The right to a jury trial in bankruptcy has long been controversial, even after Congress enacted a law in 1994 expressly authorizing the bankruptcy courts to conduct jury trials under certain circumstances. Even so, whether a defendant in turnover litigation commenced by a bankruptcy trustee or chapter 11 debtor in possession ("DIP") can demand a jury trial is an issue that remained unaddressed by the circuit courts of appeal until 2009. A ruling handed down last year by the Court of Appeals for the First Circuit examines this question as a matter of apparent first impression at the circuit-court level. In Braunstein v. McCabe, the court of appeals held that: (i) debtors in a case converted from chapter 11 to chapter 7 did not make certain expenditures of insurance proceeds within the ordinary course of business while acting as DIPs, and thus, the insurance proceeds were subject to turnover under section 542 of the Bankruptcy Code; and (ii) the debtors did not have the right to a jury trial on the issue.
Turnover Proceedings
Section 542 of the Bankruptcy Code provides a bankruptcy trustee or DIP with the power to recover property that belongs to the estate but is in the hands of a third party at the time of a bankruptcy filing. The provision is one tool among many in the Bankruptcy Code created as a way for fiduciaries to augment the bankruptcy estate by recovering assets that may be useful or necessary for the success of the reorganization, or assets that may be a source of distributions to creditors, either under a chapter 11 plan or in a chapter 7 liquidation. It complements the ability of a trustee or DIP to avoid transfers of property that were fraudulently or preferentially transferred prior to a bankruptcy filing.
"Turnover" proceedings can be utilized to recover beneficial assets that can be used, sold, or leased; to liquidate debts owing to the debtor; or to recover financial information concerning the debtor or its assets. Such proceedings typically involve creditors or other parties who have possession of estate property. Turnover may be sought from "custodians" (including court-appointed receivers and assignees for the benefit of creditors) under a separate provision (section 543). In some cases (e.g., when a chapter 11 case is converted to a chapter 7 liquidation), a trustee may even seek turnover of estate property that is in the possession of the former DIP. There are some exceptions built into section 542, including when a party obligated on a debt to the debtor has a valid right of setoff and when a party in possession of the debtor's property lacks knowledge of the bankruptcy filing and transfers the property in good faith. Also excepted are automatic transfers of a debtor's property to pay life insurance premiums and situations where "property is of inconsequential value or benefit to the estate."
Jury Trials In Bankruptcy
The Seventh Amendment to the U.S. Constitution guarantees the right to a trial by jury in "suits at common law," a phrase that the U.S. Supreme Court has consistently construed as referring to litigation involving the establishment or application of legal, rather than equitable, rights or remedies. Historically, courts of equity, among which the bankruptcy courts have traditionally been included, have not conducted jury trials.
In its 1989 ruling in Granfinanciera, S.A. v. Nordberg, which involved a fraudulent transfer avoidance action, the Supreme Court held that, to determine whether a party is entitled to a jury trial under the Seventh Amendment, a court must:
[F]irst compare the statutory action to 18th-century actions brought in the courts of England prior to the merger of the courts of law and equity. Second, the court must examine the remedy sought and determine whether it is legal or equitable in nature . . . . If, on balance, these two factors indicate that a party is entitled to a jury trial under the Seventh Amendment, the court must decide whether the U.S. Congress may assign and has assigned resolution of the relevant claim to a non- Article III adjudicative body that does not use a jury as factfinder.
Thus, if the claim at issue is only in equity, the jury-trial right will not be invoked. Even if the claim is legal, however, this may not end the inquiry. After concluding in Granfinanciera that the cause of action was legal and that the remedy sought (a money judgment) was not equitable, the Supreme Court emphasized that this finding is not conclusive as to the right to a jury trial:
[W]e do not declare that the Seventh Amendment provides a right to a jury trial on all legal rather than equitable claims. If a claim that is legal in nature asserts a "public right," as we define that term . . . then the Seventh Amendment does not entitle the parties to a jury trial if Congress assigned its adjudication to an administrative agency or specialized court of equity. . . . The Seventh Amendment protects a litigant's right to a jury trial only if a cause of action is legal in nature and it involves a matter of "private right."
The Court concluded that an action to recover a fraudulent transfer was not a public right, and because the avoidance defendant had not filed a proof of claim, and thereby submitted to the bankruptcy court's equitable power, the defendant was entitled to a jury trial.
Still, the Court expressly declined to decide whether a bankruptcy court may conduct jury trials in fraudulent transfer litigation commenced by a trustee against an entity that has not filed a proof of claim. The Court also declined to decide "whether, if Congress has authorized bankruptcy courts to hold jury trials in such actions, that authorization comports with Article III when non-Article III judges preside over them subject to review in or withdrawal by the district courts."
Following Granfinanciera, the U.S. Supreme Court held in 1990, in Langenkamp v. Culp, that a creditor who files a proof of claim and is then sued by the trustee in preference litigation is not entitled to a jury trial. The Court explained its ruling as follows:
In Granfinanciera we recognized that by filing a claim against a bankruptcy estate the creditor triggers the process of "allowance and disallowance of claims," thereby subjecting himself to the bankruptcy court's equitable power. . . . If the creditor is met, in turn, with a preference action from the trustee, that action becomes part of the claims-allowance process which is triable only in equity. . . .
In other words, the creditor's claim and the ensuing preference action by the trustee become integral to the restructuring of the debtor-creditor relationship through the bankruptcy court's equity jurisdiction. . . . As such, there is no Seventh Amendment right to a jury trial. If a party does not submit a claim against the bankruptcy estate, however, the trustee can recover allegedly preferential transfers only by filing what amounts to a legal action to recover a monetary transfer. In those circumstances the preference defendant is entitled to a jury trial.
In accordance with Granfinanciera, evaluating whether Congress "has assigned resolution of the relevant claim to a non-Article III adjudicative body that does not use a jury as factfinder" is directed specifically to the bankruptcy courts. Congress enacted legislation in 1994 specifically authorizing bankruptcy courts to conduct jury trials. The statute, 28 U.S.C. § 157(e), provides that "[i]f the right to a jury trial applies in a proceeding that may be heard . . . by a bankruptcy judge, the bankruptcy judge may conduct the jury trial if specially designated to exercise such jurisdiction by the district court and with the express consent of all the parties."
This provision was enacted to resolve a long-running dispute in the courts concerning the extent of a bankruptcy court's jurisdictional mandate and its relationship with the Seventh Amendment's jury-trial right. Under section 157(e), if a litigant has the right to a jury trial under applicable nonbankruptcy law, a bankruptcy court can conduct the trial, but only if: (i) the matters to be adjudicated fall within the court's jurisdiction; (ii) the district court of which the bankruptcy court is a unit authorizes it to do so; and (iii) all of the parties consent. However, satisfaction of these requirements does not end the analysis. A litigant otherwise entitled to a jury trial can forfeit that right by filing a proof of claim.
Rule 9015 of the Federal Rules of Bankruptcy Procedure, which implements section 157(e), provides that
[i]f the right to a jury trial applies, a timely demand has been filed . . . , and the bankruptcy judge has been specially designated to conduct the jury trial, the parties may consent to have a jury trial conducted by a bankruptcy judge under 28 U.S.C. § 157(e) by jointly or separately filing a statement of consent within any applicable time limits specified by local rule.
Standing orders authorizing bankruptcy courts to conduct jury trials in appropriate cases have been entered in nearly all federal districts.
Whether or not a defendant in a turnover proceeding (as distinguished from fraudulent transfer or preference actions) has a right to a jury trial under these authorities is a matter of dispute. The First Circuit Court of Appeals considered this question in Braunstein.
Braunstein
Edwin McCabe and his wife, Karen, lived on a houseboat that was owned by a limited liability holding company ("Holdings"). The houseboat was Holdings' sole asset. Holdings was managed, and 99 percent of its shares were owned, by The McCabe Group, a professional corporation through which Edwin McCabe and others provided legal services. Edwin McCabe was the sole shareholder in The McCabe Group and held a 1 percent share in Holdings. Holdings chartered the houseboat to The McCabe Group, which in turn subchartered the boat to the McCabes. The McCabe Group and Edwin McCabe filed for chapter 11 protection in late 2003 in Massachusetts, and Holdings filed in early 2004. Edwin McCabe essentially functioned as DIP in all three cases.
Shortly after the bankruptcy filings by The McCabe Group and Edwin McCabe, the houseboat was damaged in a maritime accident with a tugboat. The McCabes filed an insurance claim for damage to the houseboat. The claim was settled for approximately $78,000. Without notifying the bankruptcy court or seeking its approval, the McCabes arranged to have work done on the houseboat from the insurance proceeds. Although they spent more than $47,000 to have the houseboat repaired, the boat's value actually decreased.
The chapter 11 cases filed by Holdings and Edwin McCabe were converted to chapter 7 liquidations in early 2005. The chapter 7 trustee took possession of the houseboat, which he ultimately sold for $42,000. The trustee also commenced a proceeding under section 542 against the McCabes seeking
a turnover and accounting of the insurance settlement proceeds, among other things. Edwin McCabe argued that the repair expenses were meant to enhance the value of the houseboat and demanded a jury trial on the issues. The turnover claims were consolidated with certain admiralty and negligence claims in district court.
The district court rejected the jury demand and, after a bench trial, ruled that the repair expenses were "reasonable, necessary and proper" and that the McCabes had incurred them in good faith. It further found that the expenditures were made in the ordinary course of business and that the McCabes were therefore not required to seek bankruptcy-court approval. However, the district court ordered the McCabes to turn over the unexpended balance of the insurance settlement proceeds to the trustee. The McCabes appealed.
The First Circuit's Ruling
The First Circuit reversed, ruling that the full $78,000 must be turned over to the estate. It faulted the district court's reasoning that the repair payments fell within the ordinary course of the debtors' businesses because the repairs effected were not ordinary and Holdings' prebankruptcy business did not encompass houseboat refurbishment.
Addressing the jury-trial issue, the court of appeals explained that, because no statute gives a jury-trial right in section 542 turnover actions, Edwin McCabe's demand for a jury trial was purely a constitutional issue under the Seventh Amendment. Guided by the test articulated in Granfinanciera, the court concluded that: (i) a turnover action is not an action to recover damages for the taking of estate property, but an action to recover possession of property, and therefore, it evokes the court's most basic equitable powers to gather and manage property of the estate; and (ii) the turnover action at issue expressly called for an accounting, which is enough to establish that the plaintiff would not, at common law, have had an adequate legal remedy and would have proceeded in equity. Because a turnover action is equitable, rather than legal, the First Circuit held, consistent with the majority of bankruptcy and appellate courts to consider the issue, that there is no right to a jury trial in a turnover action under section 542.
Outlook
As noted, the First Circuit's approach in Braunstein is consistent with the rulings by the majority of lower courts on the right to a jury trial in a turnover proceeding under section 542. Even so, Braunstein breaks new ground at the circuit level. Moreover, the decision is an important development in the evolving bankruptcy jurisprudence on this issue and should be considered by potential defendants in turnover litigation.
Braunstein v. McCabe, 571 F.3d 108 (1st Cir. 2009).
Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989).
Parsons v. Bedford, 3 Pet. 433, 447 (1830).
Langenkamp v. Culp, 498 U.S. 42 (1990).
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