Anna's Revenge, Episode I

We may be beginning to see the fallout from Stern v. Marshall, the Supreme Court case on bankruptcy jurisdiction courtesy of Anna Nicole Smith's bankruptcy. Last week, the U.S. Court of Appeals for the Seventh Circuit issued a broad decision that would call into question the power of the bankruptcy court to hear many state-law defenses to creditor's claims in bankruptcy. To the best of my knowledge, this is the first court of appeals decision applying Stern.

The Seventh Circuit, in a case called In re Ortiz, held the bankruptcy court could not hear claims that a health care company had violated Wisconsin state law by making bankruptcy court filings containing private medical information of bankruptcy debtors. The irony is that the bankruptcy court had found the debtors had failed to establish a claim under state law, thus making the Seventh Circuit's decision a victory for the debtors involved in that particular appeal. For other bankruptcy debtors, however, the Seventh Circuit's decision could hinder their ability to assert state-law defenses such as violations of state UDAP laws (unfair deceptive acts and practices laws).

In Stern, the Supreme Court ruled that the bankruptcy court could not exercise jurisdiction over a state-law counterclaim Smith filed against her deceased husband's son. The son alleged Smith had tortiously interfered with his inheritance and had filed a claim in her bankruptcy case. Because federal bankruptcy courts are not full-fledged Article III courts, staffed by judges appointed by the president and holding life-tenure, a bankruptcy court could not hear Smith's counterclaim, which was a traditional state-law claim.

The legal answer to any of these problems is to have the federal district courts hear claims the bankruptcy courts cannot. Because federal district courts are full-fledged Article III courts, they clearly have the power to rule on any claim arising in or related to a bankruptcy case. This answer, however, is more theoretical than practical. District courts have standing orders to refer all bankruptcy cases to bankruptcy courts precisely because there are not enough district court judges to handle the enormous docket load from the bankruptcy system. Sure, individual matters in bankruptcy cases can be referred back to the district courts, but even referrals of individual matters will be expensive and full of delay.

Stern thus promised to gum up the works for bankruptcy debtors, but just how much gum had been stuck into the system depended on how one read the Supreme Court's opinion. Legal scholars disputed the breadth of the Stern decision, which the Court itself had characterized as "narrow."

Legal eagles might assert that just how narrow depends a lot on the technicalities of federal courts law. But, here is a secret. Federal courts law does not actually exist. It is something we made up to help the federal courts run better. Federal courts law is no more or no less than what the federal courts say it is.

Commentators generally agreed that the bankruptcy courts would "fix" Stern by issuing pragmatic rulings that respected the basic holding of Stern while keeping in mind the practical problems that an overly broad reading would create. My concern was expressed as follows:

Anna's case, or Stern v. Marshall as it will go down in history, could make life a little tougher for bankruptcy courts and consumer debtors as they try to wrestle with the implications of the majority's reasoning. I predict that lower courts, who are probably more concerned with keeping the system working than federal courts theory, will try to interpret the decision narrowly. My musings above will be worst-case scenarios that will not come to pass in the short run. As time goes by and cases work their way up the federal court appellate structure, Anna's case could have significant effects on practice in the federal bankruptcy courts.

In a probably undeserved self-congratulatory moment, I will say that the Seventh Circuit has done exactly what I feared. The case has moved up the federal system where it got heard by judges less familiar with the day-to-day workings of the bankruptcy system. The Seventh Circuit suggests that bankruptcy courts will lack the power to hear most claims arising between private parties disputing interests defined by state law (slip opinion at p. 14), which would seem to encompass most any claim based on state law.

For those who doubt the breadth of the Seventh Circuit's decision, consider that it involves a lawsuit of allegedly wrongful conduct during the filing of a proof of claim in a bankruptcy case. The bankruptcy court was hearing a matter that involved policing its own docket. The Seventh Circuit even holds that the lawsuit "arises under" bankruptcy law and would not exist but for the bankruptcy case. If such a lawsuit cannot be heard by a bankruptcy court, what sort of suit can?