LawFlash

Stern v. Marshall: Supreme Court Limits Bankruptcy Court Jurisdiction Over State-Law Counterclaims

June 29, 2011

On June 23, 2011, the Supreme Court decided Stern v. Marshall, 564 U.S. ___ (2011), which as a practical matter may significantly limit the litigation of state-law claims in bankruptcy courts, and eliminates the previous risk that creditors, by the mere act of filing claims, submit to bankruptcy court jurisdiction with respect to all counterclaims of the debtor. The Court held that, regardless of the authority given by federal statute, bankruptcy courts lack the constitutional authority to enter a final judgment on certain state-law claims asserted by a debtor as counterclaims to a proof of claim. As a constitutional matter, bankruptcy courts now may enter a final judgment only over counterclaims that (i) arise directly out of bankruptcy law or (ii) are so factually intertwined with the proof of claim that they would necessarily have to be resolved in the claims allowance process. The Court did not address the bankruptcy court’s jurisdiction over matters “related to” bankruptcy proceedings, for which current federal law authorizes a cumbersome process in which a bankruptcy court may propose findings of fact and conclusions of law, subject to de novo review in the district courts.

This decision pares down the bankruptcy court’s power to enter final judgments in state-law disputes in connection with the claims allowance process. Prior to this ruling, conventional wisdom was that a claimant who filed a proof of claim thereby submitted to the jurisdiction of the bankruptcy court, opening itself to adjudication by a bankruptcy judge of any counterclaim that could be asserted by a debtor. The decision in Marshall will result in more creditor claims being filed in bankruptcy court, fewer litigations of state-law counterclaims conducted there, and, possibly, a less-coordinated, longer bankruptcy process for all parties.

Background

Stern v. Marshall resolves an epic dispute between Vickie Lynn Marshall, a.k.a. Anna Nicole Smith, and Pierce Marshall, regarding the estate of J. Howard Marshall, Vickie’s deceased husband and Pierce’s father. In the midst of probate litigation in Texas, Vickie filed for bankruptcy in California. Pierce filed a claim in the bankruptcy, alleging that Vickie defamed him by persuading her lawyers to state to members of the press that he had engaged in fraud to gain control of the assets of Howard. Vickie filed a counterclaim against Pierce’s proof of claim asserting tortious interference with a gift that she expected to receive from Howard.

In November 1999, the Bankruptcy Court for the Central District of California granted summary judgment in favor of Vickie on the defamation claim and, after a bench trial, issued a final judgment awarding her hundreds of millions of dollars in damages on her counterclaim. Pierce appealed on numerous grounds, including that the Bankruptcy Court lacked jurisdiction to enter a final judgment on Vickie’s counterclaim. Pursuant to 28 U.S.C. § 157, bankruptcy courts may hear and enter final judgments in core proceedings in a bankruptcy case. In non-core proceedings that are “related to” a bankruptcy case, bankruptcy courts may only submit proposed findings of fact and conclusions of law to the district court for review and final judgment. 

On appeal, the District Court for the Central District of California reversed the Bankruptcy Court’s holding, finding that the counterclaim was not core because it was not sufficiently related to Pierce’s defamation claim. The District Court treated the Bankruptcy Court’s judgment as proposed, not final, and considered it de novo. Before the District Court entered final judgment, a Texas probate court conducted a jury trial on the merits of the parties’ dispute over Howard’s estate and entered a judgment in Pierce’s favor. The District Court nonetheless decided the counterclaim for Vickie after another bench trial and awarded her nearly $90 million in compensatory and punitive damages.

The Court of Appeals for the Ninth Circuit reversed, agreeing with the District Court that the Bankruptcy Court lacked authority to enter final judgment on Vickie’s counterclaim because the counterclaim “was not so closely related to [Pierce’s] proof of claim that the resolution of the counterclaim is necessary to resolve the allowance or disallowance of the claim itself.” However, because the Texas probate court’s judgment was the earliest final judgment on matters relevant to the counterclaim, the Court of Appeals held that the District Court should have given the state judgment preclusive effect and ruled in Pierce’s favor. 

Supreme Court Decision

The Supreme Court concluded that the Bankruptcy Court was authorized to exercise jurisdiction over Vickie’s counterclaim by 28 U.S.C. § 157(2)(C), which purports to confer core jurisdiction with respect to “counterclaims by the estate against persons filing claims against the estate.” However, in cases like Marshall, the Court found this to be an unconstitutional grant of jurisdiction to a non-Article III court.

Article III of the Constitution permits Congress to establish the federal courts, and, as a separation of powers matter, confers on the judiciary exclusive jurisdiction over “cases and controversies,” which include suits at “common law, or in equity, or admiralty.” The Court reaffirmed that the bankruptcy court falls outside of the Article III judiciary. As the Court explained in Marshall, Congress may confer jurisdiction on bankruptcy courts to decide certain matters involving “public rights.” The Northern Pipeline1 case, a seminal decision declaring certain jurisdictional provisions of the Bankruptcy Act of 1978 unconstitutional, acknowledged that the Constitution would permit bankruptcy courts to exercise such jurisdiction. But in Marshall, the Court has limited the public rights exception to “cases in which the claim at issue derives from a federal regulatory scheme [such as the Bankruptcy Code], or in which resolution of the claim by an expert government agency is deemed essential to a limited regulatory objective within the agency’s authority.” The Court viewed Vickie’s counterclaim in Marshall as materially indistinguishable from the state-law claims at issue in Northern Pipeline, and therefore held that these claims did not fall within the “public rights” exception.

The Court also rejected Vickie’s argument that, by filing his proof of claim, Pierce had voluntarily submitted to the jurisdiction of the Bankruptcy Court. It articulated two instances where a bankruptcy court would have jurisdiction to issue final judgment on a counterclaim: (1) where the debtor is asserting a right of recovery that was created by federal bankruptcy law; or (2) where the counterclaim is so factually intertwined with the proof of claim that the counterclaim would necessarily have to be resolved as part of the claims allowance process. In Marshall, Vickie’s counterclaim was a state tort action that would have existed in the absence of any bankruptcy proceeding. Moreover, Vickie’s counterclaim could not be resolved “in passing on objections” to Pierce’s claim, but required the Bankruptcy Court to make several additional factual and legal determinations, including “(1) the existence of an expectancy of a gift; (2) a reasonable certainty that the expectancy would have been realized but for the interference; and (3) damages,” as well as determining whether punitive damages were warranted. 

Observations

Stern v. Marshall could have broad implications on a bankruptcy court’s ability to issue final judgments on matters involving state law, or that otherwise do not arise out of federal bankruptcy law. With respect to counterclaims, Marshall holds that state-law claims can be finally adjudicated by a bankruptcy court only where there is a close nexus between the facts or legal issues underlying both the proof of claim and the debtor’s counterclaim. Outside of the claims allowance process, the decision appears to eliminate a bankruptcy court’s power to exercise core jurisdiction over state-law causes of action on the theory that collection of the claim might augment the bankruptcy estate. While a bankruptcy court can still exercise “related to” jurisdiction over state-law claims (including counterclaims), this allows it only to issue proposed findings of fact and conclusions of law that must be considered de novo by the district court.2 In short, the ruling could have the effect of lengthening the bankruptcy process or, as a practical matter, causing debtors to pursue affirmative state-law claims outside of the bankruptcy court.

Moreover, because the decision addresses the jurisdictional power of the bankruptcy court under the Constitution, it will have retroactive effect, and even in decided matters, litigation may now arise contesting certain orders as void.

For assistance, please contact the following lawyers in the Financial Restructuring Group:

Jeffrey S. Sabin, Co-Chair, Financial Restructuring Group
jeffrey.sabin@bingham.com, 212-705-7747

Sabin Willett, Partner, Financial Restructuring Group
sabin.willett@bingham.com, 617-951-8775

Andrew J. Gallo, Partner, Financial Restructuring Group
andrew.gallo@bingham.com, 617-951-8117


1 Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982).

2 Prior to Marshall, under Second Circuit and other law, a bankruptcy court typically would determine all matters, even in the face of a jury trial demand, up to but not including trial. Marshall now raises questions as to whether bankruptcy courts may still make these determinations.

This article was originally published by Bingham McCutchen LLP.