Co-authored by Doron P. Kenter and Jessica Diab
As we’ve reported, the judicial and academic discourse over Stern v. Marshall continues unabated. One issue that has divided courts is the effect of Stern on the authority of the bankruptcy courts to enter final judgments in fraudulent transfer actions. In fact, just yesterday, the Ninth Circuit Court of Appeals issued its much-awaited decision in In re Bellingham Insurance Agency, Inc. In Bellingham, the Ninth Circuit decided that even though federal law empowers bankruptcy judges to enter a final judgment in a fraudulent conveyance against a “nonclaimant” (i.e., someone who has not filed a proof of claim), the United States Constitution forbids entry of a final order because those claims do not fall within the public rights exception. However, defendants in such actions may (and in this case, did) consent to entry of a final judgment in the bankruptcy court – even if that consent was implied from the defendant’s failure to assert its right to final judgment from an Article III court. Moreover, the Ninth Circuit observed that bankruptcy courts may still hear and make recommendations regarding any statutorily core proceedings as to which they lack the authority to enter a final judgment. We’ll follow up with a more extensive discussion of the Ninth Circuit’s decision, but for the moment, the full text of that decision is available here.
To the contrary, a recent decision of the United States Bankruptcy Court for the Northern District of Illinois stemming from the bankruptcy of home builder Kimball Hill suggests that bankruptcy courts do have authority to enter final judgments in both fraudulent transfer and preference actions – regardless of whether the defendant filed a proof of claim (or whether the fraudulent transfer and preference claims are related to those initial claims), and regardless of whether the parties consented to final adjudication by the bankruptcy court. The Kimball Hill court concluded that the vast majority of the Supreme Court’s decision in Stern (and the Seventh Circuit’s decision in Ortiz. v. Aurora Health Care, Inc. (In re Ortiz)), was mere dicta and therefore not controlling authority for cases differing from the unique set of facts before the Supreme Court in Stern.
In KHI Liquidation Trust v. Wisenbaker Builder Servs., Inc. (In re Kimball Hill, Inc.), the bankruptcy court considered a motion to dismiss a liquidating trustee’s action to recover fraudulent transfers and preferences. The defendants argued that the court did not have constitutional authority to enter a final judgment or even to submit proposed findings of fact and conclusions of law. As to final judgment, defendants argued that the causes of action would “only augment the bankruptcy estate and would not be resolved in the claims allowance process,” and therefore could not be the subject of a final bankruptcy court judgment under Stern. As to the bankruptcy court’s ability to hear the matter and recommend proposed findings of fact and conclusions of law to the district court, the defendants asserted that 28 U.S.C. § 157(c) permitted this only in non-core matters, leaving no possibility that the bankruptcy court could consider the core fraudulent transfer and preference claims under the statutory limits of its authority. On this initial point, the bankruptcy court sided with most other courts, which have rejected the existence of a constitutional and statutory “gap” in bankruptcy court authority to hear core matters as to which it cannot enter a final judgment.
Commentary on Stern and Ortiz
Before exploring the merits of the defendants’ case, the Kimball Hill court took the opportunity to examine Stern and its progeny, particularly in the wake of the Seventh Circuit’s Ortiz decision. The court observed that the Supreme Court in Stern held only that a bankruptcy court “does not have the constitutional authority to enter final orders on counterclaims when the counterclaims are based strictly on state law and are not resolved in the claim allowance process.” Lamenting that the Supreme Court had not “stopped with the very limited language in its primary holding” and suggesting that most of the decision is non-controlling dicta (including the Court’s extensive attempts to reconcile its holding with its earlier holdings, particularly the public-private distinction in Granfinanciera), the Kimball Hill court noted that the only rule to be taken away from Stern is that bankruptcy courts have constitutional authority to enter final judgments where the action: (1) stems from the bankruptcy itself or (2) would necessarily be resolved in the claims allowance process. The bankruptcy court recognized that, under both Stern and Ortiz, the mere fact that an action “augment[s] the estate” is an insufficient basis for the bankruptcy court’s final adjudicative authority,” but cautioned that this principle should not be read as a broad limitation on bankruptcy court authority.
The Kimball Hill court took some time to distinguish the case before it from the Seventh Circuit’s decision in Ortiz (a decision that was binding on the Kimball Hill court). Even though the Kimball Hill court admitted that Ortiz contained “troubling language generalizing bankruptcy courts’ authority” that, if read out of context, “could be deemed to deny bankruptcy courts the authority to rule on any matter other than purely administrative matters arising in a debtor’s bankruptcy case,” the bankruptcy court once again noted that any such discussion is simply dicta and nonprecedential. In any event, the court observed, the proceeding before it did not involve counterclaims and was in no way “steeped in state law,” and accordingly “[did] not share anything in common with the proceedings that Stern and Ortiz held was unconstitutional other than that they are all adversary proceedings in a bankruptcy case” – which commonality was “not sufficient to expand [Stern’s] explicitly narrow holding.”
Holding: The Bankruptcy Court Has Constitutional Authority to Enter Final Judgments in Preference and Fraudulent Transfer Actions
Only after this extensive commentary did the bankruptcy court in Kimball Hill turn to the merits of the defendants’ motion to dismiss.
Turning first to the preference action, the court reasoned that it was unnecessary to examine the relation between that action and the defendant’s filed proofs of claim. The two-part test under Stern was satisfied if either the matter stems from the bankruptcy or would necessarily be resolved in the claims adjudication process. Because preference actions “only exist as a matter of bankruptcy law” and because the right to recover preferences pursuant to section 547 of the Bankruptcy Code “is both unique and vital to bankruptcy because it serves one of bankruptcy’s fundamental goals, [namely,] the equal distribution of estate property to creditors,” The Kimball Hill court found that Stern did not preclude it from entering a final judgment on the preference claims, a decision consistent with every published opinion to have addressed this question.
Turning to the fraudulent transfer action, the bankruptcy court rejected the defendants’ argument that fraudulent transfer claims “resemble state law contract claims” and were therefore outside the bankruptcy court’s authority. Instead, the bankruptcy court stated that fraudulent transfer actions, “if anything,” resemble state law fraudulent transfer claims – which are themselves derived from bankruptcy law. The court remarked that claims for recovery of fraudulent transfers “have been a part of insolvency since 1570,” and that the Uniform Fraudulent Transfer Act, which has been adopted by most states, “conforms to fraudulent conveyance law as set forth by Congress in the Bankruptcy Code.” Therefore, the court observed that “the resemblance between bankruptcy fraudulent transfer claims and state fraudulent transfer claims is because the state claims have as their source, and are modeled after, the bankruptcy claims.” Because fraudulent transfer claims were “at the core of the federal bankruptcy power” and “are integral to the debtor-creditor relationship,” the bankruptcy court sided with the “quite large” number of courts to have determined that they have authority to enter a final judgment on fraudulent transfer claims. Noting that the Supreme Court’s decision in Stern was, in the Court’s own words, “narrow,” and not meant to “change all that much” – especially regarding “the division of labor” between bankruptcy courts and district courts, the bankruptcy court concluded that there was no basis to dismiss the fraudulent transfer claim. The court remarked that, “[a]s the right to avoid a fraudulent transfer is steeped in bankruptcy law, the bankruptcy court’s entering final orders on the proceeding does not chip away at the authority that the Constitution vested to the Article III courts.” Quoting Judge Sontchi’s decision in In re: Anderson News, LLC, the court finally observed that “[t]o hold otherwise would be ‘to create a mountain out of a mole hill.’”
Extensive litigation is still underway, and a number of other courts (including the Ninth Circuit) have reached a different conclusion, finding that the bankruptcy courts do not have authority (absent consent) to enter final judgment on fraudulent transfer claims. Will other courts follow Kimball Hill? Or will they conclude that fraudulent transfer actions are outside the bankruptcy courts’ final adjudicatory authority? Regardless, if bankruptcy courts can hear such actions and adjudicate all pretrial matters (as appears to be the trend) – or even issue proposed findings of fact and conclusion of law – what is the ultimate effect of this continued discourse? Though Stern might be a mole hill, moles can still be pesky creatures. . .