The Limited Power and Authority of Bankruptcy Judges: Wellness International Network, Limited v. Sharif

In January, the U.S. Supreme Court heard oral argument in Wellness International Network, Limited v. Sharif, an appeal of a decision by the U.S. Court of Appeals for the Seventh Circuit in Chicago. The ruling by the Supreme Court could have significant consequences for the constitutional power and authority of the bankruptcy courts and magistrates. Wellness stems from a dispute about the authority of bankruptcy judges to issue final judgments on claims against a bankruptcy estate that involve State-law rights. Bankruptcy judges routinely resolve State-law issues in their judgments. This appeal raises a question of constitutional law that could significantly alter the operations of bankruptcy courts and magistrates.

Section one of Article III of the U.S. Constitution requires that the judicial power of the United States be exercised only by judges who have life tenure and protection from having their salaries reduced by acts of Congress. When Congress enacted the Bankruptcy Code of 1978, which replaced the Bankruptcy Act of 1898, it established a new system of bankruptcy courts helmed by bankruptcy judges who serve fourteen-year terms, not for life. Thus, bankruptcy judges are not “Article III judges.” Since the 1980s, their powers have afforded the Court the repeated opportunity to draw the lines that cannot be crossed by Congress when giving authority to judges who are not Article III judges.

A 1982 decision of the Supreme Court, Northern Pipeline Construction v. Marathon Pipe Line, 102 S. Ct. 2858, ruled unconstitutional the statutory grant to the bankruptcy courts of the authority to enter judgment on a State-law contract claim by a company in bankruptcy against the non-bankrupt party to the contract, which had not filed any claim in the bankruptcy. The Court noted that only matters that are at the “core” of the bankruptcy process can be the subject of a judgment by a bankruptcy judge. Core matters are those that result from the bankruptcy itself or would necessarily be resolved by the bankruptcy court when determining the validity and amount of a filed claim.

Congress responded by enacting the Bankruptcy Amendments and Federal Judgeship Act of 1984. Using the taxonomy set forth in Northern Pipeline, this act established the current system of “core” and “non-core” matters in bankruptcy cases, which is set forth in 28 U.S.C. Section 157. Under this system, purely State-law claims, such as breach-of-contract claims by the representative of the bankruptcy estate against a non-creditor, are designated as “non-core.” Core matters can be the subject of a final order of the bankruptcy judge, subject to normal appeal rights and standards, in which the appellate court will defer to the trial court to some extent, generally reversing a finding of fact only if it was clearly erroneous. By contrast, if a non-core matter is to be tried in the bankruptcy court, the bankruptcy judge may issue only recommended findings of fact, conclusions of law and a judgment, which are then reviewed de novo (“anew”—that is, without giving deference to the decision of the court below) by a district court judge, all of whom have life tenure and protection against salary diminution. In the interest of efficiency, non-core matters are usually withdrawn from the bankruptcy court and tried elsewhere.

The Supreme Court took up the constitutional power and authority of bankruptcy judges again in Stern v. Marshall, 131 S. Ct. 2594 (2011). It ruled that a bankruptcy judge exceeds his or her power by entering a final judgment on a State-law claim against a defendant who had filed a proof of claim, but the proof of claim is not based on the same transactions as the claims against the creditor. This decision gave rise to a species of claims known as “Stern claims”: claims that are defined as core claims under Section 157 but that are constitutionally prohibited from final adjudication by a bankruptcy judge. Lower courts have been divided about how to treat Stern claims.

Just three years after Stern, the Supreme Court last year re-visited the issue of the power and authority of bankruptcy judges in Executive Benefits Insurance Agency v. Arkison, 134 S. Ct. 2165 (2014). It held unanimously that a bankruptcy judge has the authority to adjudicate Stern claims as non-core claims—that is, to submit proposed findings of fact and conclusions of law to the district court for de novo review. It also held that when a district court reviews a bankruptcy court’s purported final judgment de novo, its review cures any potential Article III deficiency in the procedures used by the bankruptcy court.

Not long after issuing its decision in Executive Benefits, the Supreme Court granted Wellness International Network, Limited’s petition for certiorari. This case involves a dispute between Richard Sharif, the debtor in a chapter 7 bankruptcy case, and Wellness, one of his creditors. Wellness filed an adversary complaint in the Bankruptcy Court against Sharif, alleging that a trust with over $5 million in assets, which Sharif had not listed on his bankruptcy schedules, was his alter ego and should be considered as part of his bankruptcy estate. After the Bankruptcy Court entered default judgment for Wellness, Sharif appealed.

The Seventh Circuit held that Wellness’s claim was “a state-law claim between private parties that is wholly independent of federal bankruptcy law and is not resolved in the claims-allowance process,” 727 F.3d 751 at 775 (7th Cir. 2013), and that consequently a bankruptcy court did not have the constitutional authority to enter final judgment. The Seventh Circuit also held that Stern prohibits litigants from waiving an objection to a bankruptcy court’s entry of final judgment in a core proceeding when the objection is based on the constitutionally limited powers of bankruptcy judges.

The Supreme Court agreed to hear two questions: (1) whether a bankruptcy judge may enter a final judgment on a creditor’s claim against a bankruptcy estate that involves State-law rights; and (2) whether a debtor’s implied consent to a bankruptcy court’s authority based on the debtor’s conduct is sufficient to satisfy Article III. On the first question there is a split between  the Seventh Circuit, on the one hand, and the First, Fourth, Fifth, Sixth, Eighth and Tenth Circuits, on the other; on the second issue, between the Seventh and the Sixth Circuits. Among the amicus briefs filed, the United States submitted a brief in support of Wellness, and the American Bar Association one requesting the Court to clarify that Article III allows bankruptcy courts to enter final orders and judgments in non-core and Stern claims under Section 157 with the litigants’ consent. A decision by the Court that a bankruptcy court cannot constitutionally enter a final judgment on a claim against the estate that involves State-law rights would significantly limit the scope of the bankruptcy courts’ jurisdiction.

During oral argument, the Justices probed whether Wellness’s action to determine whether the trust assets in Sharif’s possession were part of his bankruptcy estate is a Stern claim and if it is not, whether they needed to reach the issue of consent, which they did not address in Stern or Executive Benefits. In addition, they also asked counsel which question was generating the most confusion for lower courts and which “has more real world effect,” as Justice Scalia remarked. They were also interested in the implications of any further limitations of the power and authority of bankruptcy judges on the magistrate courts as well as the federal arbitration system, which according to Justice Kagan is more potentially threatening to the integrity of the federal judicial system than the power and authority of bankruptcy judges may be. The Court is expected to issue a decision in Wellness by June of this year.