In December 2015, U.S. Bankruptcy Court Judge Laurie Silverstein of the District of Delaware confirmed a plan of reorganization in the Millennium Lab Holdings chapter 11 case that included the non-consensual release of certain claims against various non-debtor third parties.  Earlier this year, ruling on an appeal from that decision, U.S. District Court Judge Leonard Stark remanded the case to Judge Silverstein and directed her to consider whether the grant of the releases exceeded her constitutional power as an Article I judge, in view of the issues raised by the U.S. Supreme Court in its 2011 decision in Stern v. Marshall.

Judge Silverstein recently issued a comprehensive opinion in which she determined that her confirmation of the plan was constitutional and did not contravene Stern.  Her analysis brings much-needed clarity to what has been a muddled discussion.  Her unstated premise – that a viable specialized court system is necessary to address matters of bankruptcy, and that Congress unquestionably has the power under Article I to create such forums – offers a pathway out of the uncertainty created by Stern over the constitutional power of the U.S. bankruptcy courts.

Background

The Supreme Court in Stern raised long dormant separation of power concerns.  Under the U.S. Constitution, the “judicial power” of the United States can only be exercised by courts created under Article III.  Congress, however, established the U.S. bankruptcy courts in their current form in 1978 pursuant to its bankruptcy power under Article I.  A line of Supreme Court cases has limited the authority of courts created by Congress pursuant to Article I, rather than under Article III, to territorial courts, military tribunals, and courts created to hear cases involving “public rights” (i.e., 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.

The Court, in the 1982 Northern Pipeline case, invalidated the 1978 grant of jurisdiction to the bankruptcy courts, ruling that Congress had impermissibly vested Article III “judicial power” in Article I courts by allowing a bankruptcy court to hear and rule on a debtor’s breach of contract claim against another party, a “private rights” dispute.  It did, however, provide some guidance to Congress by suggesting that disputes pertaining to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” (emphasis added) constituted a type of “public right” which could be heard and decided by an Article I bankruptcy judge.  Congress responded with a new grant of jurisdictional power providing that bankruptcy courts could issue final orders with respect to a variety of enumerated “core” matters intended to implicate only such “public rights,” but that with respect to “non-core” matters affecting “private rights,” a bankruptcy court could only submit proposed findings of fact and conclusions of law, and requiring that a final order on such matters be entered by an Article III district court following a full review.

The constitutionality of the “core” – “non-core” dichotomy appeared to have been long-settled by 2011, as in cases involving other Article I tribunals the Court took an expansive view of the “public rights” doctrine, one that had appeared to be sufficiently broad to encompass the list of “core” bankruptcy matters. So it took most bankruptcy practitioners and commentators by surprise when, in Stern, the Court held that Congress had again improperly granted authority to bankruptcy courts to make certain final rulings. Stern ruled that Congress could not designate a debtor’s counterclaim against a creditor as a “core” matter if the counterclaim would not be resolved as part of the same process whereby the creditor’s claim against the debtor’s bankruptcy estate was determined.  The Court in Stern ruled that it would be unconstitutional for the counterclaim in that case, a tort action under Texas state law, to be decided by an Article I bankruptcy judge.  In the Court’s view, 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 with this reasoning is that the Supreme Court has expressly stated in other cases that parties’ rights in bankruptcy are usually determined by state law.  State law issues accordingly are intertwined with most “core” matters.  Although the Court in Stern characterized its ruling as “narrow,” its formulation of the issue suggested that “core” matters could often implicate “private rights.”  By opening up issues of bankruptcy court power regarding “core” matters to constitutional challenge, the Court created ongoing confusion regarding the extent to which U.S. bankruptcy judges can issue final rulings, which in turn has caused uncertainty in the administration of bankruptcy cases.

Millennium Lab Holdings Chapter 11 Case  

In Millennium Lab Holdings, the debtor’s equity holders had been accused of orchestrating fraudulent activity in connection with the debtor’s Medicare and Medicaid reimbursement requests.  The plan confirmed by Judge Silverstein in 2015 embodied a compromise, whereby the equity holders were to pay $325 million in exchange for a release of all claims against them held either by the debtor’s estate or directly by third parties.  Certain of the debtor’s lenders commenced litigation against the equity holders in federal district court, and objected to the releases in the plan that would preclude their claims.  Judge Silverstein overruled the objections.  She held that the non-consensual releases met the required standards under Third Circuit precedents and could be approved in connection with the confirmation of a plan of reorganization.

The constitutional issues were raised for the first time on appeal. The lenders contended that under Stern the releases were tantamount to resolving a “private rights” dispute between two non-debtor parties, and that Judge Silverstein therefore lacked constitutional authority to enter a final order resolving it.  Judge Stark agreed that the lenders were entitled to Article III adjudication of their claims, but determined that the issue had not been properly presented to Judge Silverstein, and remanded the case so that she could make the determination in the first instance.

Judge Silverstein’s Ruling on Remand

In her ruling, Judge Silverstein noted first the Supreme Court’s own admonition in Stern that it was intended to be a narrow opinion, and that its actual outcome “tread little new ground” beyond Northern Pipeline.  She then looked closely at the interpretations applied to Stern by various courts since its issuance.  Some bankruptcy judges have applied what she characterized as a “Narrow Interpretation,” limiting Stern to similar circumstances involving state law counterclaims against creditors that are not resolvable in the process of ruling on the creditor’s claims against the debtor.  Other bankruptcy judges have put forward a “Broad Interpretation” of Stern, holding that it may apply to any state law or common law cause of action commenced by a debtor or trustee against a creditor or other party.  Under what she describes as the “Broadest Interpretation,” bankruptcy judges have questioned their ability to enter final orders in other enumerated “core” proceedings.

The lenders argued that Stern did not permit Judge Silverstein to enter a final order confirming a plan of reorganization that would interfere with their causes of action against the debtor’s equity holders.  She rejected the lenders’ argument as “inverse” and “backward” reasoning: “[I]t examines the legal consequence of the confirmation order to find fault with the entry of the order, rather than examining the propriety of issuing the confirmation order in the first instance.”  She determined instead that an Article I judge should not step aside from issuing a ruling on a “core” matter simply because third parties’ rights under state or common law would be affected.

Judge Silverstein demonstrated that even under the “Broadest Interpretation” of Stern, her entry of a final order confirming the plan was within her authority.  She approached the constitutional question by noting that confirming plans of reorganization are a fundamental aspect of federal bankruptcy power, and placing the critical focus squarely on the nature of the “core” proceeding that was before her.  Although the plan affected the “private rights” of third parties by releasing certain causes of action, she held that she was not ruling on the merits of those causes of action.  Her decision was only on whether the plan (and the releases) satisfied applicable standards under the Bankruptcy Code and Third Circuit precedent:

“[T]here is no state law equivalent to confirmation of a plan.  And, third party releases do not exist without regard to the bankruptcy proceeding.  Rather, a ruling approving third party releases is a determination that the plan at issue meets the federally created requisites for confirmation and third party releases.”

Adopting the interpretation of Stern urged by the lenders, she observed, would effectively  end the viability of the U.S. bankruptcy court system, and require substantially greater involvement by Article III district court judges in bankruptcy matters – an outcome directly at odds with the Supreme Court’s stated intention in Stern that its ruling would not “meaningfully change[] the division of labor” between bankruptcy and district courts.  She noted several types of orders commonly entered by bankruptcy judges which, under the lenders’ reading of Stern, would instead need to be entered by Article III judges due to their possible impact on the rights of non-debtors under state law.  These would include orders approving sales of assets free and clear of successor liability claims under Section 363 of the Bankruptcy Code, rulings on substantive consolidation, and determinations regarding the recharacterization or subordination of debts.

Judge Silverstein tangentially alluded to the real problem raised by Stern – that by failing to articulate clearly the importance of federal bankruptcy law and a specialized bankruptcy court system as “public rights,” the Court allowed Stern to become fodder for “gamesmanship by both debtors and creditors in the bankruptcy context.”  Citing a recent Third Circuit ruling, In re Linear Electric Company, Inc., she expressly held “core” matters under the Bankruptcy Code to be “public rights.”  As such, it fell directly within her power as an Article I bankruptcy judge to confirm the Millennium Lab Holdings plan.  In Judge Silverstein’s view, “[t]here is no question [that] if the proper standard is met, a bankruptcy judge may enter a final order in a core matter that impacts or even precludes a state law action between two non-debtors.”  The preclusive effect of a ruling on the “private rights” of a non-debtor party might be an argument for a bankruptcy court to consider in weighing the merits of the releases themselves, but it could not limit the constitutional authority of a U.S. bankruptcy judge to make such a ruling.

In articulating the limits of Stern under any of its plausible interpretations, Judge Silverstein has provided guidance that can and should be followed by other courts towards viewing “core” matters as “public rights” squarely within the constitutional authority of an Article I court.  The key factor in resolving questions of bankruptcy court constitutional authority should be the nexus of any particular dispute to “the restructuring of debtor-creditor relations,” instead of whether parties’ rights under state law are affected.  Placing the focus on the “public” side of the public/private rights dichotomy can provide a path away from the confusion engendered by Stern, and restore the proper balance of U.S. bankruptcy courts’ constitutional power.

The Supreme Court recently heard arguments in a patent dispute case, Oil States Energy Services, LLC v. Greene’s Energy Group, LLC.  Although the case has nothing to do with bankruptcy law, its outcome could have a substantial impact on bankruptcy practice and litigation. Oil States Energy concerns the limits of Congress’s ability to create courts pursuant to Article I of the Constitution rather than under Article III, and therefore raises separation of power issues similar to those considered by the Court in Stern v. Marshall, its 2011 decision limiting the authority of U.S. bankruptcy courts.

The facts of Oil States are straight-forward.  Oil States Energy sued Greene’s Energy Group for patent infringement.  Greene’s Energy responded by commencing a procedure known as “inter partes review”, an administrative process that permits parties to seek review by the Patent and Trademark Office (PTO) of patent grants.  Under this process, an administrative board within the PTO can invalidate the issuance of a patent, subject to appeal and review by the U.S. Court of Appeals for the Federal Circuit.  When the PTO board found for Greene’s Energy in this instance and held the patent grant to Oils States Energy to be invalid, Oil States Energy challenged its constitutionality, contending, among other things, that Congress had impermissibly vested Article III “judicial power” in an Article I forum.

The Supreme Court has been wrestling with the limits of the constitutional authority of Article I courts off and on for well over a century. A line of 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 typically are “private rights” that must be heard by an Article III judge.

With respect to bankruptcy courts, the common understanding has been that matters pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power” under Article I, Section 8, constitutes a type of “public right” which can be heard and decided by an Article I bankruptcy judge. The Court has never expressly held this, however, or handed down a clear ruling as to where the line between “public rights” and “private rights” should be drawn in bankruptcy proceedings.  Although in some recent cases involving non-bankruptcy Article I tribunals the Court has taken an expansive and pragmatic view of the “public rights” doctrine, in Stern the Court adopted a more constricted approach.  It ruled that although an Article I bankruptcy judge could appropriately enter a final order regarding a creditor’s claim against a bankruptcy estate, a common law tort claim held by the bankruptcy estate against the same creditor nevertheless constituted a “private right” if it was not related to the initial claim against the estate, and that it was therefore unconstitutional for Congress to have authorized a non-Article III court to render a final determination on it.

As the Court in Stern candidly noted, “the distinction between public and private rights – at least as framed by some of our recent cases – fails to provide concrete guidance[.]” Stern did nothing to clarify this problem, and bankruptcy practitioners and judges have struggled since the opinion was handed down to understand the limits it placed on bankruptcy court authority.

The question in Oil States – whether an Article I tribunal may invalidate a previously granted patent – raises many of the same issues regarding “private rights” and “public rights.”  Oil States Energy contends that its dispute with Greene’s Energy is purely a private dispute over patent infringement, over which an Article I forum has no greater authority to adjudicate than the tort claim at issue in Stern.  Greene’s Energy argues in response that the case involves a “public right,” in that it derives from Congress’s patent power under Article I, Section 8, and is therefore completely distinguishable from Stern’s common law tort action.  Oil States Energy points to the Court’s concern in Stern regarding the encroachment by Congress on the essential protections of Article III, asserting that “[i]f a patent dispute case – a dispute over a private property right – may be swept out of the [Article III] federal courts to an [Article I] administrative agency simply by deeming it part of some amorphous ‘public right,’ then anything can be, and Article III’s protections are mere ‘wishful thinking.’”  Greene’s Energy counters by pointing to the Court’s discussion in Stern of a “public right” as deriving from “a federal regulatory scheme,” and the suggestion there that “what makes a right a ‘public right’ rather than private is that the right is integrally related to particular Federal Government action.”

Both bankruptcy and patent law fall squarely within the scope of Congress’s power under Article I, Section 8, and in both instances Congress has created specialized forums in an effort to allow parties to address issues which are not susceptible to efficient disposition in Article III courts. Accordingly, any ruling that the Court makes in Oil States on the distinction between “public rights” and “private rights,” and on the limits of the authority of courts created under Article I, is almost certain to have a significant impact on U.S. bankruptcy courts.

The Supreme Court’s recent decision in Merit Management Group, LP v. FTI Consulting, Inc. has appropriately drawn significant attention.  The Court, by narrowing the “safe harbor” provision of Section 546(e) of the Bankruptcy Code, has opened the door for representatives of bankruptcy estates to use the avoidance powers of the Bankruptcy Code to seek to unwind a wider range of pre-bankruptcy transactions and recover value for the benefit of creditors.  Most of the focus on the ruling has been on its anticipated impact on the administration of business bankruptcy cases.  However, it is worth noting that the Court in Merit Management has taken a more pragmatic approach to statutory interpretation in its reading of the Bankruptcy Code than in two of its other recent business bankruptcy decisions, Baker Botts v. Asarco and Czyzewski v. Jevic Holding Corp., and the result in Merit Management appears to be more consistent with the intent of Congress than in those earlier cases

The issue in Merit Management was straight forward.  Trustees in bankruptcy are authorized to set aside certain transfers made by a debtor prior to bankruptcy.  Among these, under Section 548 of the Bankruptcy Code, are so-called “constructive” fraudulent transfers, which (regardless of intent) are transfers of property made by a debtor at a time when it was insolvent and for which it received less than reasonably equivalent value.  Section 550 of the Bankruptcy Code provides that the recovery can be obtained either from the initial transferee of such property or “any immediate or mediate transferee of such initial transferee.”  A trustee’s avoidance powers are limited, however, by other sections of the Bankruptcy Code.  One of these is Section 546(e), which exempts from avoidance certain securities transactions “made by or to (or for the benefit of)” qualifying “financial institutions” or others securities entities.

Merit Management Group was a large shareholder of Bedford Downs Management Corp.. Bedford Downs’ stock was acquired by Valley View Downs LP, which borrowed $55 million to fund the transaction.  The $55 million was not paid by Valley View directly to the Bedford Downs shareholders; there were intermediate transfers.  Specifically, Valley View borrowed funds from its lender, Credit Suisse, which transferred the money to another financial institution, Citizens Bank of Pennsylvania, as escrow agent, which in turn paid the purchase price to the shareholders of Bedford Downs, including Merit Management, in exchange for the surrender of their stock certificates.

Valley View intended to develop a race track and casino in Pennsylvania, but the project never came to fruition and it eventually filed for relief under chapter 11 of the Bankruptcy Code. FTI Consulting was appointed as trustee to pursue certain causes of action on behalf of Valley View’s bankruptcy estate, and it sought to avoid the $16.5 million portion of the Bedford Downs purchase price that had been received by Merit Management.  FTI contended that Valley View was insolvent at the time it bought the Bedford Downs stock and that it did not receive reasonably equivalent value in exchange for the payment.  Among the defenses raised by Merit Management was that the transaction fell within the Section 546(e) “safe harbor” because it included transfers “to (or for the benefit of)” two “financial institutions.”   The lower court granted Merit Management’s motion to dismiss.  The Seventh Circuit Court of Appeals reversed, however, reasoning that Section 546(e) did not apply to transactions where the financial institutions involved serve as “mere conduits.”  The Supreme Court granted certiorari to resolve a split between circuits on this issue, and unanimously affirmed.

The question before the Court was whether, for purposes of applying Section 546(e), a court should consider only the challenged transaction itself (in this case, the payment from Valley View ultimately received by Merit Management), or all of the component transfers within such challenged transaction (in this case, the transfers involving two financial institutions). The Court, noting the “specific context” of the language of Section 546(e), rejected Merit Management’s argument that the statutory language “to (or for the benefit of) a . . . financial institution” required reversal, and held instead that “the [Section 546(e)] exception applies to the overarching transfer that the trustee seeks to avoid, not any component part of that transfer.”

The result in Merit Management reflects a common sense reading of the Bankruptcy Code.  The clear intent of Section 546(e) is to safeguard various types of securities transactions from being unwound in order to prevent market disruption.  Allowing an ultimate transferee such as Merit Management to benefit simply because the transferred funds passed through one or more financial institutions would not further the purpose of the safe harbor.

Unfortunately, the Court does not always temper its reading of the statutory language of the Bankruptcy Code with the “specific context” in which such language is used. Other recent Supreme Court business bankruptcy decisions have not been as pragmatic as Merit Management.

In Baker Botts v. Asarco a few years ago, the Court majority applied a narrow and literal reading to the language of Section 330(a) of the Bankruptcy Code.  The result was to deny a law firm the ability to recover the costs that it incurred in defending its application for fees in representing a debtor, even though the Bankruptcy Code requires that all such fees be approved by the bankruptcy court and that other parties receive specific notice and be given an opportunity to object.

Last year, in Czyzewski v. Jevic Holding Corp., the Court also took a narrow approach in its reading of the Bankruptcy Code.  It refused to permit an order of dismissal in a chapter 11 case to contain substantive provisions regarding the distribution of assets of a debtor’s bankruptcy estate that would contravene the Bankruptcy Code’s priority scheme.  The Court declined to allow for any flexibility on this issue, even though such “structured dismissals” had become relatively common, and the bankruptcy court in Czyzewski had expressly found that without such provisions there would have been no recovery to any parties other than the senior lenders.

A similar approach in Merit Management would likely have led to a reversal of the Seventh Circuit.  The plain language of Section 546(e) makes no distinction between transfers where a financial institutions is the actual party to a transaction and those where it simply acts as a conduit.

The Bankruptcy Code was intentionally drafted to be flexible. Jurists and practitioners must contend all the time with difficult issues which do not fit within its strict parameters.  Adherence to the plain meaning of the Bankruptcy Code’s language is important, but the language usually is not unambiguous, and the intent of Congress cannot be properly understood without reference to “specific context.” Baker Botts and Czyzewski both ignored the realities of large corporate bankruptcy cases and long-standing commercial practice. Merit Management may signal a different direction by the Court in its approach to business bankruptcy cases.

The judicial power of the United States is vested in courts created under Article III of the Constitution. However, Congress created the current bankruptcy court system over 40 years ago pursuant to Article I of the Constitution rather than under Article III.  The Supreme Court has long held that Article I courts 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.

Although it appears that all or nearly all of the justices on the Supreme Court believe that the United States bankruptcy courts are constitutional, the Court in recent years has significantly narrowed the “public rights” doctrine, which is the presumptive basis for such constitutionality. This has created confusion and given rise to substantial litigation in bankruptcy cases over the authority of bankruptcy judges to issue final orders on numerous issues.  The Court’s existing constitutional analysis regarding Article I bankruptcy courts and the public rights doctrine has come to resemble a square peg getting jammed into a round hole.  The Court needs to set forth a new rationale.

Uncertainty regarding the constitutional authority of bankruptcy courts has existed for decades, but was long quiescent until the Court’s opinion seven years ago in Stern v. Marshall.  That case was part of the tabloid fodder litigation between Anna Nicole Smith and the son of her late husband.  At some point Ms. Smith had filed for bankruptcy and Mr. Marshall filed a claim against her bankruptcy estate. The particular issue before the Court involved a state law tort counterclaim filed by Ms. Smith against Mr. Marshall.

Congress has the express power under Article I, Section 8 to pass uniform laws on bankruptcy.  Prior to Stern, it was generally believed that matters pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power” under Article I, constituted a type of “public right” that could be heard and decided by an Article I bankruptcy judge.  However, the Court never handed down a clear ruling as to where the line between “public rights” and “private rights” should be drawn in bankruptcy proceedings.

The Court in Stern held that Congress could not authorize a non-Article III court to render a final determination on the state law tort counterclaim.  The ruling in Stern showed that the scope of what constitutes a “public right” susceptible to final determination by an Article I judge was narrower than previously understood.  Although the Court’s opinion in Stern purported to be limited, its analysis made clear that the public rights underpinning of the U.S. bankruptcy court system rested on shaky ground.

The problem created by the Supreme Court’s ruling in Stern is this: the Bankruptcy Code gives the bankruptcy courts power over all of a debtor’s bankruptcy estate.  Determining the disposition of a debtor’s estate is indisputably fundamental to “the restructuring of debtor-creditor relations.” But the Supreme Court has expressly stated in other cases that parties’ property and contractual rights in bankruptcy are based on state law; state law issues are therefore an inseparable part of virtually every bankruptcy case.  For purposes of determining “public” and “private” rights, which aspect of such adjudications should control?

A decision last term regarding the authority of an Article I forum in a non-bankruptcy case further demonstrates the need for the Supreme Court to replace the public rights doctrine as the basis for the constitutionality of bankruptcy courts. In a patent dispute case, Oil States Energy Services, LLC v. Greene’s Energy Group, LLC, one party challenged the constitutionality of a procedure known as “inter partes review”, an administrative process that permits parties to seek review by the Patent and Trademark Office (PTO) of patent grants.  Under this process, an administrative board within the PTO can invalidate the issuance of a patent, subject to appeal and review by the U.S. Court of Appeals for the Federal Circuit.

The Court held that the Article I administrative review process fell within the public rights doctrine and was permissible. However, it defined the doctrine so narrowly that the public rights doctrine can no longer realistically apply to bankruptcy courts.  The public rights doctrine according to Oil States applies to matters “arising between the government and others, which from their nature do not require judicial determination and yet are susceptible of it.”  This formulation simply cannot work for bankruptcy proceedings, which are not “between the government and others” and very much do “require judicial determination.”

The Court has attempted for many years to force bankruptcy courts to fit within the permissible historical parameters for Article I – territorial courts, military tribunals, and courts created to hear cases involving public rights – but that effort has run its course. Another basis for the constitutionality of bankruptcy courts must be articulated.

The answer should be as straight-forward as recognizing that specialized bankruptcy courts under Article I are an additional category of historical exception to the judicial power of Article III. Justice Scalia made this suggestion in a concurring opinion in Stern, and Justice Thomas expounded further on the idea in a recent dissenting opinion:

    Congress . . . has assigned the adjudication of certain bankruptcy disputes to non-Article III actors since as early as 1800. . . Bankruptcy courts clearly do not qualify as territorial courts or courts-martial, but they are not an easy fit in the “public rights” category, either. . . We have nevertheless implicitly recognized that the claims allowance process may proceed in a bankruptcy court, as can any matter that would necessarily be resolved by that process, even one that affects core private rights. . . . For this reason, bankruptcy courts . . . more likely enjoy a unique, textually based exception, much like territorial courts and courts-martial do. . .  That is, Article I’s Bankruptcy Clause serves to carve cases and controversies traditionally subject to resolution by bankruptcy commissioners out of Article III, giving Congress the discretion, within those historical boundaries, to provide for their resolution outside of Article III courts.

The Court should expressly recognize the United States bankruptcy courts as a fourth category of historical exception to Article III courts. This would place such courts on firm constitutional footing and end much of the uncertainty and needless litigation over bankruptcy judges’ authority.  The Court needs to stop trying to force the square peg of U.S. bankruptcy courts into the round hole of the public rights doctrine.

The Supreme Court this week resolved a long-standing open issue regarding the treatment of trademark license rights in bankruptcy proceedings. The Court ruled in favor of Mission Products, a licensee under a trademark license agreement that had been rejected in the chapter 11 case of Tempnology, the debtor-licensor, determining that the rejection constituted a breach of the agreement but did not rescind it.  The decision means that a holder of rights under a trademark license will retain such rights even if its underlying license agreement is rejected in bankruptcy.

Tempnology was a sportsware manufacturing company. Prior to filing for chapter 11, it had entered into a distribution agreement with Mission Products, and granted Mission Products a license to use its trademarks.

Section 365(a) of the Bankruptcy Code allows a debtor to assume executory contracts (i.e., contracts for which material obligations remain unperformed on both sides) which are favorable, and to reject executory contracts which are burdensome or detrimental, in order to maximize the value of its bankruptcy estate for the benefit of its creditors.  Section 365(g) states that the rejection of a contract “constitutes a breach of such contract,” and provides the non-debtor counterparty with a claim against the bankruptcy estate for damages arising from such breach.  Following the commencement of its bankruptcy case, Tempnology chose to reject the distribution agreement, which meant that Tempnology no longer had to perform any its obligations.  A dispute arose, however, over Mission Products’ ongoing right to use Tempnology’s trademarks following the rejection.

Tempnology based its arguments primarily on Section 365(n), a provision added to the Bankruptcy Code by Congress in order to negate the effects of Lubrizol Enterprises v. Richmond Metal Finishers, a judicial decision regarding patent rights.  In Lubrizol, the Fourth Circuit Court of Appeals ruled that a debtor’s rejection of a patent license agreement terminated the licensee’s rights to use the patent.  In response, Congress specified in Section 365(n) that a licensee under a contract granting the right to use “intellectual property” could elect to retain its rights under such contract and continue to use such rights for the duration of the contract.  The definition of “intellectual property” inserted into the Bankruptcy Code did not, however, include trademarks.  Tempnology contended that the failure of Congress to include trademarks within the scope of intellectual property protected by Section 365(n) created a negative inference, and that trademark rights cannot be retained by a licensee under a rejected trademark license agreement.

The Court rejected Tempnology’s arguments. The Court emphasized that rejection of a contract in bankruptcy under Section 365 operates as a breach of the contract and not as a rescission, and that the non-debtor counterparty’s rights do not “vaporize.”  Moreover, the Court found no negative inference from the failure of Congress to include trademarks in Section 365(n).

The key to the Court’s decision is its determination that contract rejection does not permit rights granted under a trademark license agreement to be rescinded. The Court makes clear that the language in Section 365(g) that rejection “constitutes a breach” is intended to allow the debtor to cease performing under a burdensome contract, but does not allow the debtor to rescind the rights previously conveyed under such contract.  The Court observed that outside of bankruptcy, the breach of a trademark license agreement would not permit the licensor to terminate the licensee’s rights.  Allowing trademark license rights to be terminated in bankruptcy, through contract rejection, would therefore violate a basic rule of bankruptcy law by giving debtor-licensors greater rights in bankruptcy than they could possess outside of it.  The Court also noted that allowing contract rejection to terminate a licensee’s rights would effectively allow a debtor to avoid a conveyance of property (i.e., the license rights) while circumventing the Bankruptcy Code’s detailed and narrow provisions for unwinding pre-bankruptcy transfers.

The Court similarly found no merit in Tempnology’s arguments regarding Section 365(n). Tempnology contended that the specific protections to retain rights provided under Section 365(n) to holders of patent and other intellectual property licensees meant that no such protection exists for trademark licensees.  The Court held, however, that accepting Tempnology’s logic would require a reading of Section 365(g) that would be “essentially opposite” to its language that rejection “constitutes a breach.”  Moreover, it ignored that Section 365(n) was an amendment to the Bankruptcy Code designed to undo a specific judicial decision (Lubrizol), and that its legislative history expressly stated that no inferences should be drawn from its failure to include trademarks within its scope.

Many of the Supreme Court’s recent bankruptcy law rulings have not been models of clarity.  The Mission Products decision is a welcome departure from that trend.

The U.S. Supreme Court will hear the case of Czyzewski v. Jevic Holding Corp. during the new term that began last week.  The questions it presents are relatively simple.  First, can a bankruptcy court, in dismissing a case under the U.S. Bankruptcy Code, permit parties to “structure” the dismissal to include substantive provisions regarding the distribution of assets of a debtor’s bankruptcy estate, instead of simply dismissing the case and leaving parties to their remedies under applicable non-bankruptcy law?  If yes, then can such provisions effect a distribution of those assets in a manner that contravenes the Bankruptcy Code’s priority scheme?  Most observers anticipate that the Court will focus on solely on the second question, and issue a fairly narrow ruling.  A ruling on the first question, however, would be far broader and could have as significant an impact on Chapter 11 bankruptcy practice as any case that the Court has decided in decades.

The facts of Czyzewski are straight-forward.  Jevic was a New Jersey trucking company; it filed for bankruptcy under Chapter 11 of the Bankruptcy Code following a failed leveraged buyout.  Jevic never attempted to reorganize; it ceased operations immediately prior to its bankruptcy filing and terminated nearly all of its driver employees.  Its secured lender, CIT Group, held a lien on virtually all of its assets, which were worth far less than the amount owed on the loan.  The drivers filed WARN Act claims for unpaid wages against Jevic and Sun Capital, its private equity sponsor.  Sun also held a portion of the secured debt.  An official committee of unsecured creditors was appointed, which commenced fraudulent conveyance and equitable subordination litigation against CIT and Sun.

Three years later, the case was in a place that has become all too familiar to Chapter 11 practitioners. All of the assets had been sold off and the proceeds distributed to the secured lenders.  Nothing remained of the Jevic bankruptcy estate except $1.7 million in cash (which was subject to the secured lenders’ lien) and the litigation claims against CIT and Sun.  The case was effectively at an impasse.  A plan could not be confirmed, because there were insufficient funds to pay all of the expenses of administration of the Chapter 11 case, such as the fees of professionals for Jevic and the creditors’ committee.  The only other means specified by the Bankruptcy Code of resolving a Chapter 11 case are either a conversion to a liquidation under Chapter 7, or a dismissal of the case under Section 349 of the Bankruptcy Code.  Under either of those approaches, however, professional fees would not have been paid, and no recovery would have been received by any creditors other than CIT or Sun.

Another path was taken. The case was dismissed, but the dismissal was structured in such a way so as to incorporate a settlement among Jevic, CIT, Sun, and the creditors’ committee.  Such “structured dismissals” have become increasingly common over the past several years.  As a proliferation of secured financing has resulted in more cases lacking sufficient unencumbered assets to finance an exit from Chapter 11 through plans of reorganization or liquidation, structured dismissals have been utilized by creative practitioners to wind down what would otherwise be irresolvable morasses.  Under the Jevic structured dismissal, CIT and Sun agreed, in exchange for a release of the litigation, to allow the $1.7 million in cash plus another $2 million they contributed to be used to pay administrative expenses and to provide a small distribution for general unsecured creditors.

The drivers, however, were not part of the settlement, because they refused to release their WARN Act litigation against Sun. They therefore received nothing, even though their claims for unpaid wages against the Jevic bankruptcy estate were entitled to priority treatment ahead of general unsecured claims.  The bankruptcy court nevertheless approved the settlement and the structured dismissal, finding that there otherwise was “no realistic prospect” of a recovery to any parties but CIT and Sun.  The U.S. Court of Appeals for the Third Circuit affirmed.

The Supreme Court granted certiorari on the question of whether a structured dismissal in a chapter 11 case can incorporate a settlement that diverges from the Bankruptcy Code’s priority scheme. It is possible, however, that the Court may first look at the broader issue of whether a dismissal that is “structured” is even a permissible means of resolving a chapter 11 case.

These issues could lead the Court to resolve a basic question that has driven arguments on the Bankruptcy Code for decades. It’s a debate between lawyers and judges who take a pragmatic view of the Bankruptcy Code, versus those who adhere strongly to the “plain meaning” rule of statutory interpretation.  The first group believes that the Bankruptcy Code was intentionally designed by Congress to be as flexible as possible and, while unstated, also was intended to be built upon and carry forward any number of long-standing practices derived from decades, and in some instances centuries, of commercial law.  In this view, the Bankruptcy Code was specifically intended to allow parties to develop solutions to difficult issues which do not fit within the strict parameters of the statute.

Jurists and practitioners on the other side contend that bankruptcy judges must defer to the plain meaning of the Bankruptcy Code and are not at liberty to approve solutions to problematic situations, such as a structured dismissal for resolving a log-jammed chapter 11 case, which go beyond those specifically provided by Congress. In Czyzewski, the drivers contend that because there is no express authority for structured dismissals under the Bankruptcy Code, the proposed deal among the other parties must fail.  The Third Circuit acknowledged the lack of statutory authority; however, it affirmed the lower court decisions as the “least bad alternative”, and ruled that a dismissal under Section 349 of the Bankruptcy Code could be accompanied by other court orders giving effect to a settlement, providing releases, and disposing of loose ends which otherwise would require continued litigation in another forum.

The second issue delves even deeper into the heart of the Bankruptcy Code. The “absolute priority rule” means that in a plan of reorganization, creditors with claims which would be entitled to seniority in the event of a straight liquidation must get paid ahead of creditors whose claims would be junior in priority.  The Third Circuit was troubled by the fact that general unsecured creditors would receive some small payment while the drivers with higher priority claims would be paid nothing.  The Court nevertheless upheld the settlement.  It determined that under a settlement, parties could deviate from the Bankruptcy Code’s priority scheme if “specific and credible grounds” so justified.  The dispositive factor in this instance was that under the only realistic alternative, no parties other than CIT and Sun would have received anything.  Although the Jevic bankruptcy estate held litigation claims, there were no assets to fund them.  Under any viable scenario, the drivers were receiving $0.  The only real question was whether such non-payment should obviate the possibility of any other party receiving any funds.  The Third Circuit declined to find “that our national bankruptcy policy is quite so nihilistic[.]”

The Court, as demonstrated by its recent decision in Baker Botts v. Asarco, leans strongly toward the plain meaning rule of statutory interpretation in bankruptcy cases, which suggests that the Court will reverse the Third Circuit here.  The main suspense in the outcome of Czyzewski lies not in the outcome per se, but rather in whether the Court rules broadly or narrowly.  A narrow ruling addressing only the second question here, overturning the ruling below based on the proposed recovery to general unsecured creditors ahead of the drivers and their claims for unpaid wages, would be significant but not too remarkable.  The Court could go further, however, and altogether invalidate structured dismissals due to the lack of specific authority.  Such a ruling could markedly alter the chapter 11 landscape.  The Supreme Court, however, has evidenced little concern in recent times for the extent to which its rulings in bankruptcy cases conflict with established practices, such as when it invalidated a long-standing jurisdictional scheme a few years ago in Stern v. Marshall.

One of the hallmarks of Chapter 11 has been the consistent ability of practitioners and judges to adapt it to situations that lie well outside of the intentions of the drafters of the Bankruptcy Code, such as in asbestos and other mass tort cases, or mega-cases such as the GM and Chrysler bankruptcies, and which likely would otherwise defy resolution. For better or worse, a broad ruling by the Court in Czyzewski would limit creative uses of the Bankruptcy Code, and substantially affect the manner in which difficult Chapter 11 cases are approached and resolved.

The U.S. Supreme Court heard oral arguments this week in the case of Czyzewski v. Jevic Holding Corp.  Although veteran Court watchers caution about seeking to predict ultimate rulings based on justices’ questions and stated concerns, it is difficult to read the hearing transcript and not come away with the view that at least some of the Court’s members are not keen to rule on the merits here.  This would be a relief to many bankruptcy practitioners and commentators who have been concerned about a broad ruling in this case that could significantly limit the ability of parties in bankruptcy cases to craft solutions to difficult issues which do not fit within the strict parameters of the Bankruptcy Code.  A procedural disposition appears possible; alternatively, if a ruling on the merits does get handed down, it is likely to be narrowly crafted.

The complications of Jevic, and the difficult choices facing the Court here, stem from both the knottiness of the specific statutory issues which have been presented, and the complicated process of corporate bankruptcy proceedings in general.  The statutory issues are both broad and narrow: do bankruptcy courts have authority to approve a resolution of a Chapter 11 bankruptcy case in a manner different from the three options specified by the Bankruptcy Code – confirmed plan, conversion to a liquidation under Chapter 7, or dismissal?  Specifically, if the case is to be dismissed, can parties “structure” the dismissal to include substantive provisions regarding the distribution of assets of a debtor’s bankruptcy estate, instead of simply leaving parties to their remedies under applicable non-bankruptcy law?  If yes, then can such provisions effect a distribution of those assets in a manner that contravenes the Bankruptcy Code’s priority scheme?

At the hearing, the justices grappled with whether they were being asked to rule on the broader question of the permissibility of structured dismissals, or the narrower question of adherence to the priority rules.  Justice Kagan specifically pressed the petitioners’ counsel to articulate the holding that they were requesting.  Justice Alito also pushed on this point, and even suggested that the petitioners may have argued a different question than the one on which the Court granted certiorari:

“Something strange seems to have happened between the petition stage and the briefing stage in the case. The question that you asked us to take was whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme . . . And we took the case.  But then the question that you address in your brief refers to ‘structured dismissal.’  There is nothing about structured dismissal in the question that you asked us to take . . . .”

On the merits, several justices did express concern about permitting parties to reach settlements that allocate assets in a manner that diverges from the Bankruptcy Code’s priority rules without the consent of all affected parties.  At the same time, however, at least some of the Court members were aware of the “extraordinary” circumstances presented, and the possible implications of a broad ruling if all deviations from the priority rules were to be prohibited.  Justice Kagan acknowledged that the case could be “one of these extraordinary circumstances in which some people can be better off and nobody will be made worse off.  Still the question is, where is the authorization for that in the Bankruptcy Code?”  Chief Justice Roberts observed to respondents’ counsel that “the reasonableness of your position is directly related to how extraordinary the extraordinary circumstances have to be.”

The ambivalence may suggest that some of the justices prefer to avoid a ruling on the merits and are looking for another path. As Justice Alito noted, a clear conflict between circuits exists on the permissibility of asset distributions at variance with the Bankruptcy Code’s priority scheme, but not on the issue of structured dismissals.  His statement above about the possible change in the framing of the question presented could be a prelude to a procedural disposition of the case, such as a dismissal of the appeal based upon an improvident granting of certiorari.  In any event, even with a ruling on the merits it appears less likely that Jevic will be the seminal case that some have feared.

In Millennium Lab Holdings, Delaware District Court Judge Leonard Stark, on an appeal from a bankruptcy court order confirming a plan of reorganization, recently upheld a challenge to the bankruptcy court’s constitutional authority to release claims against non-debtor third parties under the plan.  Judge Stark’s opinion demonstrates the extent to which the constitutional questions raised by the Supreme Court six years ago in Stern v. Marshall continue to cast a shadow over the adjudication of bankruptcy cases.

In Stern, the Supreme Court raised separation of powers concerns regarding the authority of United States bankruptcy courts that had long been viewed as settled.  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.  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).  Although claims of citizens against one another typically are “private” rights that must be heard by an Article III judge, the common understanding regarding bankruptcy courts is that matters pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” (emphasis added) constitute a type of “public” right which can be heard and decided by an Article I bankruptcy judge.

Prior to Stern, the statute passed by Congress in 1984 conferring jurisdiction on Article I bankruptcy courts was viewed as having established the appropriate constitutional limits of such courts.  Section 157 of title 28 of the United States Code provides that bankruptcy courts can issue final orders with respect to a variety of enumerated “core” matters, but that with respect to “non-core” matters, a bankruptcy court can only submit proposed findings of fact and conclusions of law, and that a final order on such matters must be entered by an Article III district court following a full, or “de novo,” review.  Although the Court never ruled on the constitutionality of the “core” and “non-core” bankruptcy jurisdictional construct, in other cases involving Article I tribunals the Court took an expansive and pragmatic view of the “public” rights doctrine, one that had appeared to be sufficiently broad to encompass the list of “core” bankruptcy matters set forth in the statute.

In Stern, however, the Court adopted a more constricted view of “public” rights.  It held that a matter listed as “core” under the statute, a debtor’s counterclaim against a creditor, nevertheless constituted a “private” right if it was not related to the creditor’s claim against the bankruptcy estate.  The Court ruled that it was therefore unconstitutional for Congress, by designating such counterclaims as “core” matters, to authorize a non-Article III court to render a final determination on them.

Stern, by making clear that bankruptcy court rulings regarding “core” matters could be subject to constitutional challenge, has created continuing uncertainty regarding the extent to which bankruptcy courts can issue final rulings.  The problem engendered by the ruling in Stern is this: the Court 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. Stern’s conundrum is that although the list of matters under 28 U.S.C. Section 157, such as ruling on claims against the bankruptcy estate or on the turnover of property to the estate, go to the “core” of “restructuring debtor-creditor relations,” the Supreme Court has expressly stated in other cases that parties’ rights in bankruptcy, such as for breach of contract or regarding title to property, are based on state law.  State law issues accordingly are intertwined with most “core” matters.  For purposes of ascertaining a bankruptcy court’s constitutional authority, which aspect of such adjudications should control?

Two follow-up Supreme Court cases and numerous lower court opinions have failed to clarify the questions raised by Stern regarding the constitutional limits of bankruptcy court authority. Millennium Lab Holdings is the latest case to demonstrate the extent to which the ambiguity of Stern remains unresolved.

The facts of Millennium Lab Holdings are complicated, but the issues faced by Judge Stark on appeal were fairly straight-forward.  Among them was whether the plan of reorganization could release the debtor’s insiders from claims of third parties absent such parties’ consent.  The debtor’s equity holders had been accused of orchestrating fraudulent activity in connection with the debtor’s Medicare and Medicaid reimbursement requests, and were named by certain of the debtor’s lenders as defendants in an action brought outside of the bankruptcy court.  Under the plan, the equity holders were to pay $325 million in exchange for a release of all claims held either by the debtor’s estate or directly by third parties such as the lenders.

The question of whether a bankruptcy court has statutory authority and subject matter jurisdiction to enjoin and release claims non-consensually against non-debtors has long been unclear, and some courts have ruled that bankruptcy courts have no power at all to resolve disputes between non-debtor parties.  Other courts, however, relying on the general equitable power provided under section 105 of the Bankruptcy Code, and the jurisdictional authority to hear proceedings “related to” a debtor’s case, have granted such releases.  Judge Laurie Silverstein, the bankruptcy judge in Millennium Lab Holdings, determined that non-consensual third party releases could be approved if necessary in connection with the confirmation of a plan of reorganization and where basic standards of fairness were satisfied.

The lenders argued on appeal that, regardless of whether the bankruptcy court had statutory and jurisdictional power, under Stern the releases were tantamount to resolving a “private” rights dispute between two non-debtor parties, and that the bankruptcy court therefore lacked constitutional authority to enter a final order resolving it.  Judge Stark agreed that constitutional authority had to be shown.  He rejected the debtor’s response that the releases could resolved by the bankruptcy court because they were a key component of the confirmation of the debtor’s plan of reorganization, which in turn could be viewed as a “public” right.  “Appellants appear to be entitled to Article III adjudication of these claims, and Stern dictates that no final order could be entered on such claims by an Article I court barring consent of the parties (which has not been provided here).”  He concluded, however, that the issue had not been properly presented or considered by the bankruptcy court, and remanded the case to Judge Silverstein so that she could make the determination in the first instance.

Judge Stark’s opinion in Millennium Lab Holdings highlights the ongoing uncertainty created by Stern.  “Core” matters invariably implicate “private” rights of parties under state law.  The Supreme Court at some point will need to address directly how Article I bankruptcy courts can fit within the scope of the “public” rights doctrine.  Until the Court resolves this ambiguity, which may require a strict limitation or even overturning of Stern, challenges to bankruptcy courts’ constitutional authority will continue.

The Supreme Court recently granted certiorari in PEM Entities LLC v. Levin, in which it will decide whether federal or a state law should apply when a debt claim held by a debtor’s insider is sought to be recharacterized in bankruptcy as a capital contribution and treated as equity.  The case raises important questions about the extent to which the commencement of a proceeding under the U.S. Bankruptcy Code can and should affect parties’ rights and interests as they exist under non-bankruptcy law.  For this reason alone, the impact of PEM Entities is likely to be significant.

It is also possible that it could lead the Court more broadly to consider the scope of Congress’s bankruptcy power. In such event, PEM Entities potentially could provide the Court with a coherent rationale to start resolving the uncertainty it created six years ago in Stern v. Marshall regarding the constitutional authority of bankruptcy courts.

The facts of PEM Entities are straightforward.  A group of investors created an investment vehicle, Province Grande Olde Liberty, LLC (“Province”), in order to acquire real estate in North Carolina for the purpose of developing a golf course and surrounding homes.  Province obtained a bank loan of approximately $6.5 million, secured by the real estate itself, and received a separate, unsecured loan in the amount of $188,000 from an investment fund, Lakebound Fixed Return Fund LLC (“Lakebound”).

When the secured loan went into default and the bank threatened to foreclose, certain of Province’s investors formed PEM Entities LLC, and purchased the secured loan from the bank for approximately $1.24 million. The development efforts ultimately failed, however, and Province filed for protection under chapter 11 of the Bankruptcy Code.  When PEM sought to enforce its rights as a secured creditor under the purchased bank loan, certain investors in Lakebound brought an action to have the claim recharacterized as equity, and thus subordinate to Lakebound’s unsecured claim.

The bankruptcy court ruled in favor of the Lakebound investors, applying a federal standard for recharacterization in bankruptcy cases that is broader than the test that would have applied had it looked to applicable (North Carolina) state law. Under North Carolina law, the form of the transaction would probably have determined the outcome and, since PEM had purchased a loan made by a third party, PEM would have been able to enforce its rights as a secured creditor.  Under the federal test, adapted from decisions in tax cases, courts look beyond the form of the transaction to consider whether, in essence, the money at issue was invested for the purpose of being repaid with interest at an established date, or instead was a bet on the ultimate success of the venture.  The bankruptcy court, among other things, determined that when PEM acquired the bank loan, Province would not have been able to obtain financing from a non-affiliated third party, and that the PEM investors were mainly motivated to salvage their initial investment in Province.

The bankruptcy court’s ruling was affirmed on appeal by both the district court and the U.S. Court of Appeals for the Fourth Circuit, both of which similarly applied the federal standard. The Supreme Court granted certiorari in order to resolve a split among circuits as to whether federal or state law governs debt recharacterization.

PEM will argue that debt recharacterization is essentially a form of claim disallowance and is therefore governed by the plain language of section 502(b) of the Bankruptcy Code.  That section provides that claims filed against a bankruptcy estate are allowed unless the “claim is unenforceable . . . under applicable law[.]”  Since under North Carolina state law, the “applicable law” in this circumstance, the debt would not be subject to recharacterization, PEM will contend that its secured claim must be allowed.  PEM will also point to the Court’s decision in Butner v. United States, in which the Court expressly held that property rights in bankruptcy are determined by applicable state law unless “some federal interest” requires otherwise.

The Lakebound investors will counter that the equitable power of bankruptcy courts allows for the rejection of form over substance, and that the majority of circuit courts which have considered the issue have found that bankruptcy courts have the authority to recharacterize debt under section 105(a) of the Bankruptcy Code, which provides that bankruptcy courts “may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”  They will argue that recharacterization by bankruptcy courts is an essential part of maintaining the Bankruptcy Code’s priority scheme, and that using the federal test is well within the “appropriate” means of section 105(a).

In its petition for Supreme Court review, PEM described the question as a split among federal courts of appeal as to “whether (a) the doctrine [of recharacterization] is part of some general power of bankruptcy administration or (b) the existing obligations of the debtor based on the law of the [fifty] states.” (emphasis added).  This description could apply equally to numerous other provisions of the U.S. Bankruptcy Code, which in essence constitutes a federal law structure overlaying substantive rights between private parties which are governed by applicable state law.  Bankruptcy judges must often determine whether “some federal interest,” mandates a different outcome for the parties under the Bankruptcy Code than under state law.

The Court will probably rule on this question narrowly in PEM Entities and limit it to the issue of debt recharacterization.  However, it is intriguing to consider where a broader ruling on the extent of “some general power of bankruptcy administration” could lead.  In particular, it could provide the Court with a pathway out of the constitutional maze it created a few years ago in Stern v. Marshall regarding bankruptcy court authority.

In Stern, the Court disrupted a long standing delicate constitutional balance between the need for an effective system of specialized courts existing pursuant to Congress’s bankruptcy power under Article I, Section 8, and the vesting of the judicial power of the United States in the federal courts under Article III.  Since the Court in cases going back to the nineteenth century had limited the final decisional authority of Article I courts to cases involving “public” rights (e.g., cases involving claims of citizens against the government), the ability of bankruptcy courts to hear and determine cases under the Bankruptcy Code was predicated on the notion that “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” constituted a type of “public” right which could be heard and decided by an Article I bankruptcy judge.

Bankruptcy courts accordingly have since 1984 been statutorily authorized under section 157 of the Judicial Code to issue final orders with respect to a variety of enumerated “core” bankruptcy matters, such as resolving claims against a debtor’s bankruptcy estate and confirming plans of reorganization, and required to issue findings of fact and conclusions of law for review and determination by an Article III district court judge for all “non-core” matters. Stern put this balance out of kilter by focusing on parties’ “private” rights, and ruling that even “core” matters would in some situations require adjudication by an Article III judge. Stern involved a challenge to a bankruptcy court’s authority to hear and determine a bankruptcy estate’s counterclaim against an estate claimant.  Even though such counterclaims are listed as “core” matters under section 157, the Court in Stern ruled that it would be unconstitutional for the counterclaim in that case to be decided by an Article I bankruptcy judge, on the basis that it involved a “private” right because the cause of action would exist under state law “without regard to any bankruptcy proceeding.”

Stern has created a constitutional quandary.  Since (per Butner) parties’ rights in bankruptcy are usually based on state law, “core” matters will often implicate “private” rights.  The ability of bankruptcy judges to rule on fundamental matters such as determining whether certain property belongs to a bankruptcy estate has been questioned because they are governed by state law.  Although Stern’s quandary has been narrowed somewhat by subsequent Court decisions, it continues to cause confusion and uncertainty in the adjudication of bankruptcy cases.

The constitutional authority questions arising from Stern and the decisional law question of PEM Entities are very different.  However, if the Court in PEM Entities were to issue a ruling broadly focused on the scope of “the general power of bankruptcy administration” as a “federal interest” requiring the application of federal law to the question of debt recharacterization, it could lead to a viable view of such power as a “public” right.  This in turn could allow courts to make the key constitutional factor in resolving questions of bankruptcy court authority to be the nexus of a particular dispute to “the restructuring of debtor-creditor relations,” instead of whether parties’ rights would separately exist under state law.  Such a focus on the “public” side of the public/private rights dichotomy could provide a path away from the confusion engendered by Stern, and restore the constitutional balance of bankruptcy court authority.

The Supreme Court two years ago ruled in Baker Botts v. Asarco that bankruptcy professionals entitled to compensation from a debtor’s bankruptcy estate had no statutory right to be compensated for time spent defending against objections to their fee applications.  Since then, “estate professionals,” i.e., those retained in a bankruptcy case by a trustee, debtor in possession or an official committee of creditors, have sought ways to limit the potentially harsh impact of that decision.  A subsequent opinion in a Delaware bankruptcy case, In re Boomerang Tube, declined to allow Baker Botts to be circumvented by contract.  However, decisions in another Delaware case, Nortel Networks, and more recently in a New Mexico case, Hungry Horse LLC, have distinguished Boomerang Tube and permitted contractual provisions that allow payment for the defense of fees.  The pragmatic approach taken in Hungry Horse in particular offers a template that other courts will likely be urged to adopt.

In every bankruptcy case, the retention of estate professionals must be approved by the bankruptcy court. Their fees and expenses are paid out of the debtor’s bankruptcy estate and are subject to review and approval by the bankruptcy court pursuant to Section 330 of the Bankruptcy Code.  Objections from other parties have always been a recognized hazard for such professionals.  Prior to Baker Botts a majority of courts permitted the recovery of fees incurred in defending against such challenges.

The Court’s analysis in Baker Botts was straight-forward.  Under American jurisprudence, each side in a litigated dispute bears its own attorneys’ fees unless there is an applicable statute or agreement that provides otherwise.  Section 330(a)(1) of the Bankruptcy Code states: “After notice to the parties in interest and . . . a hearing . . . the court may award to . . . a professional person . . . reasonable compensation for actual, necessary services[.]”  The Court ruled that the plain text of Section 330(a) does not support a deviation from the “American Rule” regarding attorneys’ fees.  The Court’s majority stated, “[t]he word ‘services’ ordinarily refers to ‘labor performed for another.’”  Since Baker Botts was litigating to defend its own fees, the Court reasoned that it was not providing an “actual, necessary service” to the bankruptcy estate and therefore was not entitled to compensation for such time.

Baker Botts makes clear that the Bankruptcy Code does not provide a statutory exception to the American Rule.  The question remaining is whether estate professionals can sidestep it by contract.

In Boomerang Tube, Judge Mary Walrath answered that question in the negative.  The law firm chosen in that case to represent the official committee of unsecured creditors, in its application to the bankruptcy court, asked for the approval order to include a provision that would entitle it to be compensated from Boomerang Tube’s bankruptcy estate for fees incurred in defending its fees against any challenges.  The firm pointed to Section 328 of the Bankruptcy Code, which allows for the retention of estate professionals “on any reasonable terms and conditions.”  It argued that the Supreme Court in Baker Botts had noted that parties could and regularly did contract around the American Rule.

Judge Walrath denied the request. She first held that Section 328 does not create a statutory exception to the American Rule, as it makes no mention of awarding fees or costs in the context of an adversarial proceeding. She observed in contrast that several discrete Bankruptcy Code provisions do contain express language providing for payment of fees to a prevailing party.  She next rejected the law firm’s argument that Section 328 permitted a contractual agreement for the payment of defense fees.  The retention agreement was between the law firm and the official creditors’ committee, but it would be Boomerang Tube’s bankruptcy estate, a non-party to such agreement, that would bear the costs.  Finally, she determined that the proposed fee shifting provisions were simply not “reasonable” terms of employment of professionals with the meaning of Section 328.

In view of the extent to which challenges to estate professionals’ fees (or at least the threat of doing so) are ingrained in chapter 11 practice, it was unlikely that Boomerang Tube would be the last word on this issue.  Recent decisions in two cases, Nortel Networks and Hungry Horse, have distinguished Boomerang Tube.

Judge Kevin Gross, a Delaware colleague of Judge Walrath, ruled in Nortel Networks that Baker Botts and Boomerang Tube did not apply to a fee dispute between an indenture trustee and certain bondholders, and permitted the trustee to recover its attorneys’ fees for defending against the challenge.  Although this case is not directly on point as it did not involve an estate professional, and Judge Gross was not opining on whether Section 328 would permit such an agreement, he held that the bond indenture qualified as a contractual exception to the American Rule, noting that, unlike the retention agreement in Boomerang Tube, it was an agreement directly between the debtor and the trustee.

In Hungry Horse New Mexico Bankruptcy Judge David Thuma looked to Nortel Networks for support in holding that a retention agreement in a chapter 11 case between proposed debtor’s counsel and the debtor could pass muster under Section 328, thereby permitting a contractual work-around to Baker Botts.  Judge Thuma first determined that nothing in Baker Botts prevented a bankruptcy court from finding a fee defense provision in a retention agreement to be “reasonable” within the meaning of Section 328.  In his reading of Baker Botts, the Court simply limited the compensation an estate professional could receive under Section 330 to fees for services to the client, rather than on its own behalf, and noted that Section 328 had no applicability to that issue.

He then considered various other provisions typical of retention agreements, and observed that several were “reasonable” under Section 328 even if they were intended to favor the professional, rather than the client. He pointed to provisions, among other things, setting out retainer requirements, permitting an attorney to withdraw under certain conditions, and granting a lien on certain recoveries.  “A typical employment agreement between a lawyer and a client has many terms; some benefit the client, while others benefit the lawyer.  Considered together, they may be reasonable.”  The overall effect, he noted, is that “the client obtains the services of needed, able professionals.”

Judge Thuma concluded that Section 328 therefore can permit contractual exceptions to the American Rule, and outlined the terms of a fee defense provision in a retention agreement that he believed was “reasonable” and “violat[ed] neither the letter nor spirit of [Baker Botts].”  He stated that, among other things, it needed to be agreed to by the bankruptcy estate, in order to avoid the issue highlighted by Judge Walrath in Boomerang Tube, and provided also that it extended to the creditors’ committee’s professionals, in order to “level the playing field.”  He suggested sample language that he believed could be acceptable under Section 328:

Fee Defense. The Client agrees to pay all reasonable legal fees and expenses incurred by the Firm, and also by any counsel retained by the unsecured creditors’ committee (if one is formed in the Client’s bankruptcy case) for successfully defending their respective fee applications. The bankruptcy court must approve all of such fees as reasonable. The Client will have no obligation to pay for any fees or expenses the Firm incurs defending fees that are not allowed.

Disputes over payment of estate professionals’ fees will invariably remain part of the bankruptcy landscape. Estate professionals in chapter 11 cases are likely to ask bankruptcy judges in other jurisdictions to follow the pragmatic approach of Judge Thuma in Hungry Horse in order to blunt the detrimental impact of Baker Botts.