Foran Glennon Palandech Ponzi & Rudloff

August 2014

Supreme Court tries to clean up mess created by Stern v. Marshall

John Eggum

In 2011, the Supreme Court decided a case that created a massive amount of disarray and confusion in bankruptcy courts throughout the Country by (arguably) enhancing the ability – and making it frequently compulsory – for litigants to have non-bankruptcy matters filed in bankruptcy court transferred to federal district court.  Through its unanimous Bellingham decision, the Supreme Court took steps to fix some of the uncertainty caused by Stern v. Marshall.

The issue is: Can a bankruptcy court hear and enter final order on non-core matters, or should those matters be heard in district court.  Stern appeared to say that bankruptcy courts were compelled to grant motions to transfer to district court, and after Stern was decided, it became more routine for parties to file procedural motions to have bankruptcy-related, non-core litigation transferred to federal district court.  While such transfers (technically “withdrawals of the reference”) were historically permitted by statute, litigants and courts interpreted Stern as a change or at least shift in the law, compelling transfer in many cases.  In some situations, parties invoked Stern because they perceived the bankruptcy court as a disadvantageous forum in which to litigate their claims.  In other cases, transfer was sought simply because the parties believed that, consistent with Stern, the bankruptcy court lacked Constitutional authority to hear and decide their claims.  The practical result for district courts was the same: a massive increase in case load for some district judges.

Even before Bellingham, certain district courts had already been trying to deal with the effects of Stern through adopting local rules and standing orders to more efficiently handle the Stern-related caseload.  The Supreme Court’s decision in Bellingham is a strong signal confirming the appropriateness and validity of those efforts, and tacitly approving bankruptcy court’s retention of bankruptcy-related matters in bankruptcy court, even if Constitutional concerns require the bankruptcy judge to ask (“recommend”) to a district judge that a final judgment be entered in accordance with the bankruptcy judge’s findings.

The result of Bellingham is that litigants that prefer district court to bankruptcy court for non-core matters will have a more difficult time effecting transfer.  Parties that find themselves as defendants in bankruptcy court adversary proceedings and other bankruptcy-related litigation will likely find that procedural motions that were routinely granted in the period after Stern may now be denied, resulting in the proceeding remaining in the bankruptcy court.

Background: Stern v. Marshall.  Bankruptcy courts are courts of limited jurisdiction.  Unlike federal district courts, bankruptcy courts are Constitutionally prohibited from exercising the full judicial power of the United States.  Simply put, bankruptcy courts were created to deal with bankruptcies.  Because of this limited purpose, when bankruptcy courts are presented with certain non-bankruptcy issues, the Supreme Court has found that they do not have the power to fully and finally adjudicate those matters.  If bankruptcy courts could do everything that district courts could do, there would be no difference between bankruptcy courts and district courts, and that is not the system that the drafters of the Constitution intended.

The tension, of course, is that bankruptcy proceedings, by their nature, touch on all aspects of the debtor-creditor relationship, and therefore Congress has faced a recurring difficulty between balancing the need to grant bankruptcy courts sufficient power to restructure debts, and the need to restrain bankruptcy courts from doing those things which are reserved to district courts.

The current statutory system, which has been in place since the 1980s, addresses this need for balance by dividing bankruptcy proceedings into “core” and “non-core” proceedings.  Federal law provides that bankruptcy judges may hear and enter final judgments in all “core” proceedings (matters that are created by the Bankruptcy Code).  Correspondingly, for those matters that are not “core proceedings,” bankruptcy judges may not enter final judgments.  Instead, bankruptcy judges may only submit proposed findings of fact and conclusions of law to the applicable federal district court.  The federal district court may then enter a final judgment on the particular non-core matter (based upon those recommendations, or not, in the judgment of the district court).

In Stern v. Marshall, the Supreme Court found that the statute that defined “core” proceedings – the proceedings that bankruptcy courts are able to enter final judgments on – was flawed.  The Supreme Court found that certain proceedings that fell within the statutory definition of “core” were, in fact, not core proceedings.  Therefore, the Constitution prohibited bankruptcy judges from entering final judgments on these claims.

In Bellingham, the Court addressed what to do with these types of claims, referred to in Bellingham as “Stern claims.”

Facts of Bellingham.  Nicolas Paleveda and his wife owned and operated two companies – Aegis Retirement Income Services, Inc. (“ARIS”), and Bellingham Insurance Agency, Inc. (“Bellingham”).  In 2006, Bellingham became insolvent and ceased operations.  The next day, Paleveda used Bellingham funds to incorporate Executive Benefits Insurance Agency, Inc. (“EBIA”).  Paleveda and others initiated a scheme to transfer assets from Bellingham to EBIA.  The assets were deposited into an account held jointly by ARIS and EBIA, and ultimately credited to EBIA at the end of the year.

On June 1, 2006, Paleveda caused Bellingham to file a chapter 7 liquidation bankruptcy case in the United States Bankruptcy Court for the Western District of Washington.  Peter Arkison (“Arkison” or “Trustee”) was appointed as the chapter 7 bankruptcy trustee, and subsequently filed a lawsuit against Paleveda and others, alleging that Paleveda used various methods to fraudulently convey Bellingham assets to EBIA.  EBIA denied many of the Trustee’s allegations.

The Trustee filed a motion for summary judgment against EBIA in the Bankruptcy Court.  The Bankruptcy Court granted summary judgment for the trustee on all claims, including the fraudulent conveyance claims.  EBIA then appealed that determination to the District Court.  The District Court conducted de novo review, affirmed the Bankruptcy Court’s decision, and entered judgment for the trustee.

EBIA appealed to the United States Court of Appeals for the Ninth Circuit.  After considering Stern-related arguments, the Ninth Circuit affirmed.

DiscussionStern considered a Constitutional challenge to the statutory designation of a particular claim as “core.”  That claim was one for tortious interference, brought by the debtor as a counterclaim against a creditor of the bankruptcy estate.  Although the statute provides that “counterclaims by the [bankruptcy] estate against persons filing claims against the estate” are core proceedings, the Supreme Court held that, under the circumstances of Stern, they were not core proceedings.

Since Stern was decided, numerous courts, including the Ninth Circuit, suggested that the Supreme Court had created a “statutory gap” by finding that there were claims which fit the core label, but which were not actually core.  Lower courts, and the Paleveda/EBIA parties, argued that this “gap” prevented the Bankruptcy Court from taking any action on a Stern claim.  If this was correct, then the Bankruptcy Court erred in entering the summary judgment order, since it lacked Constitutional authority to enter any orders on a Stern claim due to the so-called gap.

The Supreme Court disagreed with Paleveda/EBIA, finding that the Bankruptcy Court was fully authorized to preside over the Trustee’s suit against Paleveda.  The Court determined that there was no gap created by Stern because a claim which was incorrectly labeled as “core” (because it was actually non-core) should be treated like any other “non-core” claim.  As provided in the statute, on a non-core claim, the bankruptcy court may hear the proceeding and submit proposed findings of fact and conclusions of law to the district court for de novo review and entry of judgment.

In the Bellingham case, the district court had, in fact, conducted de novo review because the Bankruptcy Court’s decision was entered on summary judgment.  Given the legal standard for such an order/judgment, even though the bankruptcy court did not specifically submit proposed findings of fact and conclusions of law, there was no reversible error.  The Supreme Court therefore affirmed the decision granting summary judgment to the Trustee.

Conclusion.  For a time, the Stern decision proved extremely helpful for litigants that wanted to have their claims adjudicated entirely before federal district courts.  Through Bellingham, the Supreme Court has shown that it did not intend to foce district courts to deal with all Stern claims in the first instance.  Instead, the traditional approach, whereby the bankruptcy court submits proposed findings of fact and conclusions of law to the district court, is to be utilized.  Following Bellingham, litigants can anticipate that even where a cause of action is merely “related” to a bankruptcy case – such as a breach of contract action or a declaratory judgment action – the bankruptcy court will preside over that action for all or substantially all of the proceeding.  Efforts may still be made to transfer a case out of the bankruptcy court in appropriate cases (such as where there are numerous non-bankrupt parties on both sides of the litigation), but in these circumstances, Bellingham gives strong arguments to the parties resisting transfer (technically, “withdrawal of the reference”).  This means that litigants may find themselves in bankruptcy court for the duration.

The case is: Executive Benefits Ins. Agency v. Arkison (In re Bellingham Insurance Agency, Inc.), 134 S. Ct. 2165 (2014).  See also Stern v. Marshall, 131 S. Ct. 2594 (2011).