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Supreme Court Agrees to Consider Constitutional Authority of Bankruptcy Courts a Third Time

July 3, 2014 by Tyson A. Crist, Partner
Supreme Court Agrees to Consider Constitutional Authority of Bankruptcy Courts a Third Time
Certiorari granted to review Seventh Circuit decision
I was wrong.  The saga continues.  In my last post I predicted it would be another seventeen years or so—another cicada cycle—until we heard from the Supreme Court again on the constitutional authority of bankruptcy courts, following the somewhat curt decision in Executive Benefits Insurance Agency v. Arkison issued on June 9, 2014.  Instead, it will be later this year or next.
On July 1, 2014, the Supreme Court granted certiorari to review two of four questions presented on appeal from the Seven Circuit Court of Appeals’ decision in Wellness International Network, Limited v. Sharif, 727 F.3d 751 (7th Cir. 2013), reh’g en banc denied, (Oct. 7, 2013).  (No. 13-935.)  Those questions are: (1) whether the presence of a state property law issue means that an action does not “stem from the bankruptcy itself,” in the parlance of Stern; and (2) whether under Article III bankruptcy courts can enter final judgments based on litigant consent, and if so, whether the consent can be implied?  The Supreme Court had previously granted certiorari in Arkison to consider the second of these questions—the consent to jurisdiction question—but then declined to address it.
If you have followed my previous posts, you know that this constitutional uncertainty emanates from the Supreme Court’s 2011 decision in Stern v. Marshall, 131 S. Ct. 2594 (2011).  In that case, the Court found that part of the bankruptcy court procedures statute (28 U.S.C. § 157) enacted by Congress was unconstitutional under Article III of the Constitution.  Fundamentally, the Court found that a bankruptcy judge, who is appointed under Article I, not III, had exceeded the bounds of this constitutional authority—had stepped into Article III territory—when he entered a final judgment on a state law counterclaim asserted by a debtor to augment the bankruptcy estate.  Stern, 131 S. Ct. at 2618.  The Supreme Court had said its ruling in Stern would “not change all that much,” but since then every level of the federal judiciary, including bankruptcy courts, district courts, circuit courts of appeal and the Supreme Court, have all had to spend untold hours and pages sorting out the implications of Stern on the constitutional authority of bankruptcy courts to rule on each type of dispute that comes before them.  Stern, 131 S. Ct. at 2618.  The Court’s grant of certiorari to review the Wellness International Network opinion is just the latest episode in this continuing saga.
In its reply brief in support of certiorari, Petitioner argued that the “Seventh Circuit’s decision threatens the efficient operation of the bankruptcy system at its very core.”  (Reply Br. at 2.)  It did so, the Petitioner argued, by concluding that: (1) bankruptcy courts cannot constitutionally decide what property belongs to the bankruptcy estate under Section 541(a) when there is an ancillary issue of state law that must be decided; and (2) debtors who file bankruptcy and submit their property to the bankruptcy court jurisdiction have not thereby consented to the entry of final judgments by the bankruptcy court.
At first glance the Seventh Circuit’s ruling, as it is described in the Petition, seems wrong.  And since it was issued last August, there have already been no less than seven opinions disagreeing with, distinguishing, or calling it into doubt.  See, e.g., In re Fundamental Long Term Care, Inc., 501 B.R. 770 (Bankr. M.D. Fla. 2013); In re Doctors Hosp. of Hyde Park, Inc., 507 B.R. 558 (Bankr. N.D. Ill. 2013); Equip. Acq. Res., Inc., 2014 WL 2746708 (Bankr. N.D. Ill. Jun. 18, 2014).  Before this ruling it had been pretty much taken for granted that state law property determinations fell squarely within the bankruptcy courts’ exclusive jurisdiction over property of a bankruptcy estate under 28 U.S.C. § 1334(e)(1).  See Tyson A. Crist, Stern v. Marshall: Application of the Supreme Court’s Landmark Decision in the Lower Courts, 86 Am. Bankr. L.J. 627, 669 (2012) (“Bankruptcy Courts have also not hesitated to enter final judgments in matters that, although they might entail state law, are essential to the functioning of the bankruptcy process, such as . . . determining what is property of the estate under § 541” (citing Velo Holdings Inc. v Paymentech, LLC (In re Velo Holdings Inc.), 475 B.R. 367, 387 (Bankr. S.D.N.Y. 2012) (holding that such determinations are “an essential part of administration of the bankruptcy and stems from the bankruptcy itself.”))).
So, what’s this all about?  Much like the sordid facts that spawned the Supreme Court’s ruling in Stern, the Sharif case has a long and sordid history.  Suffice it to say that this involved an adversary proceeding filed by a creditor of Mr. Sharif, the debtor, in which the creditor, Wellness International Network (“WIN”) argued that certain property should be brought into the bankruptcy estate because it was actually owned by Mr. Sharif through an alter-ego.  Sharif, 727 F.3d at 757 (“Count V sought a declaratory judgment . . . that the Soad Wattar Trust is Sharif’s alter ego and that its assets should therefore be treated as part of Sharif’s bankruptcy estate.”).  So, it was an alter-ego (or veil piercing) state law claim brought by a creditor to augment the existing bankruptcy estate.[1]  In contrast, Counts I through IV of the Complaint concerned the creditor’s objection to Mr. Sharif’s discharge.  Mr. Sharif conceded the bankruptcy court had authority to enter a final judgment on those claims under Section 727 of the Bankruptcy Code.  Viewed in this light, and given its similarities to Stern, it is not hard to envision the Court agreeing with the Seventh Circuit that this was just another state law claim over which a bankruptcy court could not enter final judgment due to Article III of the Constitution.  This is why Wellness may well provide the Supreme Court with the opportunity to now weigh in on the issue of whether parties can consent to have a bankruptcy court enter a final judgment on a claim for which it could not otherwise do so.  This is the issue Arkison left unresolved, on which there is split among the circuit courts of appeal—the Fifth, Sixth and Seventh Circuits holding consent does not permit bankruptcy courts to enter final judgments on Stern-type claims, while the Ninth Circuit has ruled it does.
The second question on which the Supreme Court granted certiorari concerns whether Mr. Sharif waived his rights under Article III, § 1 of the Constitution to have this case adjudicated by a district court, rather than a bankruptcy court.[2]  He may well have waived his right by filing bankruptcy.  More importantly, however, is the question of whether this was his right to waive.  This question is subsumed within the second question—does the structural integrity of our constitutional government preclude Mr. Sharif, as well as any other litigants, from waiving this right.  In other words, is 28 U.S.C. § 157(c)(2), which permits litigants to consent to final judgments of bankruptcy courts on claims that would otherwise have to be decided by the district courts, unconstitutional?  This, my friend, could impact the division of labor between the bankruptcy and district courts.
After examining the Sixth Circuit’s decision in Waldman v. Stone and the Ninth Circuit’s ruling in Bellingham Insurance Agency (which gave rise to the Supreme Court’s subsequent ruling in Arkison), the Seventh Circuit concluded that the Sixth Circuit “has the better view under current law” because the Supreme Court has held that 28 U.S.C. § 157(b) violates the structural protections of Article III, § 1, such that “a litigant may not waive an Article III, § 1 objection to a bankruptcy court’s entry of final judgment in a core proceeding.”  Sharif, 727 F.3d at 773.
Hopefully, this time the Supreme Court will reach the issue of consent and provide the lower courts, practitioners and academics alike with some concrete guidance.  This will also help to inform pending changes to the Federal Rules of Bankruptcy Procedure, also spawned by Stern.  Stay tuned.
[1]      Contrary to what you would presume after reading the Petitioner’s statement of the questions presented, the Seventh Circuit did not address whether the subject property was property of the bankruptcy estate within the context of Section 541(a).  Instead, the creditor had brought a state law alter-ego claim against the debtor.  And on appeal of the default judgment granted against Mr. Sharif as a discovery sanction, the Seventh Circuit held:
In almost all material respects, WIN’s alter-ego claim is indistinguishable from the tortious-interference counterclaim in Stern, the fraudulent-conveyance claim in Granfinanciera, the contract claim in Northern Pipeline, and the disclosure claims in Ortiz.  The alter-ego claim is a state-law claim that does not involve “public rights.”  . . . .  Instead, it is a commonlaw claim for which state law provides the rule of decision, and it is intended only to augment the bankruptcy estate. 
Wellness Int’l Network, Ltd., 727 F.3d at 774.
[2]      Interestingly, in WIN’s statement of the questions presented, it noted that although item (2) above was already before the Supreme Court in the Arkison case, WIN basically predicted that the Supreme Court would not resolve that issue in ruling on Arkison.  (Pet. for Writ at iii. (“Because of the procedural posture of [Arkison]—there the district court reviewed the bankruptcy court’s summary judgment order de novo—it is possible that the Court may conclude that no constitutional violation occurred and thus, not reach the issues on which certiorari was granted.  In such event, this case presents the opportunity to address those questions, about which there is also a split among the circuits.”).

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