Circuits Split Over Impact of Stern on Counterclaims

Circuits Split Over Impact of Stern on Counterclaims

Following last year's Stern v. Marshall bombshell, cases are slowly trickling up to the Court of Appeals level. After I wrote about a recent Fifth Circuit opinion which held that the jurisdiction of U.S. Magistrate Judges was not invalidated, a commenter pointed out a recent Seventh Circuit decision. In this post, I will look at that case, In re Ortiz, 665 F.3d 906 (7th Cir. 2011) [an enhanced version of this opinion is available to lexis.com subscribers / unenhanced version available from lexisONE Free Case Law], in which the Seventh Circuit granted a direct appeal and then concluded that it did not have a final decision to review, as well as an even more recent First Circuit case which appears to reach the opposite conclusion.

The Seventh Circuit Undoes a Direct Appeal

Ortiz involved a health care provider that filed proofs of claim in an estimated 3,200 bankruptcy cases in the Eastern District of Wisconsin over a five year period which disclosed the debtors' confidential medical information. Two sets of debtors filed class action proceedings under a Wisconsin non-disclosure statute.* Bankruptcy Judge Susan Kelley** granted summary judgment for the health care provider, finding that the debtors had not shown actual damages as required by the Wisconsin statute. Both parties requested a direct appeal to the Seventh Circuit, which was approved. However, in light of Stern v. Marshall, the Seventh Circuit concluded that it was not permitted to allow the direct appeal because there was not a "final" order.

Direct appeals to the Court of Appeals are authorized under 28 U.S.C. §158(d) [an annotated version of this statute is available to lexis.com subscribers] in three instances:

*Final orders;

*Interlocutory orders increasing or decreasing the debtor's exclusive period to file a plan; and

*With leave of court over interlocutory orders and decrees.

Even though no party had raised the jurisdictional issue, the Court concluded that it had "an independent duty to determine whether we have jurisdiction."

The Court noted the schizophrenic nature of the Stern decision which, on the one hand, claims to be a narrow decision, but on the other hand, appears to prohibit the bankruptcy courts from going beyond the power to adjudicate claims. The Court wrote:

The first question (whether the bankruptcy court had authority to enter a final order) requires a close reading of Stern v. Marshall. Although the Court noted that the question presented was "narrow," it was quite significant as Congress "may no more lawfully chip away at the authority of the Judicial Branch than it may eliminate it entirely." (citation omitted). The Court held that Article III prohibited Congress from giving bankruptcy courts authority to adjudicate claims that went beyond the claims allowance process. (citation omitted). The decision rebuffed an intrusion into the Judicial Branch that would "compromise the integrity of the system of separated powers and the role of the Judiciary in that system, even with respect to challenges that may seem innocuous at first blush." (citation omitted).

665 F.3d at 911.

Prior to Stern, the bankruptcy court's authority would have appeared clear for this was a matter "arising in" a title 11 case. Because proofs of claim only exist in title 11 proceedings, claims arising from proofs of claim could only arise in the bankruptcy context. However, the Court found that the Wisconsin non-disclosure claims were similar to the counterclaim filed by Vicki Lynn Marshall in the Stern case:

Just as Pierce's filing of a proof of claim in Vickie's bankruptcy did not give the bankruptcy judge authority to adjudicate her counterclaim, Aurora's act of filing proofs of claim in the debtors' bankruptcies did not give the bankruptcy judge authority to adjudicate the debtors' state-law claims. The debtors' claims seek "to augment the bankruptcy estate--the very type of claim that . . . must be decided by an Article III court." (citation omitted). Non-Article III judges may hear cases when the claim arises "as part of the process of allowance and disallowance of claims," (citation omitted), or when the claim becomes "integral to the restructuring of the debtor-creditor relationship," (citation omitted). Although there is some factual overlap between the debtors' claims and Aurora's proofs of claim, the bankruptcy judge "was required to and did make several factual and legal determinations that were not 'disposed of in passing on objections' to" Aurora's proofs of claim. (citation omitted). In granting Aurora's summary judgment motion, the bankruptcy judge interpreted a Wisconsin state law to require proof of actual damages as an essential element of the debtors' claims and found that there was no genuine issue of material fact as to the lack of actual damages. Nothing about these decisions involved an adjudication of Aurora's proofs of claim and there is no "reason to believe that the process of adjudicating [Aurora's] proof[s] of claim would necessarily resolve" the debtors' claims. (citation omitted). Stern reaffirmed that "Congress may not bypass Article III simply because a proceeding may have some bearing on a bankruptcy case; the question is whether the action at issue stems from the bankruptcy itself or would necessarily be resolved in the claims allowance process." (citation omitted). The debtors' action owes its existence to Wisconsin state law and will not necessarily resolve in the claims allowance process. That the circumstances giving rise to the claims involved procedures in the debtors' bankruptcies is insufficient to bypass Article III's requirements. Stern v. Marshall makes plain that the bankruptcy judge in our cases "exercised the 'judicial Power of the United States' in purporting to resolve and enter final judgment on" the debtors' Wisconsin state-law claims. (citation omitted). We thus hold that the bankruptcy judge lacked authority under Article III to enter final judgments on the disclosure claims.

665 F.3d at 914.

The Court of Appeals concluded that because the bankruptcy court lacked authority to enter a final order, that it lacked authority to grant a direct appeal. If the court had stopped there, its decision would have been clear. However, it added a cryptic comment suggesting that the bankruptcy court lacked any authority in the matter:

For the bankruptcy judge's orders to function as proposed findings of fact or conclusions of law under 28 U.S.C. § 157(c)(1), we would have to hold that the debtors' complaints were "not a core proceeding" but are "otherwise related to a case under title 11." (citation omitted). As we just concluded, the debtors' claims qualify as core proceedings and therefore do not fit under § 157(c)(1). The direct appeal provision in 28 U.S.C. § 158(d)(2)(A) also does not authorize us to review on direct appeal a bankruptcy judge's proposed findings of fact and conclusions of law.

665 F.3d at 915.

Many commentators have concluded that the Stern decision created a third category of claims to the core/non-core taxonomy: core claims in which the bankruptcy court could not enter a final judgment. The prevailing sentiment, indeed one fostered indirectly by the Stern decision itself, is that the bankruptcy courts may enter proposed findings of fact and conclusions of law in all matters in which they lack authority to enter a final judgment. The Ortiz opinion suggests that this may not be the case, but finds it unnecessary to decide the issue.

The First Circuit Shrugs Off Stern in a Footnote

The Ortiz opinion can be contrasted with a brief discussion contained in a First Circuit opinion. In re Divittorio, 2012 U.S. App. LEXIS 248 (1st Cir. 1/6/12) [enhanced version / unenhanced version]. In re Divittorio is another chapter in the home mortgage wars being fought in the courts. In that case, the debtor consented to an order conditioning the automatic stay and modifying the underlying loan. After the debtor defaulted, the creditor obtained relief from the automatic stay. The debtor then sought to "rescind" the loan. He filed an adversary proceeding for rescission under the Massachusetts Consumer Credit Cost Disclosure Act and sought to vacate the order lifting the automatic stay. The bankruptcy court declined to vacate the prior order, but stayed the foreclosure for 90 days to determine the rescission claim. The bankruptcy court concluded that the creditor had not violated the MCCCDA and the debtor appealed.

In a footnote, the court noted its belief that its jurisdiction was unimpaired.

We do not believe that the Supreme Court's recent decision in Stern v. Marshall, 131 S. Ct. 2594, 180 L. Ed. 2d 475 (2011), affects the jurisdiction of the bankruptcy court to render a decision in this matter. Stern held:

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 (citation omitted).

Here, however, it first was necessary to resolve the validity of Mr. DiVittorio's claim under the MCCCDA to determine whether HSBC was entitled to relief from the automatic stay.

2012 U.S. App. LEXIS at *18, n. 4. The Court ultimately decided the appeal in favor of the creditor.

The First Circuit's discussion is rather unsatisfying because it assumes that determination of the counterclaim was necessary to determine the motion to lift stay. However, how is this distinguishable from the argument that the Wisconsin non-disclosure claims were necessary to determine proofs of claim filed by the health provider? If anything, the automatic stay context is less compelling than determination of a proof of claim, since a motion to lift stay is a summary proceeding. Grella v. Salem Five Cent Savings Bank, 42 F.3d 26 (1st Cir. 1994).

While the Court's stated rationale may be unsound, it can probably be vindicated based on consent, since both parties litigated the matter through the bankruptcy court, district court and court of appeals without objection. The Ortiz court rejected consent. However, that case was factually distinguishable because BOTH parties objected to determination by the bankruptcy court. The debtors asked the bankruptcy court to abstain or remand, while the creditor sought to withdraw the reference.

What It Means

The two decisions may or may not signal a split between the circuits. The First Circuit's decision is so perfunctory that it may be possible for the court to distinguish it away. However, the larger lesson for creditors is that Stern v. Marshall cuts both ways. If a creditor litigates and wins in bankruptcy court, an appellate court may decide that jurisdiction to enter a final judgment was lacking and send the creditor back to relitigate. Thus, the legacy of Stern may be unending litigation.

*--While Federal Rule of Bankruptcy Procedure 9037 imposes privacy restrictions with respect to bankruptcy court filings, including proofs of claim, courts are split over whether it creates a private right of action. Cases allowing a claim for sanctions, include Matthys v. Green Tree Servicing, LLC (In re Matthys), 2010 Bankr. LEXIS S.D. Ind. 2010); French v. American General Financial Services (In re French), 401 B.R. 295 (Bankr. E.D. Tenn. 2009), while cases rejecting such a right include Carter v. Flagler Hospital, Inc., 411 B.R. 730 (Bankr. S.D. Fl. 2009); Lentz v. Bureau of Medical Economics (In re Lentz), 405 B.R. 893 (Bankr. N.D. Ohio 2009); Cordier v. Plains Commerce Bank (In re Cordier), 2009 Bankr. LEXIS 2009).

**--Judge Kelley's current claim to fame is that she is the judge presiding over the case of the Archdiocese of Milwaukee. As a woman and a practicing Catholic, she is in the unusual position of exercising at least some temporal authority over the male hierarchy of her own church.

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