Stern with a Twist: Supreme Court to Consider Constitutional Authority of Bankruptcy Courts

The Supreme Court has an opportunity to clarify the constitutionality of the allocation of power between federal district courts and bankruptcy courts. On July 1, 2014, the Supreme Court granted certiorari in Wellness International Network, Ltd. v. Sharif[1] to address the following:

(1) Whether the presence of a subsidiary state property law issue in an 11 U.S.C. § 541 action brought against a debtor to determine whether property in the debtor's possession is property of the bankruptcy estate means that such action does not "stem[] from the bankruptcy itself" and therefore, that a bankruptcy court does not have the constitutional authority to enter a final order deciding that action; and

(2) Whether Article III permits the exercise of the judicial powers of the U.S. by the bankruptcy courts on the basis of litigant consent, and if so, whether implied consent based on a litigant's conduct is sufficient to satisfy Article III.

Background

The case before the Supreme Court stems from a decade-long discovery dispute. The debtor, Sharif, entered into distributorship contracts with Wellness International Network, Ltd. ("WIN") for the sale of health and wellness products. Sharif ultimately sued WIN alleging that WIN was running a pyramid scheme. He ignored WIN's discovery requests, resulting in material facts being deemed admitted against him. The district court granted WIN's motion for summary judgment and ultimately awarded WIN $655,596.13 in attorney's fees.

Sharif ignored WIN's post-judgment discovery, and after being held in contempt, filed bankruptcy in the Northern District of Illinois. WIN filed a proof of claim, which included an approved loan application showing that Sharif possessed assets worth over $5 million. Sharif claimed that he lied on the loan application and that the assets on the application did not belong to him but were owned by a trust, of which he was a trustee.

WIN initiated an adver­sary proceeding asserting an alter-ego claim, as well as nondischargeability causes of action, primarily claiming that Sharif made false statements in connection with his case. Sharif refused to comply with discovery requests and did not produce documentation relating to the trust account. The bankruptcy court entered a default judgment against Sharif on all counts of the adversary proceeding and ordered Sharif to pay WIN’s attorney’s fees.

Sharif initially appealed but did not challenge the bankruptcy court’s authority to enter final judgment. However, four months after Sharif appealed, his sister filed a motion to with­draw the reference, arguing that the bankruptcy court lacked jurisdiction to enter final judgment on the adversary complaint under Stern. The district court denied the motion and affirmed the bankruptcy court's judgment, holding that objections based on the bankruptcy court’s authority to enter a final judgment are waivable because they do not implicate subject-matter jurisdiction. Sharif appealed to the Seventh Circuit.

Seventh Circuit's Analysis

The Seventh Circuit held that a constitutional objection to a bankruptcy court’s entry of final judgment is not waivable because it implicates separation-of-powers principles. The court noted that Stern v. Marshall addressed only a bankruptcy court’s statutory authority, but Sharif's argument addressed the bankruptcy court’s constitutional authority. The Seventh Circuit further noted that other por­tions of Stern v. Marshall cast doubt on whether waiver and consent have a role in bankruptcy due to the fact that creditors are required to go to bankruptcy court to pursue claims.

The Seventh Circuit noted that WIN's alter-ego claim was a state-law claim between private parties wholly independent of federal bankruptcy law and not resolved through the claims-allowance process. The bankruptcy court lacked constitutional authority to enter final judgment on the alter-ego claim.

The court then grappled with the question of the proper remedy. The court said that the district court shall first determine whether the alter ego claim is core or noncore. If it is noncore, then the district court can treat the bankruptcy court order as proposed findings of fact and conclusions of law to be reviewed de novo. If it is core, then it shall order that the reference be withdrawn and conduct fresh discovery proceedings in district court.

In October 2013, the Seventh Circuit denied a petition for rehearing en banc and the Supreme Court subsequently granted certiorari.

Supreme Court Issues

The parties dispute the extent of the bankruptcy court's authority to decide a state law issue. WIN contends that it was permissible for the bankruptcy court to decide that the property for which Sharif was a trustee is part of the bankruptcy estate. Sharif argues that the alter ego claim is not a core claim and therefore is exclusively within the jurisdiction of an Article III court.

The parties also dispute whether the parties can consent to the bankruptcy court adjudicating an alter ego claim. WIN contends that the right to Article III adjudication protects personal interests and is therefore waivable. Sharif argues that this is a separation of powers issue that cannot be waived.

The Supreme Court now has the opportunity to define the scope of a bankruptcy court's jurisdiction and address the issue of consent.  In Stern v. Marshall, the Supreme Court held that bankruptcy courts lacked constitutional authority to enter a final judgment on a debtor's state law counterclaim.  However, the court did not address whether litigants can confer such authority on a bankruptcy court, either through express or implied consent.  The Supreme Court had an opportunity to reach the consent issue in Executive Benefits Insurance Agency v. Arkinson but "reserve[d] that question for another day."[2]  That day has arrived.

[1]727 F.3d 751 (7th Cir. 2013).

[2] See a discussion of Arkinson at https://www.krcl.com/insights/closing-the-gap-the-supreme-court-holds-that-bankruptcy-courts-should-enter-proposed-findings-of-fact-and-conclusions-of-law-for-stern-claims/).

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