Chapter III Constitutional and Practical Problems

• Jurisdiction: United States

III. Constitutional and Practical Problems

Stern v. Marshall: A Constitutional Conundrum¹

Written by:
David P. Leibowitz
Lakelaw; Chicago

Alittle more than three months since the U.S. Supreme Court issued its opinion in Stern v. Marshall,² it has been analyzed exhaustively. The court has declared that a state law counterclaim to a proof of claim is not within the constitutional jurisdiction of the bankruptcy court, and that such a counterclaim must be heard by an Article III judge or a state court judge. To better understand Stern, it is useful to review the historical background of bankruptcy jurisdiction from the U.S. Constitution through Northern Pipeline Constr. Co v. Marathon Pipe Line Co.,³ examine how Stern differs from Marathon, and consider the implications of Stern for bankruptcy administration.

In the Beginning

The U.S. Constit-ution declares that "Congress shall have Power... To establish an (sic) uniform Rule of Naturalization, and uniform Laws on the Subject of Bankruptcies throughout the United States."⁴ The U.S. Supreme Court has inferred much from this sentence. The Court observed in Tennessee Student Assistance Corporation v. Hood that "[a] bankruptcy court is able to provide a debtor a fresh start, despite the lack of participation of all of his creditors, because the court's jurisdiction is premised on the debtor and his estate, and not on the creditors."⁵ Further examining bankruptcy's constitutional foundations in Central Virginia Community College v. Katz,⁶ the Court held that the Constitution authorized bankruptcy courts to abrogate sovereign immunity so as to allow a bankruptcy trustee to avoid preferential transfers to a state agency. The Court has stated that bankruptcy jurisdiction is, at its core, in rem.⁷ In determining bankruptcy jurisdiction, the Court has included the critical features of all bankruptcy cases, including exclusive jurisdiction over all of the debtor's property, equitable distributions to creditors, and a discharge affording the debtor a fresh start.⁸

The opinion in Katz observed that even early bankruptcy administration reflected enactment of statutes in 1800⁹ allowing for appointment of bankruptcy commissioners by the district court. These commissioners had the power to issue orders ancillary to enforcement of their in rem jurisdiction.¹⁰ Taking into account the historical and federalist context in which the Bankruptcy Clause was adopted, the Court in Katz concluded that states had agreed to abrogation of their sovereign immunity to the extent necessary for bankruptcy administration as a part of the plan of the Constitutional Convention.

Bankruptcy Act of 1898

Summary and Plenary Jurisdiction

The bankruptcy commissioners provided for under the 1800 act evolved to become bankruptcy referees under the 1898 Bankruptcy Act of 1898.¹¹ Under the 1898 Act, in force until enactment of the Bankruptcy Code in 1978,¹² referees in bankruptcy decided contested matters arising in bankruptcy cases. The referees had summary jurisdiction with respect to some matters but not others. A bankruptcy referee had summary jurisdiction to decide disputes if (1) it involved property in the actual or constructive possession of the bankruptcy estate; (2) the third party consented to exercise of the bankruptcy court's jurisdiction; or (3) it was invoked by a nondebtor through a counterclaim. All other jurisdiction was plenary and required determination by a federal or state court with full or plenary authority.¹³ However, if only plenary jurisdiction existed, then the contested matter had to be resolved in the non-bankruptcy court, which ordinarily would have heard such a matter. This often resulted in delay and expense to all parties.

Summary jurisdiction was quite limited and existed only as to property in the actual or constructive possession of the bankruptcy court if the third party consented to jurisdiction or over a counterclaim asserted by the third party.¹⁴ Even though it was clear that jurisdiction existed with respect to a compulsory counterclaim, it remained unclear as to whether a bankruptcy court had summary jurisdiction with respect to a permissive counterclaim.¹⁵ The distinction between summary and plenary jurisdiction led the 1970 Commission on Bankruptcy Laws of the United States to conclude:

The most serious objection to the division of jurisdiction is the frequent, time-consuming, and expensive litigation of the question whether the bankruptcy court has jurisdiction of a particular proceeding... Even when the trustee is likely to prevail in a contest over whether the bankruptcy court has jurisdiction, the adversary by merely litigating the issue of jurisdiction may gain most of the advantages he would get if he won on the jurisdictional issue, viz, time and bargaining leverage against the trustee. Thus, the adversary has a strong incentive to press his jurisdictional objections to the bankruptcy court's jurisdiction up through the appellate courts.¹⁶

In this context, the commission recommended that the bankruptcy court should be established under Article III of the Constitution.¹⁷ However, Congress did not accept that recommendation, ultimately setting the stage for the Stern decision.

Marathon

The Supreme Court in Northern Pipeline Constr. Co v. Marathon Pipe Line Co.¹⁸ addressed the constitutionality of granting non-Article III bankruptcy judges broad jurisdictional authority to hear all civil proceedings arising under the Bankruptcy Code, as well as controversies arising in or related to cases under the Code. In Marathon, Northern Pipeline was a debtor in chapter 11 that sued Marathon for breaches of contract, breaches of warranty and other causes of action. Marathon moved to dismiss on the ground that it would be unconstitutional to allow a non-Article III bankruptcy judge to try this case.

The Court focused on the importance of separation of powers. In particular, it focused on the importance of lifetime tenure of Article III judges, which bankruptcy judges do not have.¹⁹

Is the bankruptcy court a "legislative court" that may be established under Article I of the Constitution? This question turns on whether only "public rights" are being adjudicated.²⁰ In this case, the Court held that Congress cannot withdraw from judicial determination those matters that are in the nature of common-law rights, equity or admiralty rights; such matters must be judicially determined. However, public rights might be determined by legislative courts. The "public rights" doctrine is expressed as involving the interplay between the doctrine of sovereign immunity and the principle of separation of powers. However, matters that are "inherently judicial" were to be decided exclusively by Article III courts in the federal system.

The Court in Marathon also declined to find authority for bankruptcy courts in Article I, § 8, clause 4 of the Constitution. To allow this would allow congressional action to fully swallow up judicial authority, so the Court held the scheme of bankruptcy court jurisdiction unconstitutional and gave Congress more than two years to try to reconstitute the bankruptcy court system in a constitutional manner.

Congress Tries to Fix Marathon Problem

In 1984, Congress enacted the Bankruptcy Amendments and Federal Judgeship Act of 1984 (BAFJA). Pursuant to BAFJA, all bankruptcy cases were deemed to be within the district courts' jurisdiction. The district courts could refer any or all bankruptcy cases to the bankruptcy judges of their respective district, and could also withdraw the reference for cause shown. Bankruptcy judges were authorized to consider and enter final judgments on 16 enumerated types of core proceedings. If the bankruptcy judge considered noncore proceedings, the judge could only submit proposed findings of fact and conclusions of law to the district court for entry of a final judgment based on de novo review.

But in Granfinanciera SA v. Nordberg,²¹ the Court rejected the trustee's argument that a fraudulent-conveyance action filed against a noncreditor in a bankruptcy proceeding fell within the "public rights" exception. Such a claim was more like a common-law claim or state law contract claim, the Court held. Accordingly, Granfinanciera was entitled to all the benefits and protections of Article III of the Constitution, including the right to a jury trial before an Article III judge.

Stern; Déjà vu All Over Again

Holding that a bankruptcy court does not have the constitutional jurisdiction to consider a state law counterclaim filed by a trustee or debtor in response to a proof of claim filed by a creditor—even though such a matter is within the statutory core jurisdiction of the bankruptcy court—the Supreme Court asserted its zealous protection of Article III courts' prerogatives even more emphatically than it did in Marathon.

The Court in Stern noted that under the Bankruptcy Act, bankruptcy referees could exercise summary jurisdiction over preference claims where necessary to determine proofs of claims, citing Katchen v. Landy.²² This did not mean, however, that filing a proof of claim in the bankruptcy court constituted consent to the bankruptcy court's jurisdiction in a counterclaim filed by the debtor or trustee in response to that proof of claim, and Katchen had expressly declined to reach that question.²³

In Stern, the bankruptcy court made factual and legal determinations beyond those necessary in connection with the determination of the underlying claim. It went beyond its role as a bankruptcy tribunal and usurped the role of a judicial tribunal, the Stern opinion stated.²⁴

It made no difference to the Court that the judicial tribunal whose role was being usurped was a Texas state court—a court whose judges do not enjoy Article III status either, and indeed, a court whose judges do not have lifetime tenure. Justice John Roberts, speaking for the Court, was unconvinced that the decision in Stern would impose delay and cost upon the bankruptcy...