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Originally published in the Commercial Restructuring & Bankruptcy Alert, March 2006, Volume II, Number 3
A divided U.S. Supreme Court has ruled that the principle of state sovereignty does not prevent a bankruptcy trustee from bringing an action against state agencies to avoid and recover preferential transfers.
The decision in Central Virginia Community College v. Katz, 126 S. Ct. 990 (2006), delivered by Justice John Paul Stevens, sidesteps whether Congress’ attempt to abrogate state sovereign immunity in 11 U.S.C. §106(a) is valid. Instead, the court ruled the power to protect bankruptcy estate property stems directly from the Bankruptcy Clause of the U.S. Constitution.
In a lengthy discussion of the history of conflicting bankruptcy actions in the original 13 colonies, and the subsequent Constitutional Convention, the high court concluded that:
"[t]he history of the Bankruptcy Clause, the reasons it was inserted in the Constitution, and the legislation both proposed and enacted under its auspices immediately following ratification of the Constitution demonstrate that it was intended not just as a grant of legislative authority to Congress, but also to authorize limited subordination of state sovereign immunity in the bankruptcy arena."
The appeal in Central Virginia was brought by a group of Virginia higher education institutions considered "arms of the state" entitled to sovereign immunity. The respondent, Bernard Katz, was the court-appointed liquidating supervisor of the bankruptcy estate for Wallace’s Bookstores, Inc., which did business with the Central Virginia petitioners before filing for chapter 11 bankruptcy relief.
Katz commenced proceedings in Bankruptcy Court to avoid and recover alleged preferential transfers to each of the petitioners made by the debtor when it was insolvent. The petitioners moved to dismiss the proceedings on the basis of sovereign immunity.
In 2004, the U.S. Supreme Court upheld in Tennessee Student Assistance Corp. v. Hood, 541 U.S. 440 (2004) the application of Bankruptcy Code proceedings initiated by a debtor against a state agency to determine the dischargeability of a student loan debt.
In Central Virginia, Justice Stevens wrote, "[r]elying in part on our reasoning in Hood, we reject the sovereign immunity defense advanced by the state agencies."
"Bankruptcy jurisdiction, at its core, is in rem," the court stated. "As we noted in Hood, it does not implicate State’s sovereignty to nearly the same degree as other kinds of jurisdiction."
Distinguishing Past Statements
The court acknowledged that in the past, statements by the high court have "reflected an assumption" that sovereign immunity would apply to cases arising under the Bankruptcy Clause. See Seminole Tribe of Fla. v. Florida, 517 U.S. 444 (1996); Hoffman v. Connecticut Dept. of Income Maint., 492 U.S. 96 (1989).
However, those assumptions were made without the issue being fully debated, and the court is not bound to follow dicta where an issue has not been fully debated, Justice Stevens noted.
"Under our longstanding precedent, States, whether or not they choose to participate in the proceeding, are bound by a bankruptcy court’s discharge order no less than other creditors," wrote Justice Stevens.
Article 1 of the Constitution provides Congress with the power to establish "uniform" bankruptcy laws, and given the difficult treatment of debtors before uniform bankruptcy law existed, the Constitutional framers understood such bankruptcy laws to include "more than simple adjudications of rights in the res."
"More generally, courts adjudicating disputes concerning bankrupts’ estates historically have had the power to issue ancillary orders enforcing their in rem adjudications," Justice Stevens stated.
"Our decision in Hood illustrates the point," he noted. "[I]t was at least arguable that the particular procedure the debtor pursued to establish dischargeability of her student loan could have been characterized as a suit against the State rather than a purely in rem proceeding….But because the proceeding was merely ancillary to the Bankruptcy Court’s exercise of its in rem jurisdiction, we held that it did not implicate state sovereign immunity."
Hence, it is not necessary to determine whether actions to recover preferential transfers are properly characterized as in rem, the court reasoned.
"[T]hose who crafted the Bankruptcy Clause would have understood it to give Congress the power to authorize courts to avoid preferential transfers and to recover transferred property," the court concluded.
Justice Stevens’ majority opinion was joined by Justices O’Connor, Souter, Ginsburg and Breyer.
Dissent
Justice Clarence Thomas dissented, criticizing the majority for overriding the principle of sovereign immunity without overturning binding precedent.
"[T]oday’s ruling is not only impossible to square with the Court’s settled state sovereign immunity jurisprudence; it is also impossible to reach without overruling the Court’s judgment in Hoffman…," he wrote.
He was joined by Chief Justice John Roberts, Jr., as well as Justices Scalia and Kennedy.
This article is presented for informational purposes only and is not intended to constitute legal advice.