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Stern v. Marshall: The opening act

In its June 2011 decision in Stern v. Marshall, the Supreme Court placed new restrictions on bankruptcy courts by holding that bankruptcy courts did not have jurisdiction to enter final orders on state law counterclaims brought against creditors. The Court viewed its decision as likely to have narrow implications, as evidenced by Chief Justice Roberts’ query “[i]f our decision today does not change all that much, then why the fuss?” Subsequent lower court decisions have made it clear, however, that the ramifications of the Stern v. Marshall decision have been anything but narrow. Recently, the Court has agreed to review another case involving jurisdictional issues. Its decision is likely to further narrow bankruptcy courts' jurisdiction and thereby cause changes in the way bankruptcy cases are managed.

The facts of Stern v. Marshall are simple, though torrid, and arise out of the infamous Anna Nicole Smith bankruptcy case. In that case, Ms. Smith’s much older son-in-law had filed a claim contending that Ms. Smith defamed him by inducing her lawyers to tell members of the press he had engaged in fraud to gain control of his father’s assets. Ms. Smith then countersued claiming Mr. Marshall (the son-in-law) had indeed engaged in fraud and, therefore, Ms. Smith was entitled to half of her late husband’s massive fortune. Under 28 U.S.C. 157(b), which articulates when a bankruptcy court may enter a final order, Ms. Smith’s counterclaim against a creditor who had filed a proof of claim was considered “core,” which allowed the bankruptcy court to enter a final judgment. The bankruptcy court used that power to rule for Ms. Smith.

By the time the question reached the Supreme Court, the issue to be decided was not defamation, fraud or state law inheritance rights, but whether the bankruptcy court had the ability to enter a final judgment on a debtor’s counterclaim. Under the Supreme Court’s long-standing interpretation of Article III of the Constitution, Article III courts are the only federal courts that may enter final judgments in matters “which, from [their] nature, [are] the subject of a suit at the common law, or in equity, or admiralty.” In order for a court to be an Article III court, the judge must be given life tenure and salary protection (among other requirements). Bankruptcy courts are not Article III courts. The Supreme Court held that the bankruptcy court did not have the authority to rule on Ms. Smith’s counterclaim because it was not an Article III court. It attempted to reassure that the holding was limited only to section 157(b)’s labeling of counterclaims as “core” and not the other “core” provisions of section 157(b), of which there are sixteen.

Immediately after the decision, numerous commenters raised warning flags. While the Court’s holding had narrow immediate consequences, the logic behind the opinion threatened numerous “core matters” under section 157(b). Many highlighted that issues involving fraudulent transfers, another “core matter,” were the most susceptible to challenge. Just two years after the Supreme Court announced its decision in Stern, it has decided to hear Executive Benefits Insurance Agency v. Arkison, a case questioning a bankruptcy court’s ability to enter a final order in a fraudulent transfer case. The question then is whether or not a “fuss” is justified this time.

EBIA v. Arkison: What to expect from Stern's sequel

Arkison presents a much more common story than Stern, and could therefore have an even wider impact. Nicholas Paleveda and his wife, Marjorie Ewing, operated two closely related companies. The first, ARIS, designed and administered defined-benefit pension plans. The second, BIA, sold insurance and annuity products that funded those plans. Paleveda owned 100 percent of ARIS and Ewing owned 80 percent of BIA. The companies shared office space and a phone number. Because ARIS lacked sufficient assets to operate independently, it routed all of its income and expenses through BIA, kept joint accounting records with BIA and declared its income on consolidated tax returns with BIA. However, when BIA became insolvent, the company irrevocably assigned the insurance commissions from one of its largest clients to Peter Pearce, a longtime employee. The day after BIA stopped operating, Paleveda used remaining BIA funds to incorporate a new company, EBIA. During the next six months, during which BIA filed for bankruptcy under chapter 7 of the Bankruptcy Code, EBIA and Pearce deposited more than $300,000 dollars of insurance proceeds into a joint account held by EBIA and ARIS. The trustee in BIA’s bankruptcy case, Peter Arkison, filed a complaint against EBIA and ARIS, claiming that these deposits were a fraudulent conveyance. The bankruptcy court granted summary judgment, which is a final order, in favor of Arkison. The district court affirmed. When EBIA eventually appealed to the Ninth Circuit, it raised an objection to the bankruptcy court entering a final order for the first time, citing Stern.

The Ninth Circuit’s opinion in Arkison has three main holdings:

  • First, following the logic of Stern, the Court held that the bankruptcy court did not have jurisdiction to enter a final order.
  • The second issue focused on what the bankruptcy court did have authority to do. Under section 157(c), a bankruptcy court may either enter proposed findings of fact and law, which are then reviewed by a district court before becoming final, or it may, only if all the parties consent, enter a final order in a “non-core” issue. When a bankruptcy court drafts proposed findings of facts and law, it submits those findings to the district court in a process referred to as bifurcation. The district court then reviews the proposal without giving any deference to the submitting bankruptcy court. After Stern’s holding, and its own holding regarding fraudulent conveyances, the Ninth Circuit had to determine what authority a bankruptcy court had when it was constitutionally prohibited from entering a final order on a “core” matter. The Ninth Circuit determined that the solution was to treat these issues as if they were “non-core.” This would allow a bankruptcy court to enter proposed findings of fact and law or, if all the parties consented, allow a bankruptcy court to enter a final order.
  • The third issue the Ninth Circuit faced is whether or not the absence of objection constitutes consent to have the bankruptcy court enter a final order. The Ninth Circuit held that such an absence did equate to consent.

The ramifications of the Supreme Court’s eventual decision in Arkison could be monumental. The Ninth Circuit based its third holding on Stern’s assertion that section 157 “does not implicate questions of subject matter jurisdiction” and previous Supreme Court rulings that “as a personal right, Article III’s guarantee of impartial and independent federal adjudication is subject to waiver.” If the Supreme Court retreated from these sentiments, and held that even with consent a bankruptcy court cannot enter a final judgment on a non-core issue, then every non-core issue would have to be bifurcated between the bankruptcy court and the district court. This would cause significant delays and added cost to any bankruptcy case. The Supreme Court could hold more narrowly, and require affirmative consent to a bankruptcy court’s ability to enter a final order. Before it reaches those issues, however, the Supreme Court will need to determine whether fraudulent conveyance claims have the same Article III character as the claims in Stern.

If the Supreme Court continues its trend and holds that bankruptcy courts may not issue final orders in cases involving fraudulent transfers without consent (or perhaps even with consent), then the importance of competent bankruptcy counsel only increases. The bifurcation of cases between bankruptcy courts and federal district courts can dramatically increase the costs of bankruptcy if not properly managed. With careful planning, foresight and the proper combination of bankruptcy and constitutional acumen, debtors can mitigate, and even avoid, the costs imposed.

For more information, please contact:

Shawn M. Riley

T. Daniel Reynolds

The twists and turns of business restructuring are complex and demanding. Our attorneys approach every case with creativity and insight to ensure the solutions are cost-effective and practical. At every turn, you can be confident that our attorneys will guide you through the process, always providing practical and informed advice. We are positioned to respond to the special demands of a variety of matters in a wide range of industries, including health care, automotive, retail/distribution, real estate/construction, telecommunications, and mining/exploration.