Lest you thought you had heard the end of the Stern v. Marshall debate, two recent circuit court decisions remind us that Stern is alive and influential. In October, the Sixth Circuit weighed in on a bankruptcy court’s constitutional authority where it discharged certain fraudulent debts and awarded damages. In early December, the Ninth Circuit performed a similar constitutional analysis where the bankruptcy court decided a fraudulent transfer action against a noncreditor of the bankruptcy estate. Both courts relied heavily on Stern and its related line of cases, and provide new insight into its lingering impact.

The Sixth Circuit Decision

The case Waldman v. Stone, 2012 WL 5275241 (6th Cir., Oct. 26, 2012), began when Stone, a Chapter 11 debtor, brought an adversary proceeding against Waldman, his principal creditor. Stone scheduled Waldman’s secured claim as “disputed,” and instituted an adversary proceeding before Waldman had filed a proof of claim in the case. Stone requested that the Bankruptcy Court for the Western District of Kentucky (i) disallow Waldman’s claims on the basis that Waldman acquired such claims fraudulently, and (ii) award him affirmative damages. The bankruptcy court found that Waldman had perpetrated “one of the most egregious frauds [it] had ever encountered,” invalidated all of Stone’s obligations to Waldman, and awarded compensatory and punitive damages to Stone. The district court affirmed.

On appeal to the Sixth Circuit, Waldman challenged the jurisdiction of federal courts, in general, to decide Stone’s claims, contending that the claims did not “arise under” federal law. Waldman also challenged the statutory authority of the bankruptcy court and asserted that the bankruptcy court lacked constitutional power to enter judgment on Stone’s claims. The Sixth Circuit addressed each of these arguments in turn.

First, the Sixth Circuit concluded that Waldman’s objection to the jurisdiction of the federal courts was meritless. Constitutionally, even if Stone’s claims were based in state law, a federal court may adjudicate such claims based on the relationship to the bankruptcy. Under 28 U.S.C. § 1334(b), so long as Stone’s claims could have any effect on the bankruptcy estate, a federal court has jurisdiction. Here, Stone sought to disallow Waldman’s claim in the bankruptcy, and sought damages which, if awarded, would provide assets for his other creditors. Accordingly, Stone’s claims were “related to” the bankruptcy and a federal court had jurisdiction.

Second, the Sixth Circuit addressed Waldman’s assertion that the bankruptcy court could not enter a final judgment on Stone’s claims because those claims were not “core proceedings” under 28 U.S.C. § 157. The Sixth Circuit declined to address the merits of this objection, noting that Waldman’s own pleadings called Stone’s claims core, and accordingly, Waldman forfeited his objection to the bankruptcy court’s authority on that basis.

Finally, the Sixth Circuit took up Waldman’s contention that the bankruptcy court exercised Article III “judicial power” when it decided Stone’s claims, and thus exceeded its constitutional authority. Looking at Stone’s claims separately, and relying on Stern’s summary of the law on this issue, the Sixth Circuit decided the bankruptcy court could constitutionally enter a final judgment on Stone’s disallowance count. Recognizing that the Supreme Court has never expressly decided whether Article III allows a bankruptcy court decide on a debtor’s claim objections, the Sixth Circuit held that this function is of basic importance to bankruptcy administration and that the Supreme Court has “never intimated that Article III bars a bankruptcy court from” doing so. The Sixth Circuit was not bothered by the fact that Waldman had not actually filed a proof of claim in Stone’s bankruptcy case, noting that it was Waldman’s attempt to collect on Stone’s debts that pushed Stone into bankruptcy, that Waldman certainly would have filed a claim had Stone not filed an adversary proceeding first, and that Waldman was a secured creditor who was not required to file proof to preserve his claim.

In contrast, the Sixth Circuit compared Stone’s affirmative claims for damages to the counterclaim in Stern, which “arose exclusively under state law” and “existed without regard to any bankruptcy proceeding.” The affirmative claims, the Sixth Circuit noted, required Stone to prove facts beyond those crucial to his disallowance claim, and an adjudication of the affirmative claims would not necessarily resolve the allowance of Waldman’s claim. Therefore, the Sixth Circuit held that the bankruptcy court lacked jurisdiction to enter a final order on the damages requests, and requested that, on remand, the bankruptcy court “recast” its judgment on Stone’s affirmative claims into findings of fact and conclusions of law for the district court to review de novo.

The Ninth Circuit Decision

In In re Bellingham Insurance Agency, 2012 WL 6013836 (9th Cir., Dec. 4, 2012), the Ninth Circuit also examined the jurisdiction of bankruptcy courts post-Stern. In that case, the owners of related companies deposited commissions earned into an account held jointly by the companies, though one of the companies — BIA — was insolvent. The owners also used funds belonging to insolvent BIA to incorporate EBIA, a new, third company, and then transferred all commissions from the joint account to EBIA. After BIA filed for Chapter 7 in the Western District of Washington, the Trustee brought a fraudulent transfer action against EBIA and the other entity to recover the transfers. The bankruptcy court granted summary judgment for the Chapter 7 Trustee, holding that transfers to EBIA were fraudulent and that EBIA was liable as a “mere successor” to the debtor. The district court affirmed.

Here, the Ninth Circuit was presented with a slightly more succinct question related to Stern: can a bankruptcy court enter a final judgment in a fraudulent transfer case brought against a noncreditor to the bankruptcy estate? EBIA raised this issue for the first time in its motion to vacate judgment for lack of subject matter jurisdiction, filed after briefing and on the eve of oral argument.

Relying heavily on Stern and Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989), the Ninth Circuit analyzed whether the fraudulent transfer action was so central to BIA’s bankruptcy proceeding that it should be considered a “public right,” and thus could be adjudicated by a non-Article III court. The Ninth Circuit found that the question had been answered in Granfinanciera, which was “conclusive” that a fraudulent transfer claim against a noncreditor is a legal cause of action that is not a “public right.” The Stern court buttressed the Granfinanciera ruling by stating that a fraudulent transfer claim against a noncreditor is a legal course of action on which only an Article III court can render a final judgment.  Taken together, Stern and Granfinanciera resolved any doubt for the Ninth Circuit, which held that the non-Article III bankruptcy court lacked constitutional authority to enter a final judgment on a fraudulent transfer action against EBIA, a noncreditor to the estate.

Then, the Ninth Circuit notably held that the constitutional right to an Article III hearing can be waived by a defendant. EBIA, the Ninth Circuit held, waived its right to an Article III hearing by not only failing to object to the bankruptcy judge’s authority to enter a final judgment, but by suspending its demand for a jury trial to allow the bankruptcy court to decide the claim. Further, since 28 U.S.C. § 157(c)(2) provides that a bankruptcy court may enter final judgments in non-core proceedings with the consent of the parties, the Ninth Circuit reasoned that certainly parties may consent to the same in a core proceeding, such as a fraudulent transfer claim. By waiting until the eve of oral argument on its appeal to move to vacate, the Court concluded EBIA also impliedly consented to the bankruptcy court’s jurisdiction. Although Stern was not decided until EBIA’s appeal was pending, the Ninth Circuit held that EBIA had sufficient notice of the jurisdictional issue, and further, Stern itself applied the “doctrine of litigant consent.” Then, addressing the bankruptcy court’s judgment on its merits, the Ninth Circuit affirmed, finding that the transfers to EBIA were constructively fraudulent under 11 U.S.C. § 548 and under Washington state law, and that EBIA was liable as BIA’s successor.

Finally, recognizing that its decision left unanswered a very practical question, the Ninth Circuit addressed one additional lingering issue — may a bankruptcy judge constitutionally “hear and determine” a fraudulent transfer claim? The court held that since fraudulent transfer claims are classified as “core,” the bankruptcy court can hear such claims and may submit proposed findings of fact and conclusions of law to the district court.

Conclusion

The decisions described are evidence of the continued erosion of the bankruptcy courts’ jurisdiction in the wake of Stern. In light of these decisions and other post-Stern cases, litigants must be vigilant to protect their constitutional rights and have matters heard in the appropriate tribunal. Litigants should also be very wary of waiving any jurisdictional challenges that they may have in proceedings commenced in bankruptcy courts. These decisions serve to provide further guidance on when such waiver can occur and the constitutional limits of a bankruptcy court’s authority.