Leveraging confusion over power allocation in the US bankruptcy system

One of the last places a hedge fund manager or client wants to be is on the business end of a lawsuit by a US bankruptcy trustee or DIP. Suits by the trustees of fraudulent or failed investment schemes and collapsed LBO deals to recover pre-bankruptcy payments as “fraudulent conveyances” or “preferences” continue to captivate media attention.   

One source of potential settlement leverage for the defence in such cases has been thrust into the spotlight again recently. This leverage arises from capitalising on the confusion surrounding the esoteric notion of judicial authority and the odd structure of the US bankruptcy system.

The crux of the issue is the seemingly innocuous question of where such cases must be heard in the US –before the Bankruptcy Court or its related District Court.

The choice might affect the result, even though the same law will govern, because the Bankruptcy and District Court judges sometimes apply their discretion and appraise factual disputes in starkly differing ways in cases like these.

Equally as important, the process of moving the case from one forum to the other, and the costs, delays and other inconveniences of the different procedures available in the District Court, make for powerful settlement leverage against a trustee or DIP who may well be disinclined to spend the time and other resources in this shuttle litigation.

The potential settlement leverage derives from the fact that the US Bankruptcy Courts are not full-fledged and independent courts under the US constitutional scheme. Instead, as a result of the complex “federalism” interplay between state and federal law, as well as a longstanding dispute about the size and structure of the federal judiciary, the US Bankruptcy Courts are simply “administrative divisions” of the US District Courts.

Congress has been consistently unwilling to provide to Bankruptcy Court judges the same sorts of job security and other independence protections enjoyed by life-tenured District Court judges. Accordingly, in an uneasy statutory compromise, only the District Courts have formal authority to adjudicate bankruptcy-related disputes.

Every District Court, however, formally delegates this power to manage bankruptcy cases to its Bankruptcy Court “division” by standing or ad hoc order. As the US Supreme Court reminded us in 2011, however, in a landmark case called Stern v. Marshall, the federal Constitution imposes subtle but important limits on the extent to which the District Courts can delegate their authority to the Bankruptcy Courts in this way.

Two principal strategies are often used by defendants to capitalise on the restrictions on Bankruptcy Court powers. One strategy involves the all but uniquely US institution of the civil jury. In 1989, the US Supreme Court in Granfinanciera confirmed that the Seventh Amendment to the US Constitution indeed guarantees the right to a jury trial in civil cases involving money disputes over more than $20, and this applies in bankruptcy cases where trustees or DIPs seek disgorgement of fraudulent conveyances.

The following year, the Supreme Court in Langenkamp recognised that a defendant could inadvertently waive this right to a jury trial by submitting a claim in the bankruptcy case, but if no claim is submitted (or a submitted claim is withdrawn), and the defendant demands a jury trial, the trial will in all likelihood have to be conducted in the District Court. Because the US Bankruptcy Courts are not full-fledged and independent federal courts, they can conduct jury trials only with the express permission of their District Court and the express consent of the parties.

In a multi-million-dollar lawsuit, the expense and inconvenience of conducting a jury trial and operating in two or more different courtrooms may well not dissuade a trustee or DIP from pursuing recovery, but the jurisdictional tension creates at least mild settlement leverage for defendants.

The second and potentially more aggressive leverage strategy was illustrated in May in Kirschner v. Agoglia, a case involving the Refco Litigation Trust pending in the Bankruptcy Court in Manhattan.

The Refco trustee sought recovery of $80 million in payments to several former Refco executives, arguing in part that these payments represented fraudulent conveyances to the executives involved in the securities fraud that brought on Refco’s collapse.

The defendants seized on the Stern v Marshall ruling, which has generated mass confusion as to whether the Bankruptcy Courts can even properly hear fraudulent conveyance cases and other “private right” claims to recover money for a bankruptcy estate. Claims on “public rights” might be constitutionally delegated to the Bankruptcy Courts, but in cases that resemble a classic lawsuit of a private plaintiff seeking a monetary recovery from a private defendant, the inferior constitutional status of the Bankruptcy Courts makes them unable to enter “final orders” with respect to such claims.

In what has become a common defence strategy, the Refco defendants asked the District Court to “withdraw the reference,” that is, to reverse the standard delegation of the case to the Bankruptcy Court and take the case back to be adjudicated before the District Court, the only court with full constitutional authority to enter a final judgment.

The New York District Court judge in Kirschner agreed that the Bankruptcy Court lacked constitutional authority to enter a final judgment in the case.

The District Court nonetheless arrived at a creative compromise solution: Despite a lack of constitutional or statutory authority, the Bankruptcy Court could at least make a preliminary “report and recommendation” to the District Court, since this labour-saving technique preserves the benefits of the Bankruptcy Court’s intimate knowledge of the case and could be justified on the basis that Congress must have intended for this stop-gap measure to remain available, at least pursuant to the District Court’s “inherent authority” to manage its workload.

It is far from clear that other District Courts will resolve the conundrum of split court authority in this way, so requests for withdrawal of the reference away from Bankruptcy Courts and back to the District Courts will likely continue to represent a source of settlement leverage for defendants in fraudulent conveyance and other money-recovery lawsuits, at least in the short term.

The ongoing struggle over the division of authority over bankruptcy cases and the constitutionally permissible scope of authority of the US Bankruptcy Courts will continue to present opportunities for strategic posturing by those sued by bankruptcy trustees and DIPs.

As any first-year law student must understand, seemingly esoteric procedural points often mean the difference between a loss and a win, perhaps especially in the bankruptcy court system.


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Jason Kilborn
Professor Jason Kilborn teaches business and commercial law at John Marshall Law School in Chicago.  His primary focus is on the comparative analysis of insolvency systems for individuals, though his interest extends to international bankruptcy as well. He recently co-authored a book on international co-operation in cross-border insolvency cases, published by Oxford University Press. Jason KilbornProfessor of LawUIC John Marshall Law School, Chicago300 S. State St. Chicago, IL 60604USAT: +1 (312) 386 2860+1 (312) 386 2860E: [email protected]W: http://jkilborn.weebly.com Call Send SMS Call from mobile Add to Skype You'll need Skype CreditFree via Skype

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