Supreme Court Decides to Maintain the Viability of the U.S. Bankrupt...

Four years ago, in Stern v. Marshall, the Supreme Court stunned many observers by re-visiting separation of powers issues regarding the jurisdiction of the United States bankruptcy courts that most legal scholars had viewed as long settled. Stern significantly reduced the authority of bankruptcy courts, and bankruptcy judges and practitioners both have since been grappling with the ramifications of that decision. It quickly became clear, notwithstanding the Court’s characterization of its holding in Stern as “narrow,” that the Court would need to address and clarify two key questions regarding the power of judges and courts created under Article I, rather than Article III, of the Constitution: the scope of what constitutes a “public right” in the context of bankruptcy that can be decided by an Article I judge, and whether the right to have a dispute determined by an Article III judge may be waived by consent

The Supreme Court this week, in Wellness International Network v. Sharif, answered one of those questions, and in doing so escaped somewhat from the formalistic straitjacket of Stern. The Court ruled that Article I bankruptcy judges can, with the knowing consent of the parties, issue final decisions on matters that would otherwise necessitate a ruling by an Article III judge. If the narrow view of the authority of bankruptcy judges articulated in Stern had prevailed in Wellness International, bankruptcy judges would no longer be able to make final rulings on issues as integral to the bankruptcy process as determinations regarding what constitutes property of the bankruptcy estate. If bankruptcy judges’ powers were so severely circumscribed, there would be little purpose served by having separate specialized bankruptcy courts. Simply put, in ruling as it did, the Court effectively preserved, for the time being, the viability of the United States bankruptcy courts. However, by leaving the other key question unanswered, the Court ensured that some uncertainty will continue to hover over issues of bankruptcy court jurisdiction.

To recap how the Supreme Court got itself to this point:

Under the U.S. Constitution, the “judicial power” of the United States can only be exercised by courts created under Article III. Among other things, judges of Article III courts have lifetime tenure in order to ensure judicial independence. Congress established the U.S. bankruptcy courts pursuant to its power to establish uniform laws on bankruptcy under Article I of the Constitution, rather than under Article III. U.S. bankruptcy judges are appointed for 14 year terms. A line of Supreme Court cases has limited the power of Congress to create courts pursuant to Article I, rather than under Article III, 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 since the Supreme Court last invalidated the grant of jurisdiction to the bankruptcy courts in 1982 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 a type of “public rights” that could be heard and decided by an Article I bankruptcy judge.

The Supreme Court surprised the commercial legal community in Stern by reopening the question of the constitutionality of the U.S. bankruptcy courts. The Court’s holding in Stern showed that the scope of what constitutes a “public right” susceptible to final determination by an Article I judge is 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 problem created by the Supreme Court’s ruling in Stern is this: 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?

Wellness International highlighted the ramifications of Stern’s cramped view of bankruptcy court authority. The case 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 his 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, 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 had expressly sought the jurisdiction of an Article I bankruptcy court by filing a bankruptcy petition. The Seventh Circuit agreed with Sharif on these points and reversed the bankruptcy court ruling.

The Court ruled yesterday that the right to have a dispute determined by an Article III judge may be waived by consent. Justice Sotomayor, writing for the majority, clearly recognized the implications of a ruling against Wellness International, not only for the bankruptcy courts but also for other Article I judges, such as the U.S. magistrates. She noted that Congress has authorized 534 U.S. magistrates and 349 bankruptcy judges, a combined total of 883 Article I judges that far exceeds the 677 Article III district court judges. In the one year period between October 1, 2013 and September 30, 2014, over 960,000 cases were filed in the bankruptcy courts, more than double the number of cases filed in U.S. district and circuit courts. Magistrates handle large numbers of federal misdemeanor cases and significant pretrial work in civil and felony criminal cases. In short, without the bankruptcy judges and magistrates, Justice Sotomayor observed, “the work of the federal court system would grind nearly to a halt.”

The Court did not, however, make a decision as to whether Sharif had, by voluntarily filing his bankruptcy case and invoking the authority of an Article I bankruptcy court, “knowingly and voluntarily consent[ed] to the adjudication by a bankruptcy judge.” The Court instead remanded the case to the Seventh Circuit to make that determination. If the Seventh Circuit decides that the act of filing of a bankruptcy petition in and of itself evinces consent, it would eliminate the power of any bankruptcy debtor to challenge bankruptcy court jurisdiction. If, however, the Seventh Circuit were to rule that simply commencing a bankruptcy case is not sufficient in and of itself, then the import of this case could be significantly limited.

More importantly, the Court avoided completely the crucial question as to the scope of what constitutes a “public right” in the context of bankruptcy; i.e., whether the dispute between Sharif and Wellness International regarding whether certain assets constituted property of Sharif’s bankruptcy estate “stem[med] from the bankruptcy itself.” There invariably will be cases going forward where the consent of a party to allow bankruptcy court adjudication will not exist. The question as to the types of matters that can be decided by an Article I judge will then need to be squarely addressed. Until the Supreme Court confronts and clearly delineates the extent of bankruptcy judges’ authority, some uncertainty will continue to hover over issues of bankruptcy court jurisdiction.