Wellness Case Brings Healing for Authority of Bankruptcy Courts

By Stephen W. Sather

Barron & Newburger, P.C.

Austin, TX

Resolving an issue left open by two prior decisions, the Supreme Court ruled that the right to entry of a final judgment by an Article III court, like the right to trial by jury, is a personal right which can be waived or consented away (subject to supervision by an Article III Court).    The decision left Chief Justice Roberts, whose broad language in Stern v. Marshall spawned a plethora law review articles, in the minority, while Justice Sotomayor wrote for the six justices in the majority.   Wellness International Network, Ltd. v. Sharif, No. 13-935 (5/26/15).

The Stern Problem

Article III of the Constitution states that the judicial power is vested in courts created under that Article, which is to say, judges appointed by the President, confirmed by the Senate and enjoying life tenure.    Over the years, Congress created many other judges, such as U.S. Magistrate Judges, Administrative Law Judges and Bankruptcy Judges, to help with the workload of the federal courts.   These judges were not appointed by the President or confirmed by the Senate and did not enjoy life tenure.    While they were under the supervision of Article III Judges, some of these legislatively created judges enjoyed great levels of independence.

In Stern v. Marshall, 564 U.S. ___, 131 S.Ct. 2594 (2011), the Court said that Congress did not have unlimited power to create adjuncts to assist the Article III judges.   Specifically, the Court said that the Bankruptcy Court did not have the power to enter a final judgment on a state law counterclaim brought by a debtor against a creditor.    Judges, practitioners and academics alike wondered whether the system of independent Article I Bankruptcy Judges could survive this ruling.    This uncertainty was engendered by the narrow scope of the actual issue decided and the sweeping language used by Chief Justice Roberts to support it.   Taken to its fullest extent as suggested by the dissenting justices in that case, it could have meant that Bankruptcy Court's lacked the power to decide anything that could have been decided by courts of law in 1789 and parties lacked the authority to consent to a different result. 

  

 Life After Stern

The sky did not fall following Stern and the Bankruptcy Courts continued to operate.   However, there was a split of authority as to whether parties could consent to entry of a final judgment by a Bankruptcy Court in a Stern case.    Last year, in Executive Benefits Ins. Agency v. Arkison, 134 S.Ct. 2165 (2014), the Court ducked the consent issue.   Instead, it found that regardless of the Bankruptcy Court's authority to enter a final judgment, it could hear cases within its jurisdiction and submit a report and recommendation to the District Court which could review it on a de novo basis. This was important because the Bankruptcy Court decision was a summary judgment which the District Court was bound to review on a de novo basis in any event.   As a result, even if the Bankruptcy Court lacked authority to enter a final judgment, the District Court's ruling on appeal was the functional equivalent of entry of a final judgment by that court.

This ruling preserved the ability of Bankruptcy Courts to hear disputes in the first instance.   However, it left open the question of whether Bankruptcy Courts could issue final orders in all matters with consent or by waiver.   The consent issue had enormous practical significance.    If parties could not give valid consent, they could have an advisory trial in the Bankruptcy Court and then request a do-over in the District Court if they didn't like the result.    There was also the possibility (although I am not aware of this actually happening) of a party agreeing to litigate in Bankruptcy Court and ignoring the result on the basis that it had never been approved by the District Court.

The issue split the circuit courts.   The Fifth, Sixth and Seventh Circuits nixed consent while the Ninth Circuit permitted it.   Today's decision resolved that split and established that parties can consent to entry of a final judgment by a Bankruptcy Judge.   The decision also acknowledges the practical reality that without legislatively created courts, "the work of the federal court system would grind nearly to a halt."   Opinion, p. 2.   In a footnote, the Court noted that the 349 Bankruptcy Judges hear twice as many cases as all of the District and Circuit judges combined.
  

What Happened

Sharif was a distributor for Wellness International Network, a manufacturer of health and nutrition products.    Sharif sued Wellness but wound up owing $650,000 in attorneys' fees after he failed to comply with discovery and other litigation obligations.    When Sharif filed bankruptcy, Wellness wanted to know about the $5 million in assets he had listed on a loan application in 2002.   Sharif glibly admitted that he had lied about owning the assets and said that they really belonged to a trust which he administered for his mother and sister.

Wellness filed an adversary proceeding against Sharif seeking to deny his discharge and establish that the trust was an alter ego.   Sharif answered and conceded that these claims were core proceedings.   Once again, Sharif failed to provide responsive discovery answers.   As a result, the Bankruptcy Court entered default judgment against him and denied his discharge.   The Bankruptcy Court also found that the trust was his alter ego because the Debtor "treats [the Trust's] assets as his own property."
  

Sharif appealed to the District Court.   While his case was pending, the Stern decision came out.   He asked to supplement his briefing to assert that the District Court should treat the Bankruptcy Court's ruling as a report and recommendation.   The District Court denied the request for additional briefing as untimely and affirmed the Bankruptcy Court.

The Seventh Circuit affirmed in part and reversed in part.  It upheld denial of the discharge as something that the Bankruptcy Court had the authority to grant.   However, it reversed the ruling on the alter ego claim.   It held that not only did the Bankruptcy Court lack authority to enter a final judgment, but that it might have lacked authority to even hear the case in the first place.   (The latter ruling was based on the fact that 28 U.S.C. Sec. 157 did not authorize Bankruptcy Courts to issue reports and recommendations in core proceedings.   In Executive Benefits, the Supreme Court clarified that Bankruptcy Courts could issue a report and recommendation in any case in which it could not issue a final judgment, thereby eliminating the so-called statutory gap).

The Majority Ruling

Justice Sotomayor began her discussion of consent by stating, "(a)djudication by consent is nothing new."    Opinion, p. 8.    After discussing cases, the Court held that the right to an Article III tribunal is both a personal one which may be waived and a structural one that must be respected.  Justice Sotomayor wrote:

The entitlement to an Article III adjudicator is “a personal right” and thus ordinarily “subject to waiver,” (citation omitted). Article III also serves a structural purpose, “barring congressional attempts ‘to transfer jurisdiction [to non-Article III tribunals] for the purpose of emasculating’ constitutional courts and thereby prevent[ing] ‘the encroachment or aggrandizement of one branch at the expense of the other.’” Id., at 850 (citations omitted). But allowing Article I adjudicators to decide claims submitted to them by consent does not offend the separation of powers so long as Article III courts retain supervisory authority over the process.

Opinion, pp. 11-12.    In reaching this formulation, Justice Sotomayor resolved a question which had been dividing commentators for years:   was the right to an Article III Court personal and thus waivable or was it structural and therefore immutable?   Although the Court answered "both," it did so in a way that set a low bar for satisfying the structural concerns of the Constitution.   So long as the Article III judiciary retained "supervisory authority" over the legislatively created courts, separation of powers was not violated.    Stated another way, Congress can create judicial helpers for the Article III Courts but cannot create an entire independent system out of whole cloth.

Under this standard, it is clear that Bankruptcy Courts are under the supervisory authority of the Article III Courts.   Bankruptcy Judges are appointed by Article III judges and may be removed by them.   They are a unit of the District Court and enjoy their authority by virtue of an order of reference from the District Courts.   The District Courts also have the power to withdraw that reference.   Indeed, if a District Court wished to do so, it could revoke the order of reference completely and decide all bankruptcy matters.    Decisions of Bankruptcy Courts are reviewed by either the District Courts or by Bankruptcy Appellate Panels (with consent).   However, Bankruptcy Appellate Panels only exist if created by the Court of Appeals.

The Court further noted that the Bankruptcy Courts do not possess "free-floating authority to decide claims traditionally heard by the Article III Courts" but instead may hear "a narrow class of common law claims" which are incidental to their primary bankruptcy powers.   Finally, the Court noted that Bankruptcy Courts were not created by Congress "to aggrandize itself or humble the Judiciary."   Instead, the Court noted the practical benefit to the Article III Judiciary from having Bankruptcy Courts: 

Congress could choose to rest the full share of the Judiciary’s labor on the shoulders of Article III judges. But doing so would require a substantial increase in the number of district judgeships. Instead, Congress has supplemented the capacity of district courts through the able  assistance of bankruptcy judges. So long as those judges are subject to control by the Article III courts, their work poses no threat to the separation of powers.

Opinion, pp. 14-15.
  

Having ruled that consent was possible, the Court ruled that it need not be express. 

Nothing in the Constitution requires that consent to adjudication by a bankruptcy court be express. Nor does the relevant statute . . . mandate express consent; it states only that a bankruptcy court must obtain“the consent”—consent simpliciter—“of all parties to the proceeding” before hearing and determining a non-core claim.

Opinion, p. 18.   Thus, the Court remanded the case to the Seventh Circuit to decide the question of whether consent had indeed been given.

The majority opinion was joined in by Justices Kennedy, Ginsberg, Breyer and Kagan. Justice Alito concurred in the judgment with the demurrer that he would not have reached the issue of whether consent could be implied.

The Chief Justice and Justices Scalia and Thomas dissented.

The Dissents

At thirty-nine pages, the dissents are nearly twice as long as the majority opinion.    The dissenting justices (each of whom was in the majority in Stern) did not agree that supervisory authority satisfied separation of powers.   The Chief Justice expressed his preference that the Court would have once more avoided deciding the consent issue.   He warned that by deciding the larger issue, the Court was descending a slippery slope.

By reserving the judicial power to judges with life tenure and salary protection, Article III constitutes “an inseparable element of the constitutional system of checks and balances”—a structural safeguard that must “be jealously guarded.”(citation omitted).

 Today the Court lets down its guard. Despite our precedent directing that “parties cannot by consent cure” an Article III violation implicating the structural separation of powers, (citation omitted), the majority authorizes litigants to do just that. The Court justifies its decision largely on pragmatic grounds. I would not yield so fully to functionalism. The Framers adopted the formal protections of Article III for good reasons, and “the fact that a given law or procedure is efficient, convenient, and useful in facilitating functions of government, standing alone,will not save it if it is contrary to the Constitution.” (citation omitted).

 The impact of today’s decision may seem limited, but the Court’s acceptance of an Article III violation is not likely to go unnoticed. The next time Congress takes judicial power from Article III courts, the encroachment may not be so modest—and we will no longer hold the high ground of principle. The majority’s acquiescence in the erosion of our constitutional power sets a precedent that I fear we will regret. I respectfully dissent.

Roberts, C.J., Dissenting, pp. 1-2.    The Chief went on to quote significant amounts of his opinion from Stern.  He effectively established that despite his protestations to the contrary, he never intended for Stern to be a narrow ruling.   Instead, he sought to interpose the Article III Judiciary as a bulwark against Congressional interference in the bankruptcy arena no matter how difficult or impractical this might be.   His dire sermon concluded with an allusion to the Bible.

Ultimately, however, the structural protections of Article III are only as strong as this Court’s will to enforce them. In Madison’s words, the “great security against a gradual concentration of the several powers in the same department consists in giving to those who administer each department the necessary constitutional means and personal motives to resist encroachments of the others.”The Federalist No. 51, at 321–322 (J. Madison). The Court today declines to resist encroachment by the Legislature.  Instead it holds that a single federal judge, for reasons adequate to him, may assign away our hard-won constitutional birthright so long as two private parties agree. I hope I will be wrong about the consequences of this decision for the independence of the Judicial Branch. But for now, another literary passage comes to mind: It profits the Court nothing to give its soul for the whole world . . . but to avoid Stern claims?

 Roberts, C.J., Dissenting, p. 20.

Justice Thomas complained that both the majority and the Chief Justice had failed to answer the question of "whether a violation of the Constitution has actually occurred."    Justice Thomas does not appear to answer this question either.   Instead, he appears to conclude that the parties did not brief the proper issues and that those issues "merit closer attention by this Court."   As a result, Justice Thomas would have decided the case on the narrow ground of whether an alter ego claim is in fact a Stern claim.

What It Means

This case has two main impacts:  the practical and the political. 
  

On a practical level, Wellness has brought healing to the uncertainty wreaked by Stern.   We now have a pretty solid flow chart for knowing what Bankruptcy Courts should do with matters brought before them.

1. Is there jurisdiction under 28 U.S.C. Sec. 1334?   If yes, proceed to #2.   If no, stop.
2. Has the District Court withdrawn the reference?  If yes, stop.  If no, proceed to #3.
3. Must or should the Court abstain?  If yes, stop.   If no, proceed to hear the matter.
4.  Is the claim one which could have been heard by the courts of law in England in 1789?  If no, proceed to enter a final judgment.  If yes, proceed to #5.
5. Does the matter involve the res or is it necessary to determine a proof of claim?   If yes, proceed to final judgment.   If no, proceed to #6.
6. Have the parties consented to entry of a final judgment, either expressly or implicitly?  If yes, proceed to enter a final judgment.   If no, enter a report and recommendation

While I may be oversimplifying this, I think it captures the general idea of where we are today.

On a political level, Justices Breyer, Ginsberg, Sotomayor and Kagan have made the journey from  the dissent in Stern to the majority in Wellness.   They were able to make this transition because Justices Alito and Kennedy changed positions.  While this is rank speculation, it is entirely possible that Justices Alito and Kennedy could see the harm in giving the Bankruptcy Courts unlimited power to rule on state law counterclaims and therefore joined the majority in Stern, but did not want to jeopardize the authority of U.S. Magistrates or other consent-based mechanisms.   If the Chief  had gotten his way, the magistrate system, which operates on referral and consent, could well have fallen.

An older definition of conservative is to conserve, to observe respect for existing institutions.    In his desire to assert the dignity of the Article III Judiciary, the Chief Justice could have torn down decades of smoothly functioning institutions, jeopardizing not only Bankruptcy Judges but Magistrate Judges and possibly arbitrators as well.    Thus, Justices Alito and Kennedy could have joined both majorities out of a sense of conservatism.