called for secured creditors to "gift" new equity to a debtor's existing equity holder before fully satisfying the claims of an intermediate class of creditors. The DBSD opinion is complex and multifaceted. This case law analysis focuses only on the portions of the DBSD opinion that address whether a secured creditor can "gift" new equity to an existing equity holder over the objection of an intermediate class of creditors.

Case Background

On May 19, 2009, satellite communications company DBSD North America, Inc. ("DBSD") filed a voluntary Chapter 11 bankruptcy petition in the Southern District of New York. Subsequently, various claims were filed against DBSD, including three claims of particular relevance to the Second Circuit's decision: (i) a first lien debt secured by a first-priority lien on all of DBSD's assets ("first lien debt"); (ii) a second lien debt secured by a second-priority lien on all of DBSD's assets ("second lien debt"); and (iii) the unliquidated and disputed claim of Sprint Nextel Corporation ("Sprint").

According to the bankruptcy court's valuation of DBSD, DBSD's value was insufficient to cover the second lien debt.  In the words of the Second Circuit, this valuation left unsecured creditors, like Sprint, "out-of-the-money."

After certain negotiations, DBSD proposed a plan of reorganization ("plan") which, as amended, provided that that holders of unsecured claims, such as Sprint, would receive shares in the reorganized entity worth less than the full value of their claims, and the existing shareholder, whose interest was junior to unsecured creditors, would receive shares and warrants of stock (in quantities greater than those aggregately received by all unsecured creditors). Considering Sprint's "out-of-the-money" position, the plan provided Sprint with more than it might otherwise be entitled to under the Bankruptcy Code's priority scheme. Nevertheless, Sprint objected to the confirmation of the plan, arguing that, among other things, the plan violated the "absolute priority rule" of section 1129(b) of the Bankruptcy Code. 

The absolute priority rule is codified in section 1129(b) of the Bankruptcy Code, which provides that a plan of reorganization can only be "crammed-down" over the dissent of an impaired class of creditors if it "does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under and has not accepted the plan." 11 U.S.C. § 1129(b)(1). With respect to unsecured claims, a plan is not "fair and equitable" unless either: (i) the holders of claims "receive or retain on account of such claim[s], property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or (ii) the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property...."  11 U.S.C. §1129(b)(2)(B) (emphasis added).

In objecting to confirmation of the plan, Sprint argued that the plan could not be confirmed because it violated the absolute priority rule by providing the junior-positioned equity holder with property (shares and warrants) on account of its claim ahead of unsecured creditors who were receiving less than the allowed amounts of their claims. The bankruptcy court disagreed. Describing the situation a bit differently and relying on the concept of "gifting," 1 the bankruptcy court held that the plan did not violate the absolute priority rule because the holders of the second lien debt, who themselves were not receiving the full value of their claims, were "gifting" a portion of the recovery that they were otherwise entitled to (the shares and warrants), to the equity holder. 

The bankruptcy court held that it would allow such gifting "at least where, as here, the gift comes from secured creditors, there is no doubt as to their secured creditor status, there are understandable reasons for the gift, where there are no ulterior, improper ends … and where the complaining creditor would get no more if the gift had not been made."  DBSD, 634 F.3d at 87 (quoting In re DBSD North America, Inc. ("DBSD I"), 419 B.R. 179, 212 (Bankr.S.D.N.Y.2009).  

The bankruptcy court confirmed the plan and, upon Sprint's appeal to the United States District Court for the Southern District of New York, its decision was affirmed. Sprint next appealed to the Second Circuit.

The Second Circuit's Opinion

One of the main issues addressed by the court was whether the "gift" of shares and warrants to the existing equity holder violated the absolute priority rule. According to the court, the appellees, citing In re SPM Mfg. Corp., 984 F.2d 1305 (1st Cir. 1993), 2 a case widely seen as first validating the practice of "gifting," contended that the gift rightfully belonged to secured creditors to do with as they saw fit and that, pursuant to the gifting doctrine, until the secured creditors' debts were "paid in full, the Bankruptcy Code's distributional priority scheme, as embodied in the absolute priority rule, [was] not implicated."  DBSD, 634 F.3d at 97. The court rejected this argument explaining that the absolute priority rule set forth in section 1129(b)(2)(B):  (i) "applies to 'any property,'  …  not 'any property not covered by a senior creditor's lien.;'" (ii) "focuses entirely on who 'receive[s]' or 'retain[s]' the property 'under the plan,' …. not on who would receive it under a liquidation plan" and (iii) "applies to any distribution 'under the plan on account of' a junior interest…, regardless of whether the distribution could have been made outside the plan, and regardless of whether other reasons might support the distribution in addition to the junior interest." Id. at 97-98 (emphasis in original) (internal citations omitted).

The court also distinguished the case before it from SPM. The court observed that SPM was a Chapter 7 liquidation case, which, unlike DBSD's Chapter 11 reorganization case, was not subject to the rigid absolute priority rule of section 1129(b)(2)(B). Further, the court noted that the secured creditor in SPM had obtained relief from the stay and therefore, the property in question in SPM was already the secured creditor's property. In contrast, according to the court, the property to be gifted under the DBSD plan "remained in the estate throughout, and never belonged to the secured creditors outright."  Id. at 98 (citations omitted). Thus, the court found that SPM was irrelevant and inapplicable.  Id.
Next, reviewing the bankruptcy court's decision de novo, the court evaluated the following elements of the absolute priority rule as derived from the text of section 1129(b)(2)(B)(ii) of the Bankruptcy Code: (i) the receipt of "any property" by the equity holder; (ii) "under the plan;" which is (iii) distributed "on account of" the existing equity's junior interest. Id. at 95-96. The court first found that the shares and warrant easily met the definition of "property," a term that it stated should be interpreted broadly, particularly when preceded by the word "any." Id. at 95. 

Second, the court found that the shares and warrants were received "under the plan." Indeed, the text of the plan clearly provided that the existing equity holder would receive the shares and warrants. Id.  Lastly, the court found that the shares and warrants were distributed "on account of" the existing equity's junior interest. Id. at 95-96. As pointed out by the court, according to the plan, the gift of shares and warrants to the existing equity holder was "in full satisfaction, settlement, release, and discharge of the existing stockholder interest." Id. The court explained that regardless of how one interpreted the phrase "on account of" - as "because of" or as "in exchange for" - the existing equity holder was receiving the gift on account of its current equity interest.  Id.  Accordingly, having found that all three elements were satisfied, the court held that the gift proposed by the plan was an impermissible violation of the absolute priority rule and that the bankruptcy court erred in confirming the plan.  Id. at 101.

Comment

DBSD applies a strict yet straightforward and textual interpretation of the absolute priority rule. The decision appears to have closed the door on the practice of gifting of estate property under a Chapter 11 plan in the Second Circuit. Nevertheless, given the court's analysis in distinguishing SPM, questions remain as to the permissibility of gifting in a Chapter 7 case, what effect stay relief would have on the ability of a secured creditor to gift under a plan, and whether gifting can be accomplished outside of a plan of reorganization. 

Legislation Updates:

  • California A.B. 506: A bill related to local government bankruptcy and neutral evaluation.

    Status: Enrolled and presented to the Governor at 3:30 p.m. (9/23/11).
  • California S.B. 664: A bill related to banking and financial institutions.

    Status:  Chaptered by Secretary of State.  Chapter 243, Statutes of 2011. Do pass to
    consent to calendar. (9/6/11)
  • Delaware H.B. 58: An act to amend Title 10 of the Delaware code relating to foreclosures, including a foreclosure mediation program for homeowners.

    Status: Signed by Governor (9/21/2011)

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1 Although, section 1129 of the Bankruptcy Code sets forth what appears to be an "absolute" rule, several cases have allowed a class of senior creditors to voluntarily redistribute or "gift" a portion of its recoveries to a junior class of creditors outside the strict confines of the rules set forth in section 1129.  The theory applied in such cases has become known as "gifting." See e.g. In re SPM Mfg. Corp., 984 F.2d 1305 (1st Cir. 1993), In re MCorp Financial, Inc., 160 B.R. 941 (S.D. Tex. 1993); In re Genesis Health Ventures, Inc., 266 B.R. 591, 618 (Bankr. D.Del. 2001);  In re Parke Imperial Canton, Ltd., 1994 WL 842777 (Bankr. N.D. Ohio 1994); In re Journal Register Company, 407 B.R. 520 (Bankr. S.D.N.Y. 2009).

2 In SPM, an undersecured bank, holding liens on substantially all of a Chapter 11 debtor's assets, reached an agreement with the committee of unsecured creditors, which provided that, among other things, the assets of the estate would be sold, the case would be converted to Chapter 7, and the bank would carve out funds to be paid directly to the committee for distribution to the unsecured creditors. Through this arrangement, the parties avoided transferring the funds to the debtor's estate (which would have required that the funds be paid to priority tax claimants ahead of the other unsecured creditors).  The First Circuit held that the agreement was valid. The court reasoned that because the bank was undersecured and the validity of its lien was undisputed, the debtor's estate had no right to share in the proceeds of the bank's collateral, and, correspondingly, the court had no basis under the Bankruptcy Code to order the bank to pay a portion of its claim proceeds to the estate.  Id. at 1313-1315.