Category Archives: Bankruptcy Litigation

The Mass of Contradictions that Define “Bad Boys” in Sports, Art, Life, and the Law

The phrase “bad boys” is one that conjures up a multitude of contradictory connotations. In sports, the Detroit Pistons wore the moniker proudly as they pummeled their way to consecutive NBA championships. Those bad boys, however, are long gone and now the same team is just plain bad.

In art, Jerry Bruckheimer produced “Bad Boys” in 1995 and “Bad Boys II” in 2003, starring Will Smith and Martin Lawrence as bad boy Miami detectives. These likable actors, however, failed to convey much of a bad boy image and critics panned the movies. Not deterred, a third installment, “Bad Boys III,” is scheduled for 2015, but it too (like “Die Hard 5”) is likely to disappoint.

In life, John Alleman had become a Las Vegas sensation. Starting in about June 2011, he stood outside the Heart Attack Grill for nothing more than the love of the place (and some occasional free food) and colorfully pitched and cajoled people to sample such delicacies as Flatliner Fries, Butterfat Shakes, and the king-of-them-all, the Quadruple Bypass Burger (which holds the Guinness World Record for the “most calorific burger”). Late last year, this bad boy suffered a massive heart attack at a bus stop and died, thus ending his short—but glorious—reign as Sin City’s leading tempter of fate.

In the law, bad boys often find they pay a hefty and quite disproportionate price for their bad acts. Consider, for example, the case of Michael Turner. This bad boy received a $40,000 insurance settlement check three days before he filed bankruptcy and then cashed the check three days after he filed bankruptcy, using about one-quarter of the proceeds to pay down a mortgage while pocketing the rest.  His failure to disclose this asset in his bankruptcy schedules, as mandated by the Code, led a grand jury three years later to return a six-count indictment against him that eventually resulted in a bankruptcy fraud conviction and a 27 month jail sentence.  The 11th Circuit recently upheld his sentence as appropriate under today’s harsh federal sentencing guidelines. United States v. Turner, 2013 WL 510092 (11th Cir., Feb. 12, 2013).

Some bad boys, however, manage to avoid the cudgel of the law by seizing onto a loophole that averts near-certain doom. Consider, for example, bad boy Bernie Kurlemann, whose bank fraud conviction was reversed because the statute only criminalizes “false statements.”  Since he kept his mouth shut and told only half the truth, the court ruled, he couldn’t be convicted under a statute that does not criminalize “half-truths,” “material omissions,” or “concealments.”   United States v. Kurlemann, 2013 WL 513976 (6th Cir., Feb. 13, 2013) . True, Kurleman was still convicted on bankruptcy fraud charges, but that paled in comparison to the time he would have served had the bank fraud conviction been upheld.

Finally, consider so-called “bad boy” bank guaranties, where one’s personal liability to a lender is instantly multiplied from a fraction of the loan amount to the full indebtedness simply because one engaged in any one of various enumerated “bad acts” (such as waste, fraud, misappropriation, bankruptcy, receivership, violation of special purpose entity covenants, or incurrence of subordinate debt without the lender’s consent). Here in Illinois, bad boy Laurance Freed, developer of the long-vacant “Block 37” on North State Street in Chicago, committed such a bad boy act when he had the temerity to contest the bank’s appointment of a receiver and file defenses to the bank’s foreclosure action. Though the ensuing delays were but a mere nuisance for the bank, that didn’t stop the Illinois Appellate Court from affirming that (i) Freed’s nominal challenges to the bank’s actions triggered the full $206 million recourse liability (up from $50 million) and (ii) the increase was not wholly disproportionate to the damages suffered by the bank from having to deal with the nuisance litigation and so was not an unenforceable penalty. In sum, the Court held, if you’re a “bad boy” under your own contractual definition of one, don’t expect a Court to bail you out of your own mess. Bank of America v. Freed, 2012 WL 6725894 (Ill. App. Ct., December 28, 2012).

In conclusion, there’s a clear moral to this story:

Except perhaps in sports and art, being a bad boy can be hazardous to life (RIP Mr. Alleman), liberty (Turner Kurlemann), and the pursuit of happiness (Freed)!

Thanks for reading!

US Supreme Court Deciphers “Defalcation” in Bullock: A Canonical Exercise in “Reading Law” (Scalia/Garner)

The US Supreme Court has long taught the importance of certain canons of interpretation unique to bankruptcy law, the more significant ones being:

  • The Fresh-Start Policy:  A primary purpose of bankruptcy is to relieve the debtor “from the weight of oppressive indebtedness and permit him to start afresh….” (Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934).
  • Equality of Distribution:  “[H]istorically one of the prime purposes of the bankruptcy law has been to bring about a ratable distribution among creditors of a bankrupt’s assets….”  Young v. Higbee Co., 324 U.S. 204, 210 (1945); Union Bank v. Wolas, 502 U.S. 151, 161 (1991).  “Any doubt concerning the appropriate characterization [of a bankruptcy statutory provision] is best resolved in accord with the Bankruptcy Code’s equal distribution aim.”  Howard Delivery Serv., Inc. v. Zurich American Ins. Co., 547 U.S. 651, 667 (2006) (discussed at length in this blog post).
  • Narrow Construction of Priority Provisions:  Canon favoring equality of distribution gives rise to a “corollary principle that provisions allowing preferences must be tightly construed.”  Howard Delivery Serv., Inc. v. Zurich American Ins. Co., 547 U.S. 651, 667 (2006).
  • Narrow Construction of Exceptions to Discharge:  “[E]xceptions to the operation of a discharge … should be confined to those plainly expressed.”  Gleason v. Thaw, 236 U.S. 558, 562 (1915).  This furthers bankruptcy’s policy of achieving a “fresh start.”  Kawaauhau v. Geiger, 523 U.S. 57, 62 (1998).
  • Significance of Past Bankruptcy Practice:  “[Do] not read the Bankruptcy Code to erode past bankruptcy practice absent a clear indication that Congress intended such a departure.”  Pennsylvania Dept. of Public Welfare v. Davenport, 495 U.S. 552, 563 (1990).
  • Property Rights in Estate Assets Dependent on State Law:  “Property interests are created and defined by state law…. Unless some federal interest requires a different result, there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.”  Butner v. United States, 440 U.S. 48, 57 (1979).
  • Creditors’ Rights Dependent on State Law:  “What claims of creditors are valid and subsisting obligations against the bankrupt at the time a petition in bankruptcy is filed is a question which, in the absence of overruling federal law, is to be determined by reference to state law.”  Vanston Bondholders Protective Comm. v. Green, 329 U.S. 156, 161 (1946).

Last year, Justice Scalia and Professor Bryan Garner published a phenomenal book, Reading Law: The Interpretation of Legal Texts.  Many know of Justice Scalia, though he’s probably at the low end of the already (unfairly) historically low favorability rating for the Supreme Court.  Many fewer know of Professor Garner, but if you’re not his fan, you should be.  He’s prolific beyond words, which are his specialty (and as to which he has no modern equivalent).  His writings include: Garner’s Modern American UsageLegal Writing in Plain EnglishGarner’s Dictionary of Legal Usage, and The Winning Brief, each one of which should be on your bookshelf.  He also has been the Editor-in-Chief of Black’s Law Dictionary since 1995.  Follow Professor Garner on Twitter and learn, among other things, of the latest smiling antiquarian bookseller whose shelves he recently raided.  Before Reading Law, Justice Scalia and Professor Garner published an invaluable guide to litigators entitled, Making Your Case: The Art of Persuading Judges (2008).

In the book’s introduction, Chief Judge Easterbrook called Reading Law “a great event in American legal culture.”  Judge Posner, however, wasn’t quite as enamored with it, which apparently got a bit under Justice Scalia’s skin, prompting this retort from Judge Posner.  (All seems well now, however, as Judge Posner was placed at the same table as Justice Scalia at last month’s Chicago Lawyers’ Club luncheon event promoting the book, though as fate would have it Justice Scalia’s plane was late, so we’ll never know how that seating arrangement would have worked out.)

The book cites to 57 interpretive canons (split among 5 “fundamental principles,” 11 “semantic” canons, 7 “syntactic” canons, 14 “contextual” canons, 7 “expected-meaning” canons, 3 “government-structuring” canons, 4 “private right” canons, and 6 “stability” canons) and concludes by “exposing” 13 far more controversial “falsities” (such as “the false notion that committee reports and floor speeches are worthwhile aids in statutory construction”).  It also contains the best bibliography imaginable of over 1,500 books and articles on legal interpretation dating back as early as 1621 (Coke’s First Part of the Institutes of the Laws of England) and 1677 (Hatton’s Treatise Concerning Statutes).

The Supreme Court’s recent unanimous decision in Bullock v. BankChampaign, N.A., No. 11-1518 (May 13, 2013), which was decided primarily based on the book’s Canon No. 31, the “Associated-Words Canon” (better known as noscitur a sociis–“it is known by its associates”), highlights the importance of keeping Justice Scalia’s and Professor Garner’s book close at hand.  In describing how this canon works, Justice Scalia and Professor Garner call it “a classical version, applied to textual explanation, of the observed phenomenon that birds of a feather flock together.”  They further explain:

When several nouns or verbs or adjectives or adverbs–any words–are associated in a context suggesting that the words have something in common, they should be assigned a permissible meaning that makes them similar.  The canon especially holds that “words grouped in a list should be given related meanings.”  (p.195) (citing Third Nat’l Bank in Nashville v. Impac Ltd., 432 U.S. 312, 322 (1977)).

The issue faced by the Supreme Court in Bullock was what mental state would be required under Bankruptcy Code section 523(a)(4) for a debt owed by an individual debtor to be excepted from discharge because of the debtor’s “defalcation while acting in a fiduciary capacity.”  (Section 523(a)(4) in its entirety excepts from discharge any debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.”)

The Court granted certiorari because the cases interpreting this statutory provision were split regarding where on the spectrum from negligence to actual intent one’s state of mind must fall so that the debt arising from defalcation of one’s fiduciary duty should be nondischargeable in bankruptcy.  The First and Second Circuits required a minimum of “extreme recklessness.”  The Fifth, Sixth, and Seventh Circuits required a minimum of “objective recklessness.”  Mere negligence or innocent mistake was sufficient for the Fourth, Eighth, and Ninth Circuits.

The Court ultimately sided with the First and Second Circuits and adopted a scienter that embraces an “extreme recklessness” standard.  (Op. at 9).  The Court agreed with the Second Circuit that adopting the scienter standard “has the virtue of ease of application since the courts and litigants have reference to a robust body of securities law examining what these terms mean.”  (Op. at 9) (quoting In re Hyman, 502 F.3d 61, 69 (2d Cir. 2007)).  The Court also specifically included within actionable recklessness “the kind set forth in the Model Penal Code … [where] the fiduciary ‘consciously disregards’ (or is willfully blind to) ‘a substantial and unjustifiable risk’ that his conduct will turn out to violate a fiduciary duty.”  (Op. at 6).  “That risk,” the Court held, ” ‘must be of such a nature and degree that, considering the nature and purpose of the actor’s conduct and the circumstances known to him, its disregard involves a gross deviation from the standard of conduct that a law-abiding person would observe in the actor’s situation.’ ”  (Op. at 6) (quoting ALI, Model Penal Code §2.02(2)(c)) (emphasis in opinion).

As with all Supreme Court cases, however, it’s not the answer that’s of greatest import, but how the Court got there.  In Bullock, the Court arrived at its conclusion, first and foremost, by applying the noscitur a sociis canon and holding that the mental state required for “defalcation” by a fiduciary under Code section 523(a)(4) is on par with the other fraudulent or felonious intentions characteristic of its statutory neighbors “fraud,” “embezzlement,” and “larceny”.  (Op. at 7) (“And here, the additional neighbors (‘larceny’ and, as defined in Neal, ‘fraud’), mean that the canon noscitur a sociis argues even more strongly for similarly interpreting the similar statutory term ‘defalcation’.”)

Also important to the Court’s decision was the bankruptcy-specific canon that “exceptions to discharge should be confined to those plainly expressed.”  (Op. at 8).  Applying a heightened intent standard for a fiduciary’s “defalcation,” the Court held, was “consistent with a set of statutory exceptions [in Code section 523 generally] that Congress normally confines to circumstances where strong, special policy considerations, such as the presence of fault, argue for preserving the debt.”  (Id.).  “In the absence of fault,” the Court continued, “it is difficult to find strong policy reasons favoring a broader exception here….”  (Id.)

Notably, the Respondent had the support of 13 professors (including Ken Klee), whose amicus brief rejected the noscitur a sociis canon as inapplicable on the basis that the words “fraud,” “embezzlement,” and “larceny” were “remote companions” to the term “defalcation.”  They also criticized the focus of the inquiry being on the “fresh start” of the debtor “rather than on the injury to trust beneficiaries, to whom Congress granted special protection under clause (4).”  (Profs. Amicus Brief at 20, 34).  The Respondent’s position was also supported by the Office of the United States Trustee, which (as noted by Professor Mann in this post on SCOTUS Blog) hadn’t lost an argument before the Court in the last 15 years in which it called for interpretations that more broadly enforce the exceptions to an individual’s bankruptcy discharge.

The Petitioner, conversely, could muster just one professor to support him, Eric Brunstad, who Professor Mann calls “the most noted of Supreme Court bankruptcy advocates, [who] has argued, briefed, and won more bankruptcy cases in the Supreme Court than any other attorney in history.”  Eric argued that (i) the Court “routinely” applies the noscitur a sociis canon in circumstances like these and (ii) the canons equally applicable here in favor of the Petitioner are those that (A) require “narrow construction of the exceptions to discharge relief” and (B) “[do] not … erode past bankruptcy practice absent a clear indication that Congress intended such a departure.”  (Brunstad Amicus Brieat 18-26).

Thus far, Reading Law has been cited since its publication last year in 12 merits briefs in eight different cases before the Court.  Professor Mann warned in another SCOTUS Blog post that Bullock’s “noscitur a sociis argument is presented replete with risky citations to the discussion of that topic in Justice Scalia’s recent book (with Bryan Garner) on Reading Law – risky because of the likelihood the citations will irritate Justice Scalia’s colleagues.”  That risk factor seems overblown given the 9-0 decision.  Naturally, the Court didn’t cite Reading Law as authority for its result; and why should it?  If the Court can’t cite to a prior one of its cases that employs the canon in question (as it did in Bullock to Justice Harlan’s opinion for the Court in Neal v. Clark, 95 U.S. 704, 709 (1878)), then that canon is not likely to see the light of day for the first time in a 21st century opinion!

In the end, we are left with another short, satisfying bankruptcy opinion from the Court that confirms the importance of canonical thinking in interpreting the Bankruptcy Code’s thornier provisions.  My next blog post, shortly forthcoming, will discuss the significance of the holding in Bullock beyond just the narrow context of nondischargeability cases in bankruptcy.

Meanwhile, we wish Justice Breyer, Bullock’s author, a speedy recovery from his shoulder replacement surgery, but his issuance of Bullock less than three weeks later seems a good sign that all is proceeding well for him!

Thanks for reading!

US Supreme Court’s Decision in Bullock: A Significant Development in Determining “Recklessness” Under Federal Law?

Last week I published a blog post on the US Supreme Court’s unanimous decision in Bullock v. BankChampaign, N.A., No. 11-1518 (May 13, 2013), that focused on the Court’s application of the noscitur a sociis canon to the bankruptcy nondischargeability statute dealing with “defalcation in a fiduciary capacity.”

I write this second blog post discussing Bullock because I think the case will prove especially noteworthy for those who deal with the concept of “recklessness” in their civil practice.

Professor Ann Morales Olazábal authored an article entitled Defining Recklessness: Doctrinal Approach to Deterrence of Secondary Market Securities Fraud, 2010 Wis. L. Rev. 1415, in which she looked at attempts to define “recklessness” in tort, criminal, patent, securities, and employment law (among others) and concluded that “the single common thread among the recklessness standards employed in this mixed bag of legal inquiries may be their opacity and lack of susceptibility to any kind of uniform application.”  Id. at 1422.  In the federal securities context, she writes, “[a]s in other legal arenas, recklessness in the 10(b) context has nowhere been defined serviceably or with any real consistency.”  Id. at 1424.

In What Is Securities Fraud?, 61 Duke L.J. 511, 534-36 (2011), Professor Sam Buell wrote that courts in the securities law context differ on whether recklessness should be defined by a “conscious disregard” or a “super-negligence” standard:

Scienter is a confusing word because its most natural meaning–and the one often associated with it–is knowledge.  But the term is used, at least in the area of securities fraud, to mean simply level of fault.  A statement like “scienter is required for liability” often is meant to do no more than rule out strict liability.  In this form, scienter stands for a full menu of choices on the matter of awareness: knowledge, knowledge plus willful blindness, recklessness, gross negligence, or negligence.

Which level to choose is a function of the conception of fraud one wishes to pursue….  A regime centered on culpability and blameworthiness–in its focus on responsibility for acts of deception–is likely to require not only some scienter but a high level of awareness….

Whatever level of fault is chosen, it must be clearly specified.  Specifying the level of fault is especially important with regard to recklessness because the law of fraud has often been unclear as to whether reckless fraud exists or should exist.

The most precise and demanding definition of recklessness, and the one most often used in criminal law, is the one found in the Model Penal Code: the conscious disregard of a substantial and unjustifiable risk–provided that the actor’s disregard of that risk grossly deviates from how a reasonable person would act in the same circumstances.  Under this definition, recklessness is a form of knowledge.  The actor is actually aware of the risk that inheres in the situation, as opposed to, in the case of a full knowledge requirement, having the practical certainty that it inheres.  I call this the “conscious-disregard” form of recklessness.

As is well known, other formulations of recklessness treat it as a heightened form of negligence.  In these formulations, recklessness does not generally require the actual, subjective disregard of a risk.  As with negligence, the actor must have failed to advert to and act upon a risk–the difference from negligence being that the actor’s failure represents more than a lack of due care.  The failure demonstrates a high level of social deviance.  That deviance relates to the degree of the risk, the nature of the risk, or a combination of the two. I call this the “super-negligence” form of recklessness.  (Emphasis added).

Perhaps, then, Bullock points a way out of this legal morass in regards to what constitutes reckless misconduct.  As noted in my earlier post, in deciding what mental state would be required under Bankruptcy Code section 523(a)(4) for a debt owed by an individual debtor to be excepted from discharge because of the debtor’s “defalcation while acting in a fiduciary capacity,” the Court ultimately sided with the First and Second Circuits and adopted a scienter that embraces an “extreme recklessness” standard.  (Op. at 9).  In so doing, the Court agreed with the Second Circuit that adopting the scienter standard in the nondischargeability context “has the virtue of ease of application since the courts and litigants have reference to a robust body of securities law examining what these terms mean.”  (Op. at 9) (quoting In re Hyman, 502 F.3d 61, 69 (2d Cir. 2007)).

What is most significant in the Court’s opinion for purposes of this blog post was the Court’s specifically tying actionable recklessness to “the kind set forth in the Model Penal Code … [where] the fiduciary ‘consciously disregards’ (or is willfully blind to) ‘a substantial and unjustifiable risk’ that his conduct will turn out to violate a fiduciary duty.”  (Op. at 6).  “That risk,” the Court held, ” ‘must be of such a nature and degree that, considering the nature and purpose of the actor’s conduct and the circumstances known to him, its disregard involves a gross deviation from the standard of conduct that a law-abiding person would observe in the actor’s situation.’ ”  (Op. at 6) (quoting ALI, Model Penal Code §2.02(2)(c)) (emphasis in opinion).  Significantly, the Court then closed this discussion of actionable recklessness by cross-referencing Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), where the Court defined scienter for securities law purposes as “a mental state embracing intent to deceive, manipulate, or defraud.”  Id. at 194 n.12.  (Op. at 6).

The Court’s juxtaposition of the Model Penal Code’s “gross deviation” standard of recklessness with scienter under the federal securities laws has not been embraced by the case law.  My quick research in Section 10(b) cases found this connection between recklessness and the Section 2.02 of the Model Penal Code only twice since Hochfelder was decided in 1976.  See In re Comshare Inc. Securities Litigation, 183 F.3d 542, 550 n.6 (6th Cir. 1999); and In re Baesa Securities Litigation, 969 F. Supp. 238, 241 (S.D.N.Y. 1997).

Bullock‘s defining scienter as including recklessness only under what Professor Buell calls “the most precise and demanding definition of recklessness … found in the Model Penal Code” should prove to be an important development not only in the context of the federal securities law, but in the context of all other federal civil laws where liability is based on one’s recklessness.

Thanks for reading!

A Guest Post by Yitzhak Greenberg: “Deeper into the Darkling Abyss: The 5th Circuit joins the 6th and 7th Circuits in Finding that Consent Cannot Cure A Bankruptcy Court’s Stern Infirmity”

Blogging has enabled me to meet many people I otherwise likely would never have met.  On such person is Yitzhak Greenberg, a bankruptcy attorney in New York City who clerked for Judge Arthur Gonzalez and whose practice is focused on all aspects of bankruptcy (including the representation of both debtors and creditors).  Yitzhak is passionate about contributes to the advancement of our understanding of complex bankruptcy law issues.  Among other things, he has written for The Bankruptcy Strategist and the Norton Bankruptcy Advisor and has participated in panels sponsored by the PLI and Law Journal Newsletters.

He can be reached at [email protected] or [email protected].

Yitzhak has long taken an interest in the bankruptcy jurisprudence expounded by the US Supreme Court.  His discussion in the July 2011 issue of the Norton Bankruptcy Advisor, entitled Credit Bidding After Philadelphia Newspapers: The Fat Lady Has Not Sung, merited citation by the Radlax petitioner in its opening merits brief on the subject of credit bidding.

Yitzhak now graciously offers, through this guest post, an analysis of whether a bankruptcy court can enter a final order in a Stern proceeding with the parties’ consent.  Yitzhak shows that the seemingly obvious answer is anything but.  His discussion is a good preview of the issues that the Supreme Court will address this coming term in Bellingham (see also Weil Bankruptcy Blog for further background into the case).

The famed Professor Karl Llewellyn equated the study and practice of law to the boy in the nursery rhyme who jumps into a bramble bush, thereby scratching out his eyes, and then summons “all his might and main” to jump into a second bush, thereby having them scratched back in.  Yitzhak in this guest post offers “a modest proposal” out of the bramble bush through amendments to the local district courts’ standing orders of reference.  Still, even if Courts were to adopt Yitzhak’s proposal, thereby avoiding further needless brain damage on the issue, the Supreme Court will rule on the issue, thus allowing us to both have the bramble bush and eat it (as suggested by John Heywood in his book of proverbs in 1546).

Special thanks to Yitzhak for offering to share his wisdom with readers of this blog.  My blogging has been a definite casualty of a busier work schedule and pretty mischievous twin boys (now five years older than in this post).  I hope Yitzhak’s second guest post (first one on “Stub Rent”) encourages other guest post submissions (and his return).  With total page views on the blog to date at over 750,000, it’s a good way to hit one’s target audience.

Deeper into the Darkling Abyss: The Fifth Circuit joins the Sixth and Seventh in Finding that Consent Cannot Cure A Bankruptcy Court’s Stern Infirmity

“Or whether instead they [i.e., the Article III Cases] are but landmarks on a judicial ‘darkling plain’ where ignorant armies have clashed by night.” Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50, 91 (1982), (Rehnquist, J., concurring).

In Stern v. Marshall, 131 S.Ct. 2594, 2609 (2011), the Supreme Court held that Congress’s grant of authority to a bankruptcy court to enter a final judgment in all “core” proceedings violated Article III of the Constitution because Article III prohibits the entry of final judgments by a bankruptcy court (i.e., a non Article III court) in proceedings that are “the stuff of the traditional actions at common law tried by the courts at Westminster in 1789.”  Wellness Intern. Network, Ltd. v. Sharif, 2013 WL 4441926 at *17 (7th Cir. 2013) (quoting Stern, 131 S. Ct. at 2609and Northern Pipeline, 102 S. Ct. 2858, 2881 (1982)). Thus, Stern created a new category of proceedings that are “core” but unconstitutional (hereinafter, “Stern Proceedings”).

The Circuits are split regarding whether consent can cure a bankruptcy court’s infirmity to enter a final order in a Stern Proceeding. The Sixth Circuit concluded that consent cannot cure a bankruptcy court’s Stern infirmity.  Waldman v. Stone (In re Stone), 698 F.3d 910 (6th Cir. 2012). In contrast, the Ninth Circuit found that consent permits a bankruptcy court to enter a final order in a Stern Proceeding.  In re Bellingham Ins. Agency, 702 F.3d 553 (9th Cir. 2012).

The Supreme Court granted certiorari to the appeal of Bellingham. Shortly thereafter, the Seventh Circuit weighed in on the split between the Sixth and Ninth Circuits and agreed with the Sixth Circuit’s decision in Waldman that consent could not cure a bankruptcy court’s Stern infirmity.

More recently, the Fifth Circuit joined the fray and found that the structural concerns of Article III cannot be ameliorated by consent or waiver. In re Frazin, 2013 WL 5495920 (5th Cir. 2013).  In contrast to the Seventh Circuit’s almost eleven-page analyses of consent and the holdings of the other Circuits, the Fifth Circuit addressed consent in a relatively short footnote that failed to discuss WaldmanBellingham, or Wellness.  The Fifth Circuit reasoned:

However, when “separation of powers] is implicated in a given case, the parties cannot by consent cure the constitutional difficulty…. When these Article III limitations are at issue, notions of consent and waiver cannot be dispositive because the limitations serve institutional interests that the parties cannot be expected to protect.” C.F.T.C. v. Schor, 478 U.S. 833, 850–51 (1986). As discussed above, Stern makes clear that the practice of bankruptcy courts entering final judgments in certain state-law counterclaims “compromise[s] the integrity of the system of separated powers and the role of the Judiciary in that system.” 131 S. Ct. at 2620. Thus, structural concerns cannot be ameliorated by Frazin’s consent or waiver.

Frazin, 2013 WL 5495920 at *10, fn. 3 (5th Cir. 2013).

A remarkable feature of the Fifth Circuit’s treatment of consent in Frazin is its failure to distinguish its holding from Technical Automation Services Corp. v. Liberty Surplus Ins. Corp., 673 F.3d 399(5th Cir. 2012). There, the Fifth Circuit determined that Stern does not affect an Article I magistrate judge’s statutory authority to enter final orders on common law causes of action with consent, but avoided making a comparable determination regarding Article I bankruptcy judges, stating: “The similarities between bankruptcy judges and magistrate judges suggest that the Court’s analysis in Stern could be extended to this case, the plain fact is that our precedent in Puryear is there, and the authority upon which it was based has not been overruled”.  Id. at 407.

Frazen, therefore, simply disregards the elephant in the room: If bankruptcy judges and magistrates are similar, why does consent only allow a magistrate judge to enter a final order in matters that would otherwise by the exclusive province of an Article III court?

Before the Seventh Circuit’s decision in Wellness and questions raised by the fact that the US Supreme Court granted certiorari in Bellingham, many courts viewed the Sixth Circuit’s decision in Waldman as aberrational.  Consent was viewed as a cure to a bankruptcy court’s Stern infirmity; parties could simply waive their Article III rights.  Waldman was viewed as inconsistent with the bankruptcy regime’s strong reliance on consent and inapposite to the well-accepted jurisprudence rooted in the bankruptcy case law, the Federal Magistrates Act, and Supreme Court case law.  Case law support is articulated in Bellingham, which concluded that “[i]f consent permits a non-Article III judge to decide finally a non-core proceeding, then it surely permits the same judge to decide a core proceeding in which he would, absent consent, be disentitled to enter final judgment.”  Bellingham, 702 F.3d at 567.  Support in the Federal Magistrate Act is based on the oft-stated similarity between bankruptcy judges and magistrate judges and the fact that the Federal Magistrate Act allows “federal magistrate judges, acting with the consent of the litigants, to enter final judgments in proceedings that would otherwise be the exclusive province of Article III courts.”  Id. at 567 n. 10.  Finally, support is Supreme Court case law based on the Court’s statement that “as a personal right, Article III’s guarantee of an impartial and independent federal adjudication is subject to waiver.” Commodity Futures Trading Commission v. Schor, 478 U.S. 833, 848 (1986).

Bellingham highlighted Waldman’s failure to adequately distinguish its holding from the numerous instances where consent does cure an Article III infirmity.  Courts in other jurisdictions paid scant attention to Waldman.  But Wellness addressed issues ignored by Waldman and provides a road map of how the Supreme Court could find that the Article III protections cannot be waived by consent, thereby meaning that Waldman can no longer be ignored with impunity.

In so doing, the Seventh Circuit analyzed the complexities of Article III’s protections.  Section 1 of Article III not only protects individual interests but also is “an inseparable element of the constitutional system of checks and balances.” Stern 131 S.Ct. at 2597.  Wellness noted that “[t]he dual nature of Article III renders notions of waiver and consent more nuanced than they are in other areas….  [T]he difficulty [is] separating out the waivable personal safeguard from the nonwaivable structural safeguard.”  Wellness, 2013 WL 4441926 at *15.  Significantly, Wellnessdistinguished between consent to entry of a final order by a bankruptcy court in a core proceeding versus consent in a noncore proceeding.  Id. at *17.

In any event, the statutory scheme established by Congress for core proceedings differs in significant respects from the scheme for noncore proceedings [and magistrate judges]… Section 157(c)(2) permits a bankruptcy judge to enter final judgment in a noncore proceeding, but only if the parties consent and the district court decides to refer the matter to the bankruptcy court. Thus, a strong argument can be made that with respect to noncore proceedings Congress has left the essential attributes of judicial power to Article III courts, and so the structural interests at issue with regard to core proceedings are not present under the current statutory scheme applicable to noncore proceedings.


A Modest Proposal: Amending the Standing Orders of Reference.

Core but unconstitutional is an oxymoron. Congress created the categories of core and noncore in response to Northern Pipeline, which concluded that the 1978 Act’s grant of authority to bankruptcy courts violated Article III.  With this historical background, the Ninth Circuit found that statutorily a bankruptcy judge may only determine a claim that meets Congress’ definition of a core proceeding and “arises under or arises in title 11”(i.e., the statute limits a bankruptcy court’s jurisdiction to instances where the exercise of such jurisdiction is consistent with Article III).  In re Marshall, 600 F.3d 1037, 1055 (9th Cir. 2010).  While the Supreme Court rejected this rationale and found that a portion of the statute could and did violate Article III, the Ninth’s Circuit understanding could be implemented through (i) Congress amending the statute to limit the jurisdiction of bankruptcy courts to matters that “arises under or in title 11” (and thus not include “related to” proceedings) or (ii) the District court’s amending of standing orders of reference to withdraw the reference for Stern Proceedings.

Of the two, the district court’s amending of the standing orders is obviously far more expeditious and simpler than waiting for Congress to act (which in its present state is unlikely to ever happen on this arcane issue).  The Seventh Circuit found that the structural interests are protected in a noncore proceeding because, in addition to consent, the District Court must decide to refer the case to a bankruptcy court for a final order.

As such, a simple solution to latest Stern quandary is found by the district court’s retaining — and not automatically referring — Stern Proceedings to the bankruptcy court.  If the district court were to refer a Stern Proceeding to a bankruptcy court, the entry of a final order would be consistent with both the individual and institutional safeguards of Article III:  the district court will have referred the matter to the bankruptcy court and the parties will have consented to the proceeding.  Still, a note of caution is in order because it must be noted that Seventh Circuit in Wellness was “not express[ing] an opinion on the constitutionality of § 157(c)(2), or for that matter § 636(c)(1) which permits litigants to consent to entry of final judgment by a magistrate judge.”  Wellness, 2013 WL 4441926 at *17.

Chief Judge Easterbrook Writes That Free Market Competition Trumps Equity’s Attempted Free Lunch Under the New Value Exception to the Absolute Priority Rule

A 7th Circuit opinion authored by Chief Judge Easterbrook last week had me again looking across the street at 203 North LaSalle and wondering whether the US Supreme Court will ever finally decide whether there is a “new value” exception to the absolute priority rule (which requires that when an unsecured creditor class objects to a plan of reorganization, it must be paid in full before junior claims or interests get anything).

The question of whether there’s a “new value” exception to the absolute priority rule (i.e., whether old equity can contribute new capital and receive new equity interests in the reorganized entity) was expressly left open by the US Supreme Court in Bank of America National Trust & Savings Ass’n v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999).  Before the case went to the Supreme Court, the 7th Circuit ruled in 203 N. LaSalle  that the oft-ignored decision in Case v. Los Angeles Lumber Products Co., 308 U.S. 106 (1938), provided the basis for the new value exception in cases where the equity interest holder contributes new value that is both reasonably equivalent to the value of the equity interest and necessary for the debtor’s successful reorganization.  In re 203 N. LaSalle St. P’ship, 126 F.3d 955 (7th Cir. 1997).  While refusing to specifically endorse a new value exception or “corollary” to the absolute priority rule, the Supreme Court in 203 N. LaSalle held: “[A]ssuming a new value corollary [exists], [then] plans providing junior interest holders with exclusive opportunities free from competition and without benefit of market valuation” violate the absolute priority rule.”  203 N. LaSalle, 526 U.S. at 458.

In In re Castleton Plaza, No. 12–2639, 2013 WL 537269 (7th Cir. Feb. 14, 2013), the 7th Circuit Court of Appeals faced an issue never before addressed by a Court of Appeals, that being whether “an equity investor can evade the competitive process by arranging for the new value to be contributed by (and the new equity to go to) an ‘insider’ [as defined in the Bankruptcy Code]”?  The 7th Circuit found no difficulty in answering this question with a resounding “NO”!  Notably, instead of chopping through the bramble bush of nuanced statutory interpretation, the Court’s opinion relied principally on broad bankruptcy policy objectives.  The Court stated:

In 203 North LaSalle the Court remarked on the danger that diverting assets to insiders can pose to the absolute-priority rule.  526 U.S. at 444.   It follows that plans giving insiders preferential access to investment opportunities in the reorganized debtor should be subject to the same opportunity for competition as plans in which existing claim-holders put up the new money….

Nor does the rationale of 203 North LaSalle depend on who proposes the plan. Competition helps prevent the funneling of value from lenders to insiders, no matter who proposes the plan or when.  An impaired lender who objects to any plan that leaves insiders holding equity is entitled to the benefit of competition.  If, as [the debtor and insiders] insist, their plan offers creditors the best deal, then they will prevail in the auction.  But if, as [the objecting secured lender] believes, the bankruptcy judge has underestimated the value of [the debtor’s] real estate, wiped out too much of the secured claim, and set the remaining loan’s terms at below-market rates [via cramdown], then someone will pay more than $375,000 (perhaps a lot more) for the equity in the reorganized firm.

The judgment of the bankruptcy court is reversed and the case is remanded with directions to open the proposed plan of reorganization to competitive bidding.

But if the plan was confirmed, how is it that the direct appeal of the plan confirmation order to the 7th Circuit did not get mooted out through substantial consummation of the plan?  Simple.  The parties in this motion stipulated to entry of this order by the Bankruptcy Court, thereby staying the effectiveness of the confirmation order pending resolution of the issue on appeal.  Of course, since the only major creditor in the case was the senior secured lender (with a large unsecured deficiency claim) who was objecting to the plan, it had a lot more flexibility in respect of the bonding requirement necessary to stay the effectiveness of the confirmation order pending appeal.  Indeed, as the Court-approved disclosure statement demonstrates, the secured lender appealing the decision was virtually the only creditor of significance in this single asset real estate case.  As such the lender here really didn’t have much to lose by appealing the order since obtaining a stay of the confirmation order pending appeal likely would not have required it to dig very deep to come up with the funds necessary to post a bond and obtain a stay pending appeal.

Is this decision significant?  You bet, and I expect it to reverberate loudly as time progresses.  Before this decision, creative lawyers could reach into their trick bag and try to evade 203 N. LaSalle’s competitive bidding requirements by arguing that the statute doesn’t apply to “new value” contributors who held no equity interests prepetition.  They then could solicit the support of senior secured creditors and propose a “new value” plan acceptable to the secured lender that would call for “new value” contributions from friendly sources and thereby squeeze value to which the intervening unsecured class would be entitled under the absolute priority rule.  And since unsecured creditors in more complex business reorganizations—unlike secured lenders in single asset real estate cases—generally lack the financial incentive or wherewithal to obtain a stay of a plan confirmation order pending appeal, they are swiftly mooted out in the process, leaving equity to walk away with the value while unsecureds are left “holding the bag” (as our founding fathers were wont to say).

Now, however, with the 7th Circuit’s decision in the books, there’s no authority for filing such plans in the first place (at least in the 7th Circuit, though I expect other Courts and Circuits will follow its lead).  Of course, there’s always the hope that the Supreme Court will take this case up on appeal given how rarely such issues wind their way through the appeals process without getting mooted out along the way.  That was a good reason for the Court to take up RadLAX and is an equally good reason to take up this decision too (particularly since, as the 7th Circuit noted, “[b]ankruptcy judges have disagreed on the answer” to the question posed by the case).

Finally, it’s worth noting how a rather simple and seemingly straightforward Supreme Court decision like the one inRadLAX can never be underestimated.  To the 7th Circuit, RadLAX established a policy directive of “protect[ing] creditors against plans that would give competing claimants too much for their new investments and thus dilute the creditors’ interests.”  That’s the first time I’ve seen RadLAX being cited for such a broad policy objective.  It is a principle worth remembering, however, especially when responding to legal gimmickry that attempts to grind Bankruptcy Code provisions like trees in a wood chipper.  Such gimmicks simply won’t carry the day, regardless of their artfulness and basis in principles of statutory construction, where they undermine important policy objectives established in Supreme Court precedent.

Thanks for reading!