United States: Wellness International: U.S. Supreme Court Rules That Bankruptcy Courts May Adjudicate "Stern Claims" With Litigants' Consent

Last Updated: July 31 2015
Article by Jane Rue Wittstein and Genna L. Ghaul
Most Read Contributor in United States, September 2019

"In Wellness Int'l Network, Ltd. v. Sharif, ___ U.S. ___, 135 S. Ct. 1932 (2015), a divided U.S. Supreme Court resolved the circuit split regarding whether a bankruptcy court may, with the consent of the litigants, adjudicate a claim that, though statutorily denominated as "core," is not otherwise constitutionally determinable by a bankruptcy judge. The majority held that so long as consent—whether express or implied—is "knowing and voluntary," Article III of the U.S. Constitution is not violated by a bankruptcy court's adjudication of such a claim. The ruling builds upon the Supreme Court's recent decisions in Stern v. Marshall, 564 U.S. ___, 131 S. Ct. 2594 (2011), and Executive Benefits Insurance Agency v. Arkison, ___ U.S. ___, 134 S. Ct. 2165 (2014). Wellness nonetheless leaves many significant jurisdictional and constitutional questions unanswered.

Bankruptcy Jurisdiction in a Post-Stern v. Marshall World

Article III, Section 1 of the U.S. Constitution provides that "[t]he judicial Power of the United States, shall be vested in one supreme Court, and in such inferior Courts as the Congress may from time to time ordain and establish." It further states that such judges "shall hold their Offices during good Behaviour, and shall, at stated Times, receive for their Services, a Compensation, which shall not be diminished during their Continuance in Office."

Given these provisions, the exercise of the "judicial Power of the United States" is vested in so-called Article III judges. Bankruptcy judges, however, are not Article III judges. They do not have life tenure, and their salaries are subject to diminution. Instead, bankruptcy judges are technically authorized under Article I, which governs the legislative branch and authorizes the establishment of a uniform system of federal bankruptcy laws. Under principles of separation of powers, bankruptcy judges cannot exercise the judicial power reserved for Article III judges.

Thirty-three years ago, in Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982), the Supreme Court struck down certain provisions of the Bankruptcy Act of 1978 because it conferred Article III judicial power upon bankruptcy judges who lacked life tenure and protection against salary diminution. After more than two years of delay, Congress enacted the Bankruptcy Amendments and Federal Judgeship Act of 1984 to fix the statutory infirmity identified in Marathon. The jurisdictional scheme for bankruptcy courts continues in force today. Or nearly so.

Congress established the jurisdiction of the bankruptcy courts in the Federal Judicial Code, 28 U.S.C. §§ 1 et seq. ("title 28"). As amended in 1984, 28 U.S.C. § 1334 provides that the district courts shall have "original and exclusive jurisdiction of all cases under title 11" and "original but not exclusive jurisdiction of all civil proceedings arising under title 11, or arising in or related to cases under title 11." Section 151 of title 28 provides that each bankruptcy court is "a unit of the district court" in the federal district where it is located. Each district court may—but need not—refer cases and matters within the scope of bankruptcy jurisdiction to the bankruptcy court in its district.

Section 157(b) of title 28 provides that "[b]ankruptcy judges may hear and determine all cases under title 11 and all core proceedings arising under title 11, or arising in a case under title 11." Thus, a bankruptcy court may enter a final order with respect to all bankruptcy cases before it and all matters within the scope of its "core" jurisdiction. Such a final order is subject to appellate review by the applicable district court or bankruptcy appellate panel (and, thereafter, by the applicable court of appeals). Section 157(b)(2) of title 28 provides a nonexclusive list of matters that purportedly fall within "core" jurisdiction.

A bankruptcy court may also hear a noncore proceeding that is "related to" a bankruptcy case, but absent consent of the litigants, a bankruptcy court cannot enter a final order when exercising related to jurisdiction. Instead, it may issue only a proposed order, which is reviewed de novo by the district court.

In 2011, the Supreme Court in Stern shook up the jurisdictional scheme established in title 28 and declared that a portion of title 28 addressing the bankruptcy courts' core jurisdiction was unconstitutional. According to Stern, the 1984 jurisdictional scheme did not adequately address the Marathon issue, at least not in all instances. In Stern, the Court held that, even though bankruptcy courts are statutorily authorized under 28 U.S.C. § 157(b)(2) to enter final judgments on various categories of bankruptcy-related claims, Article III prohibits bankruptcy courts from finally adjudicating certain of those claims. Specifically, the Court ruled that a bankruptcy court lacks constitutional authority under Article III to enter a final judgment on a state law counterclaim of the bankruptcy estate which is not resolved in the process of ruling on a creditor's proof of claim, even though 28 U.S.C. § 157(b)(2)(C) identifies such a counterclaim as a core proceeding.

While Stern itself purported to be a narrow decision, it has given rise to a great deal of litigation concerning whether or not a particular claim, though statutorily denominated as core, is in fact a claim that is finally determinable by a bankruptcy judge. Further, in the years since Stern, courts have also struggled with the following issues: (i) whether a bankruptcy court has jurisdiction to address, and how it should deal with, a claim that, while statutorily denominated as core, is not in fact constitutionally determinable by an Article III judge (a "Stern claim"); and (ii) the effect of a party's consent to adjudication of a Stern claim by a bankruptcy court.

In its 2014 ruling in Arkison, a unanimous Supreme Court decided the first of these two issues by explaining that when a bankruptcy court is confronted with a claim which is statutorily denominated as "core" but is not constitutionally determinable by a bankruptcy judge under Article III of the U.S. Constitution, the bankruptcy judge should treat such a claim as a noncore "related to" matter that the district court reviews de novo. The ruling eliminated any supposed statutory gap created by Stern and maintained, for the most part, the "division of labor" between bankruptcy courts and district courts.

Arkison did not reach the question of whether a party's consent to adjudication of a Stern claim can cure any constitutional deficiency, as the Court found that the district court's de novo review of the bankruptcy court's judgment was sufficient to cure any potential error in that case.

In Wellness, the Supreme Court addressed this issue head-on.

The Dispute

Richard Sharif and Wellness International Network ("Wellness") entered into a contract under which Sharif would distribute Wellness's health and nutrition products. The parties' relationship quickly deteriorated, and in 2005, Sharif commenced a lawsuit against Wellness in federal court, claiming Wellness was running a pyramid scheme. After Sharif's repeated failure to respond to discovery requests and other litigation obligations, the court entered a default judgment for Wellness and later sanctioned Sharif by awarding Wellness more than $650,000 in attorneys' fees.

In February 2009, and in the midst of Wellness's ongoing efforts to collect its attorneys' fees, Sharif filed a chapter 7 case in the Northern District of Illinois. Sharif's bankruptcy petition listed Wellness as a creditor. However, Sharif once again refused to comply with Wellness's repeated requests for information. Upon its own initiative, Wellness discovered a loan application Sharif had filed in 2002 that listed more than $5 million in assets. Sharif claimed he had lied on the loan application and that the listed assets were actually owned by a trust Sharif administered on behalf of his mother for the benefit of his sister (the "Trust"). Wellness rejected this explanation and filed an adversary proceeding complaint against Sharif which, in addition to objecting to Sharif's discharge, sought a declaratory judgment that the Trust was Sharif's alter ego and that the Trust's assets should therefore be treated as part of Sharif's bankruptcy estate.

In his (pre-Stern) answer to the complaint, Sharif admitted that the adversary proceeding was a "core proceeding" under title 28, meaning that the bankruptcy court could enter a final judgment subject to appeal, and he requested judgment in his favor on all counts. But again, Sharif was repeatedly delinquent in meeting his discovery obligations. As a consequence, the bankruptcy court denied Sharif's request to discharge his debts; entered a default judgment for Wellness in the adversary proceeding; and declared, as requested by Wellness's complaint, that the Trust's assets were the property of Sharif's bankruptcy estate.

Sharif appealed to the district court. Six weeks before Sharif filed his opening brief, Stern was handed down by the Supreme Court. In light of Stern and a later-issued Seventh Circuit decision interpreting Stern, and despite not having originally cited Stern in his opening brief, Sharif moved for supplemental briefing so that he could challenge the bankruptcy court's constitutional authority to enter a declaratory judgment regarding the Trust. The district court denied as untimely Sharif's motion for supplemental briefing and affirmed the bankruptcy court's decision.

Sharif again appealed, this time to the U.S. Court of Appeals for the Seventh Circuit. The Seventh Circuit agreed with the district court that Sharif's untimely Stern objection ordinarily would not be preserved. Even so, the Seventh Circuit ruled that a litigant cannot waive a Stern objection because such an objection concerns "the allocation of authority between bankruptcy courts and district courts" under Article III and thus "implicate[s] structural interests." On the merits, the Seventh Circuit affirmed the bankruptcy court's denial of Sharif's discharge but found that the declaratory judgment sought in Wellness's adversary complaint concerned a Stern claim regarding which the bankruptcy court lacked the constitutional authority to enter a final judgment.

The Supreme Court granted Sharif's petition for a writ of certiorari as to whether: (i) the presence of a subsidiary state property law issue in an action brought against a debtor to determine whether property in its possession is property of the bankruptcy estate under section 541 of the Bankruptcy Code means that the action does not "stem[] from the bankruptcy itself" (and thus is not a core proceeding) and, therefore, that a bankruptcy court does not have the constitutional authority to enter a final order deciding that action; and (ii) Article III permits the exercise of the judicial power of the United States by a bankruptcy court on the basis of litigant consent and, if so, whether implied consent based on a litigant's conduct is sufficient to satisfy Article III.

The Supreme Court's Ruling

The Supreme Court affirmed in a split decision. The five-justice majority, however, declined to consider the question of whether the claims asserted by Wellness were, in fact, core and skipped directly to the question of consent.

Writing for the five-justice majority, Justice Sonia Sotomayor highlighted the practical considerations at stake if the Court were to hold that Article III is violated when parties consent to adjudication by a bankruptcy judge. Such a decision, she wrote, would severely diminish the "distinguished service" of 883 full-time magistrate judges and bankruptcy judges; this, in turn, would cause "the work of the federal court system [to] grind nearly to a halt." According to the majority, such a result would be completely at odds with Stern, in which the Court described its holding as a "narrow" one that did "not change all that much" about the division of labor between the district courts and bankruptcy courts. If Stern is truly a narrow decision, Justice Sotomayor stated, it cannot "bar consensual adjudications by bankruptcy courts."

After setting this backdrop, Justice Sotomayor turned to the premise underlying the majority ruling—that "[a]djudication by consent is nothing new." She noted the Court's precedent in Commodity Futures Trading Comm'n v. Schor, 478 U.S. 833 (1986), which involved the defendant's waiver of the right to have his claims heard before an Article III court after submitting those claims to the Commodity Futures Trading Commission. She also explained that, in Gomez v. United States, 490 U.S. 858 (1989), and Peretz v. United States, 501 U.S. 923 (1991), the Court emphasized the importance of consent in the context of allowing a magistrate judge to supervise the jury selection process. In her view, those cases stand for the common principle that "[t]he entitlement to an Article III adjudication is 'a personal right' and thus ordinarily 'subject to waiver.' " Justice Sotomayor noted that Article III also serves a "structural purpose" by barring legislative attempts to erode the power of the judicial branch in favor of Congress. She concluded that, so long as "Article III courts retain supervisory authority over" Article I adjudicators, there is no offense to the separation of powers.

In Wellness, the majority determined that permitting bankruptcy courts to consider Stern claims by consent would not " 'impermissibly threaten[] the institutional integrity of the Judicial Branch' " (quoting Schor). Again with "an eye to the practical effect" which the Court's decision would have on the federal judiciary, Justice Sotomayor considered that bankruptcy judges, like magistrate judges, are appointed and subject to removal by Article III judges. Further, she explained, bankruptcy courts hear matters solely on a district court's reference, which the district court may withdraw sua sponte or at a party's request. Justice Sotomayor likened this dynamic to the relationship between district courts and magistrate judges, where the district court decides whether or not to invoke the assistance of a magistrate judge. Finally, she emphasized that bankruptcy courts' ability to resolve claims typically heard by Article III courts is limited to "a narrow class of common law claims" and that the legislative grant of this ability was not intended to "aggrandize [Congress] or humble the judiciary." In sum, Justice Sotomayor concluded, "[S]o long as [bankruptcy judges] are subject to control by the Article III courts, their work poses no threat to the separation of powers."

Having dismissed all but de minimis structural concerns, the majority revisited Stern. The majority noted that Stern was premised on "non-consent to adjudication by the Bankruptcy Court" and therefore does not apply to the "question of whether litigants may validly consent to adjudication by a bankruptcy court." Justice Sotomayor again emphasized the narrow holding of Stern and the absence of any intention in the ruling to turn the division of labor between district courts and bankruptcy courts on its head.

Finally, the majority ruled that consent to adjudicate a Stern claim may be express or implied, so long as it is "knowing and voluntary." Because it was unclear "whether Sharif's actions evinced the requisite knowing and voluntary consent, and also whether . . . Sharif forfeited his Stern argument below," the Court remanded the case to the Seventh Circuit to resolve those issues.

Justice Samuel Alito filed a concurring opinion in which he agreed with the majority opinion but stated that he would not have decided whether consent may be implied. In Justice Alito's view, it was unnecessary to reach this question because Sharif had forfeited his Stern objection by failing to timely present it to the district court.

Chief Justice John Roberts, Justice Antonin Scalia, and Justice Clarence Thomas dissented. The dissenters faulted the majority for, among other things: (i) failing to decide the case on the issue of whether the presence of a subsidiary state property law issue in an action brought against a debtor to determine whether property in its possession is property of the bankruptcy estate means that the action is noncore, leaving the bankruptcy court without constitutional authority to enter a final order deciding the dispute; (ii) yielding too fully to functionalism at the expense of the judiciary's constitutionally endowed power; and (iii) failing to inquire "whether bankruptcy courts act within the bounds of their constitutional authority when they adjudicate Stern claims with the consent of the parties.

Outlook

Wellness is a welcome clarification of the effect of consent on bankruptcy courts' adjudication of Stern claims. However, the opinion does not offer any guidance on what constitutes "knowing and voluntary" consent or when such consent (express or implied) must be given in order to cure any constitutional deficiency. In addition, like Arkison, Wellness does nothing to help explain which claims, as a constitutional matter, can be finally determined by a bankruptcy judge. The majority passed on the opportunity to clarify the scope of Stern claims. Thus, disputes over whether a claim is a Stern claim are likely to continue.

The U.S. District Court for the Southern District of New York recently shed light on the question of whether a bankruptcy court has power to make a final decision on disputed ownership of property so long as there are not adverse claims by third parties—a question on which the majority in Wellness expressed "no view."

In Ka Kin Wong v. HSBC Bank USA, N.A. (In re Lehman Bros. Holdings Inc.), 2015 BL 195866 (S.D.N.Y. June 15, 2015), the plaintiffs filed a motion to withdraw the reference to the bankruptcy court of an adversary proceeding that dealt with the contested ownership of property held by the debtor, over which the plaintiffs alleged a common law constructive trust. Because the plaintiffs claimed that property held by the estate was subject to a constructive trust, the dispute affected the "administration of the estate" and was arguably a core proceeding under 28 U.S.C. § 157(b)(2)(A).

The Ka Kin Wong court examined whether the Supreme Court's ruling in Stern affected the Second Circuit's ruling in Orion Pictures Corp. v. Showtime Networks, Inc., 4 F.3d 1095 (2d Cir. 1993). In Orion, the Second Circuit instructed district courts, in deciding whether to withdraw the reference to a bankruptcy court, to "first evaluate whether the claim is core or non-core" and then "weigh questions of efficient use of judicial resources, delay and costs to the parties, uniformity of bankruptcy administration, the prevention of forum shopping and other related factors."

In Ka Kin Wong, the district court also analyzed "whether the bankruptcy court may constitutionally enter a final judgment" on the plaintiffs' claims. It concluded that, although the bankruptcy court's ability to do so "is not in and of itself determinative of whether the Court should grant a motion to withdraw the reference," there was a "strong argument that Plaintiff's claims here are core and constitutionally within the province of the bankruptcy court for final adjudication." Thus, the district court found with respect to this element of the Orion test that, where the property is in the debtor's possession and there is no adverse claim by third parties, the bankruptcy court may have power to make a final decision regarding ownership notwithstanding the involvement of common law (or, as in Wellness, state law) issues relating to the claims. However, examining the remaining Orion factors, the Ka Kin Wong court ruled that withdrawal of the reference was not warranted.

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