Stites & Harbison, PLLC

On June 23, 2011, in a 5-4 opinion authorized by Chief Justice Roberts, the U.S. Supreme Court ruled in Stern v. Marshall that a bankruptcy court lacks constitutional authority to render final judgment on a bankruptcy estate’s compulsory state law counterclaim against a creditor when it is not necessary to resolve the counterclaim as part of the claims allowance process and where the counterclaim is not integrally related to a particular federal government action. The divided Court chastised Congress for handing off the work of Article III judges to those who do not have life tenure and other guarantees of independence, even if they bear the title (bankruptcy) “Judge.” This decision removes from the bankruptcy courts the authority to decide a small, but potentially significant, group of debtors’ claims. This ruling could have wide-ranging implications for a bankruptcy court’s ability to preside over litigation of claims within bankruptcy cases and could signal a huge shift in the statutory and constitutional underpinnings of bankruptcy court jurisdiction, a legacy likely to outlast the ephemeral fascination some may have with the debtor in this case, the late Anna Nicole Smith.

Ms. Smith (her real name was Vickie Lynn Marshall) pursued millions of dollars from the estate of her tycoon husband J. Howard Marshall. Ms. Smith’s estate lost the case in the real, bitter end. Her estate’s claim for many millions in damages is gone, and the estate of her adversary — the (also) late E. Pierce Marshall, son of her late husband — wins all of his father’s $1.6 billion estate despite her claim that he used fraud to shut her out of the family wealth.

To make a VERY long story very short, Vickie sued Pierce in Texas state probate court for allegedly tortiously interfering with her husband’s intended gift of half of his estate to Vickie, and Pierce countered by suing Vickie for defamation. Both of these opposing claims are traditional state law claims having no direct connection with bankruptcy law. After the senior Marshall’s death in 1995, Vickie filed for bankruptcy in the Central District of California. Pierce filed a proof of claim in Vickie’s bankruptcy case for the same alleged defamation damages, and Vickie defended/objected to the defamation claim on the basis of truth and filed a compulsory counterclaim claiming Pierce tortiously interfered with her alleged gift.

In 1999-2000, the Bankruptcy Court disallowed the defamation claim on summary judgment and found in favor of Vickie on her counterclaim after a bench trial. Pierce appealed the Bankruptcy Court’s decision to the District Court, and while that appeal was pending but before the District Court ruled, a Texas probate court rendered final judgment in favor of Pierce on both claims after a jury trial.

In 2001, the District Court concluded that the Bankruptcy Court should not have characterized Vickie’s counterclaim as a “core” bankruptcy matter and therefore treated the Bankruptcy Court’s judgment as “proposed findings and conclusions” rather than a final judgment. Significantly, however, the District Court proceeded to decide the matter for itself (in favor of Vickie) rather than to give preclusive effect to the Texas Probate Court’s judgment (in favor of Piece), which had become final before the District Court’s contrary ruling. The 9th Circuit Court of Appeals agreed with the District Court on the “core” jurisdiction issue, but went further to reverse because the Texas Probate Court, having won the “race to judgment,” should have been accorded full faith and credit in the District Court, thereby precluding any inconsistent result. Enter the U.S. Supreme Court.

After many twists and turns, the intervening deaths of both parties, and millions of dollars of litigation costs, the Supreme Court narrowly decided that, like federal judges, not all counterclaims are created equal. Agreeing with the District Court and the 9th Circuit, the Supreme Court decided that allowing Bankruptcy Courts to enter final judgments on some counterclaims grounded in state law runs afoul of the Article III of the United States Constitution. When a counterclaim is merely “related to” a bankruptcy case, because it simply may have some conceivable effect upon the estate but does not also “arise in” the bankruptcy case or “arise under” the Bankruptcy Code, even if Congress characterized it as a “core” matter, a Bankruptcy Judge may not enter final judgment consistent with the U.S. Constitution. The Supreme Court found that while jurisdiction may exist where it is necessary to resolve a counterclaim in order to resolve the creditor’s claim, Vickie’s tortious interference claim did not have to be adjudicated in order to resolve Pierce’s defamation claim. The Supreme Court acknowledged the “public rights” exception to limited jurisdiction sometimes applies where one party is a governmental entity but declined to rule on the scope of such exception where the parties are individuals asserting state law claims.

Historically, Congress enacted the current version of 28 U.S.C. § 157 in 1984, creating the concept of the “core proceeding” in response to the Supreme Court’s 1982 decision in Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., which declared unconstitutional previous Congressional grants of jurisdiction to bankruptcy courts under the then-new Bankruptcy Code of 1978. That the Supreme Court now has held unconstitutional one of the enumerated “core proceedings” in 28 U.S.C. § 157(b)(2), which was Congress’ attempt to address Marathon, could make Stern v. Marshall the first in a long line of ground-shifting actions to address the constitutional and statutory infirmities highlighted in Marathon.

Only time will tell whether Stern v. Marshall will have significant practical effects on bankruptcy litigation. Courts and litigants will now have to wrestle with the added cost and delay of waiting for District Courts to decide state law compulsory counterclaims and such issues as whether a creditor’s right to a jury trial on such counterclaims requires transfer of some or all claim litigation to the District Court, whether and to what extent parties can consent to final rulings by the Bankruptcy Court, and how to define the outer bounds of the bankruptcy courts’ jurisdiction going forward. Any of these issues could divide the Courts and lead to forum shopping.

Madison L. Martin became an associate in the firm's Nashville office after practicing law in Delaware for several years with a focus on bankruptcy and general commercial litigation. In 2009, she became Counsel to the firm. She is a member of the Creditors' Rights & Bankruptcy Service Group.