12.2 Sovereign Immunity

• Library: Bankruptcy Practice in Virginia (Virginia CLE) (2017 Ed.)

12.2 SOVEREIGN IMMUNITY

12.201 Statutory Framework. Section 8 of Article I of the United States Constitution provides that "[t]he Congress shall have Power . . . to establish . . . uniform Laws on the subject of Bankruptcies throughout the United States."

The Eleventh Amendment provides that "[t]he Judicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by citizens of another State, or by citizens or subjects of any Foreign State."

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Section 106 of the Bankruptcy Code provides that

(a) Notwithstanding an assertion of sovereign immunity, sovereign immunity is abrogated as to a governmental unit to the extent set forth in this section with respect to the following:

(1) Sections 105, 106, 107, 108, 303, 346, 362, 363, 364, 365, 366, 502, 503, 505, 506, 510, 522, 523, 524, 525, 542, 543, 544, 545, 546, 547, 548, 549, 550, 551, 552, 553, 722, 724, 726, 744, 749, 764, 901, 922, 926, 928, 929, 944, 1107, 1141, 1142, 1143, 1146, 1201, 1203, 1205, 1206, 1227, 1231, 1301, 1303, 1305, and 1327 of this title.

(2) The court may hear and determine any issue arising with respect to the application of such sections to governmental units.

. . .

(b) A governmental unit that has filed a proof of claim in the case is deemed to have waived sovereign immunity with respect to a claim against such governmental unit that is property of the estate and that arose out of the same transaction or occurrence out of which the claim of such governmental unit arose.

(c) Notwithstanding any assertion of sovereign immunity by a governmental unit, there shall be offset against a claim or interest of a governmental unit any claim against such governmental unit that is property of the estate.

12.202 Central Virginia Community College v. Katz. ²⁰ In this case, a Chapter 11 trustee brought an adversary proceeding to avoid preferential transfers by a debtor to various state institutions of higher learning. The state colleges moved to dismiss on grounds of sovereign immunity, which was denied by the bankruptcy court and affirmed by the district court and the Sixth Circuit Court of Appeals. In a 5-4 decision, the United States

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Supreme Court held the bankruptcy trustee's power to set aside preferences to a state agency is not barred by the doctrine of sovereign immunity. Rejecting the implications of Seminole Tribe v. Florida, ²¹ the Court found that the adoption of the Bankruptcy Clause in Article I of the Constitution was for the purpose of preventing state interference with a bankruptcy discharge. Bankruptcy jurisdiction as understood at the constitutional framing is in rem and, therefore, does not implicate state sovereignty as much as other types of jurisdiction. The power granted to Congress includes the power to prevent assertion of sovereign immunity as ancillary to in rem adjudications, and the states agreed in the plan of the Constitutional Convention not to assert immunity. Therefore, to the majority, the correct question is not whether Congress' attempt to abrogate sovereign immunity in section 106(a) of the Bankruptcy Code is valid, but whether "Congress' determination that the [s]tates should be amenable to preferential transfer proceedings is within the scope of its power to enact '[l]aws on the subject of Bankruptcies.'" ²² The Court found such power is within Congress' power, which is derived from the Bankruptcy Clause itself and the plan of the Constitutional Convention.

The dissent argued that the states are not subject to suit by private parties absent their consent or a valid Congressional abrogation and that nothing in Article I of the Constitution establishes these preconditions. The dissenters further asserted that the Constitution merely established federal power to legislate in the area of bankruptcy and did not manifest an intention to waive sovereign immunity.

12.203 Lower Court Decisions Interpreting Katz.

A. In re French. ²³ In this case, a Chapter 7 trustee brought an adversary proceeding under section 548 to set aside a transfer of property from the debtor to her children. The Fourth Circuit focused on the extraterritorial effect of the Bankruptcy Code and whether the Bankruptcy Code should defer to Bahamian law because the property which was the subject of the transfer was located in the Bahamas. The fact that Congress had shown its affirmative intention that property of the estate should be available for creditors meant that the Bankruptcy Code law on fraudulent transfers rather than Bahamian law would apply. Relying on Katz and its statement that "the

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Framers' primary goal was to prevent competing sovereign's interference with a debtor's discharge," the Fourth Circuit determined that United States law, not Bahamian law, should apply.

B. In re Supreme Beef Processors, Inc. ²⁴ In this case, a trustee brought suit against the United States Department of Agriculture for tortious interference with existing contracts and other related causes of action. The Fifth Circuit analyzed section 106 in detail and held that Katz has no effect on the waiver of federal sovereign immunity. The Fifth Circuit noted that section 106(a) distinguishes between sovereign immunity for suit and immunity from liability. Sections 106(b) and (c) vest the bankruptcy court with jurisdiction to hear certain claims but do not create substantive nonbankruptcy law that will govern a claim. These sections waive sovereign immunity for compulsory counterclaims to governmental claims and permissive counterclaims to governmental claims capped by a setoff limitation. The grant of jurisdiction to entertain such claims is wholly distinct from an abrogation of all defenses to a claim. Applicable state law or federal law governs counterclaims and offset claims. Accordingly, the trustee has no claim for offset against the federal government, because any such claim was barred under the discretionary function exception and the intentional torts exception of the Federal Tort Claims Act.

C. In re Soileau. ²⁵ In this case, the court found that obtaining a discharge for amounts owed to a state on bail bonds did not infringe on the sovereignty of the state.

D. In re Mini. ²⁶ In this case, the plaintiffs sued the California Board of Equalization, claiming that it had violated a discharge injunction in attempting to collect discharged responsible officer sales tax obligations. Sovereign immunity did not protect the arm of the state from an award for damages and attorney fees for its violation.

E. In re Automotive Professionals, Inc. ²⁷ In this case, the court found that sovereign immunity cannot be asserted as a defense to a turnover request from a bankruptcy trustee.

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F. In re Kids World of America, Inc. ²⁸ In this case, a debtor brought a turnover action against the State of Georgia, seeking money owed pursuant to an asserted contract for services. The State of Georgia sought summary judgment on the defense of sovereign immunity. The court held that Katz abrogates sovereign immunity in these types of matters.

G. In re Kids World of America, Inc. ²⁹ In this case, the court determined that a turnover action brought by the debtor against the State of Georgia was a core matter. The court noted that the turnover action could have been brought as a breach of contract action in a state court. The court relied on Katz, which dealt with a preference action to hold that the state had abrogated sovereign immunity in a contract action that could have been brought in state court.

H. In re Bluewater Palmas Ltd (RM). ³⁰ In this case, Blue Water Funding sought interest on a judgment under 28 U.S.C. § 1961 against the Department of Treasury of the Commonwealth of Puerto Rico. The Department of Treasury argued that it did not waive sovereign immunity by filing a proof of claim. The court held that it is well settled that a state waives its sovereign immunity when it files a proof of claim, which is akin to participation in the case.

I. In re Davis. ³¹ In this case, the State of Texas filed a complaint asserting that the debtor's obligation to the State of Texas was not subject to discharge without the state's consent because of sovereign immunity. The court held that a discharge proceeding is an in rem proceeding similar to the in rem proceeding described in Katz. The debtor was not seeking monetary damages or affirmative relief from the state. Moreover, the filing of the adversary proceeding objecting to the discharge waived the state's sovereign immunity.

J. In re El Comandante Management Co. ³² In this case, the court found that eminent domain power is different from a state's police and regulatory power. Actions to acquire property by eminent domain are not

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excepted from the automatic stay. In order to come within the police and regulatory power exception to the automatic stay the action must be in furtherance of public health, safety, or welfare.

K. In re Quality Stores, Inc. ³³ In this case, a Chapter 11 debtor brought an adversary proceeding against the Vermont Department of Taxes to recover sales tax overpayments. Vermont argued that Katz is limited to in personam proceedings which are necessary to effectuate the bankruptcy court's in rem jurisdiction and that an action for tax refund is not an in rem...