Chapter II Commencing Litigation

• Jurisdiction: United States

Chapter II Commencing Litigation

A. Choice of Forum: Federal or State Court

As set forth in Chapter I, an action for fraudulent conveyance is a longstanding state law remedy, and in current practice fraudulent conveyance claims are asserted under both state and federal law, in both state and federal courts. Consideration of whether to initiate litigation in federal or state court involves issues of jurisdiction and strategy.

The first question a practitioner should examine in addressing this question is whether federal court is available as an option — i.e., whether jurisdiction exists in federal court. For some fraudulent conveyance actions, the answer will be readily apparent. For example, for intentional and constructive fraudulent conveyance actions asserted under the avoidance sections of the Bankruptcy Code (e.g., §§ 548 and 544), a jurisdictional basis exists for commencing litigation in federal court because Congress has so provided.⁵⁶

Federal jurisdiction over the Code's avoidance actions may be thought of as a specifically enumerated form of federal question jurisdiction. More broadly, where an action involves federal claims or otherwise presents a federal question, jurisdiction may exist over related state law claims in the case under a theory of supplemental jurisdiction.⁵⁷

Where only state law fraudulent conveyance claims are being asserted, diversity jurisdiction may yet provide a basis for federal jurisdiction.⁵⁸ Further, a practitioner will want to examine whether federal jurisdiction exists under a targeted statute, such as the Class Action Fairness Act (CAFA)⁵⁹ or the Edge Act.⁶⁰

Where jurisdiction arguably exists in both state and federal courts, strategic considerations will come into play. As with any choice-of-forum issue, the practitioner will want to consider how the course of litigation is likely to be affected by the choice of forum — i.e., the expertise of the bench, the rules and practices that shape the scope of discovery, the speed with which the litigation will proceed, the rules and procedures governing trial, and the nature of the appellate process. Further, the practitioner should consider the options and responses available to defendants, including removal of a state court action to federal court.⁶¹

Where a case involving fraudulent conveyance claims proceeds in federal court, it will often implicate questions of bankruptcy court jurisdiction and the proper division of authority and labor between the bankruptcy and district courts. That issue is addressed in the subsequent section.

B. Bankruptcy Courts' Authority to Adjudicate Fraudulent Transfer Actions

Fraudulent transfer claims often are a prominent aspect of litigation in bankruptcy courts. Nevertheless, the constitutional underpinnings of bankruptcy court authority to resolve such claims are murkier than many practitioners have understood, at least prior to the decision of the Supreme Court in Stern v. Marshall, 131 S. Ct. 2594, 2611 (2011). That decision forced the constitutional issue to the fore and has engendered a range of further practical and theoretical questions and responses from the courts.

1. Bankruptcy Court Authority and Article III Concerns

District courts have "original and exclusive jurisdictions of all cases under [the Bankruptcy Code]."⁶² The bankruptcy courts "may hear and determine all cases under title 11 and all core proceedings arising under title 11, or arising in a case under title 11," upon referral by a district court.⁶³ Pursuant to such statutory authority, bankruptcy courts have overseen and adjudicated fraudulent conveyance litigation before them for decades.

Bankruptcy courts are not Article III courts, however. Article III of the Constitution provides that judges exercising "the judicial Power of the United States ... shall hold their Offices during good Behaviour [and] receive for their Services[] a Com-pensation[] [that] shall not be diminished."⁶⁴ Bankruptcy court judges do not meet this criteria, as they are appointed to 14-year terms by the courts of appeals for the circuits in which their districts are located.⁶⁵

Article III criteria provide a bedrock separation-of-powers requirement intended to protect the independence of the judiciary from encroachments by the legislative and executive branches, and therefore Congress may not "withdraw from judicial cognizance any matter which, from its nature, is the subject of a suit at the common law, or in equity, or admiralty."⁶⁶ Only Article III judges may resolve such suits.⁶⁷

a. The "Public Rights" Exception

Although it might appear in light of these principles that bankruptcy courts, as non-Article III courts, lack constitutional authority to resolve the litigations before them, in fact much of their work may fall within a "public rights" exception to the Article III rule, and it is on this basis that Congress and the courts have historically proceeded.

The Supreme Court has characterized "public rights" cases as "those arising between the Government and persons subject to its authority in connection with the performance of the constitutional functions of the executive or legislative departments.... [W]hat makes a right 'public' rather than private is that the right is integrally related to particular federal government action."⁶⁸

In 1982, the Supreme Court in the Northern Pipeline case considered whether the Bankruptcy Act of 1978 contravened Article III principles through its delegation to the bankruptcy courts the power to determine a state law contract claim against an entity that was not otherwise part of the bankruptcy proceedings.⁶⁹ A majority of the Court, while not agreeing on the scope of the public rights exception, found that the statutory grant of power exceeded Article III.⁷⁰

Following Northern Pipeline, Congress in 1984 revised the statutes governing bankruptcy jurisdiction and bankruptcy judges, providing that the newly constituted bankruptcy courts could enter final judgments only in certain statutorily defined "core" proceedings.

b. Core vs. Non-Core: Statutory Definitions

Congress has broadly defined those matters that are "core" and thus intended to be subject to final adjudication by the bankruptcy courts, enumerating a nonexclusive list of 16 types of proceedings.⁷¹ The matters include what one court has characterized as the bankruptcy courts' "bread and butter."⁷² This broad and nonexclusive listing of statutorily "core" matters thus includes not only matters such as administration of the bankruptcy estate and adjudication of claims against the estate, but also matters such as "proceedings to determine, avoid, or recover fraudulent con-veyances."⁷³

Under the statute, if the case is core, the bankruptcy court may make a final determination.⁷⁴ If the case is non-core (but otherwise related to a case under title 11), the bankruptcy court's adjudicative authority is limited to submitting proposed findings of fact and conclusions of law to the district court for its consideration, unless the parties otherwise consent.⁷⁵ Any objections to these proposed findings are subject to de novo review by the district court.⁷⁶

c. Stern v. Marshall

The statutory distinction between core and non-core cases was intended to solve the constitutional Article III issue by allowing "public rights" matters to be adjudicated by the bankruptcy courts while reserving final adjudication in "non-core" matters to the Article III courts. In Stern, however, the Supreme Court indicated that Congress had not fully succeeded in placing only "public rights" matters in the core category.⁷⁷

In Stern, the Supreme Court considered the authority of a bankruptcy court to issue a final adjudication as to a state law counterclaim that would not be resolved in the adjudication of a proof of claim in the bankruptcy.⁷⁸ The matter was "core" by statute, but the Supreme Court found that it did not fall within the "public rights" exception to the Article III rule, and therefore final adjudication could be performed only by an Article III court:

Article III of the Constitution provides that the judicial power of the United States may be vested only in courts whose judges enjoy the protections set forth in that Article. We conclude today that Congress, in one isolated respect, exceeded that limitation in the Bankruptcy Act of 1984. The Bankruptcy Court below lacked the constitutional authority to enter a final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor's proof of claim.⁷⁹

Stern thus indicates that it is not sufficient for the bankruptcy court's final adjudica-tory authority that the matter be statutorily "core." The matter must also be constitutionally core — i.e., fall within the "public rights" exception to the Article III rule.

Notwithstanding the Supreme Court's statement in Stern that "[w]e do not think the removal of counterclaims such as [that at issue here] from core bankruptcy jurisdiction meaningfully changes the division of labor in the current statute,"⁸⁰ the decision has engendered a range of questions and judicial responses, often within the context of motions to withdraw the reference, discussed infra.

d. Exceptions to the "Public Rights" Limitation: Proof of Claim and Consent

Even if a cause of action is not a "public rights" matter, it may be suitable for final adjudication by a bankruptcy court if it falls within one of two circumstances: (1) it is necessarily resolved in adjudication of a proof of claim, or (2) it is adjudicated under consent of the parties.

i. Causes of Action Tied to Proofs of Claim Filed in the Bankruptcy Case

It appears to remain the case following Stern that a bankruptcy court may exercise final adjudication authority over a cause of action if that cause of action necessarily will be resolved in the course of resolving a proof of claim filed by a creditor.⁸¹ By filing a proof of claim, a creditor may bring itself voluntarily into the bankruptcy court with a claim the value...