Still Trying to Close the Stern v. Marshall Can of Worms – The Supreme Court to Grapple Again With Thorny Questions of Bankruptcy Court Jurisdiction

Still Trying to Close the Stern v. Marshall Can of Worms – The Supreme Court to Grapple Again With Thorny Questions of Bankruptcy Court Jurisdiction

 by Ben Feder

Three years ago, in Stern v. Marshall, a case that arose out of the endless litigation between Anna Nicole Smith and the son of her late husband, the Supreme Court stunned the commercial legal community by reopening what many had believed were long-settled questions regarding the constitutionality of the United States bankruptcy courts [an enhanced version of this opinion is available to lexis.com subscribers]. Although the Court’s opinion in Stern purported to be limited, its analysis made clear that the jurisdictional underpinnings of the entire bankruptcy court system rested on shaky ground. Since then, practitioners and lower courts have struggled to deal with the ramifications of that decision.

In essence, courts created by Congress pursuant to its powers under Article I of the Constitution (which includes the power to establish uniform laws on bankruptcy), rather than under Article III, are limited to territorial courts, military tribunals, and courts created to hear cases involving “public rights” (e.g., cases involving claims of citizens against the government). Claims of citizens against one another under state law, such as for breach of contract or common torts, are “private rights” that must be heard by an Article III judge. It had long been believed, however, since the Supreme Court last invalidated the grant of jurisdiction to the bankruptcy courts in 1982 [Northern Pipeline Construction Co. v. Marathon Pipe Line Co. et al. enhanced version] and Congress responded with the Bankruptcy Reform Act of 1984, that disputes pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” constituted the type of “public rights” that could be heard and decided by an Article I bankruptcy judge.

Stern v. Marshall upended this understanding of bankruptcy court authority and made clear that the scope of what constitutes a “public right” susceptible to final determination by an Article I judge was far narrower than previously understood. The Court in Stern described the query for constitutional purposes as “whether the action at issue stems from the bankruptcy itself [i.e., Congress’s bankruptcy power under Article I].”  If the matter would exist under state law “without regard to any bankruptcy proceeding,” then it is a “private right” upon which an Article I bankruptcy judge cannot make a final ruling.

The Court granted certiorari last year in the bankruptcy case of Executive Benefits Insurance Agency v. Arkison. The Ninth Circuit held in Executive Benefits that the entitlement to have a “private right” dispute heard by an Article III judge was an individual right that could be waived. Many observers believed, based on Stern, that the Supreme Court in Executive Benefits would either strike down or substantially limit the power of U.S. bankruptcy court judges to render final determinations in matters before them. Relief was therefore palpable in the bankruptcy bar after a unanimous Court instead issued a narrow decision that substantially ignored the constitutional questions stemming from Stern [enhanced version].

The Court, however, only postponed the inevitable need to articulate the full scope of Stern. Because Executive Benefits did nothing to clarify the two crucial issues raised by Stern – the extent of what constitutes a “public right” in the context of a bankruptcy proceeding, and whether the right to have a matter heard by an Article III judge is an individual right that can be waived – the Court ensured that uncertainty would continue to hover over the jurisdiction of bankruptcy courts. Likely recognizing this, only a few weeks after its ruling in Executive Benefits, the Court has given itself another chance to consider those questions, granting certiorari in Wellness International Network v. Sharif

Wellness International stems from Sharif’s personal bankruptcy case, which he filed after Wellness International obtained a substantial judgment against him. Wellness International brought an action before the bankruptcy court, challenging Sharif’s claim that certain assets were property of a separate trust and thus excludable from the bankruptcy estate under Section 541(a) of the Bankruptcy Code. The bankruptcy court found in favor of Wellness International, and Sharif appealed. He claimed, among other things, that in the wake of Stern v. Marshall, the bankruptcy court lacked the constitutional authority to enter a final judgment, because the question of ownership of the supposed trust assets was purely an issue of state law, independent of federal bankruptcy law. He also argued that the right to a determination of this issue by an Article III court was not a right that could be waived, not even by a debtor that expressly sought the jurisdiction of an Article I bankruptcy court by filing a bankruptcy petition. The Seventh Circuit ruled for Sharif on these points. 

Wellness International highlights the inherent conundrum posed by Stern with respect to bankruptcy court jurisdiction. The Bankruptcy Code gives the bankruptcy courts power over all property of a debtor’s estate under Section 541(a). Determining what constitutes property of a debtor’s bankruptcy estate is indisputably fundamental to “the restructuring of debtor-creditor relations.”  But the Supreme Court has expressly stated in other cases that property rights in bankruptcy are based on state law. State-law issues are an inseparable part of virtually every bankruptcy case. For purposes of determining “public” and “private” rights, which aspect of such adjudications should control? 

The Supreme Court’s answer will determine whether the current structure of the bankruptcy courts remains viable.

 Read more articles at Kelley Drye & Warren LLP’s Bankruptcy Law Insights blog.

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