U.S. Supreme Court Closes the Stern Gap and Restores Working Order in Bankruptcy Procedure

June 10, 2014

On June 9, 2014, the Supreme Court issued its opinion in Executive Benefits Insurance Agency v. Arkison, No. 12-1200, 573 U.S. __, (June 9, 2014).

In a 9-0 decision, the Supreme Court removed concerns that proceedings before a bankruptcy court may be later rendered a nullity.  Specifically, the Court affirmed the Ninth Circuit’s conclusion that claims that are statutorily defined as "core" bankruptcy claims by 28 U.S.C. § 157(b)(2), but on which the bankruptcy court lacks constitutional authority to enter final orders under Stern v. Marshall, 131 S. Ct. 2594 (2011)–i.e., claims that fall in the Stern "gap"–may nonetheless be heard by the bankruptcy court as if they were "non-core" claims under 28 U.S.C. § 157(c)(1).

In so holding, the Supreme Court rejected a holding from the Seventh Circuit that, when a claim falls in the Stern "gap," the bankruptcy court lacks authority to enter orders of any kind and any proceedings before the bankruptcy court should be regarded as a nullity.[1]  Instead, the Supreme Court held that the severability clause in the statute governing bankruptcy court jurisdiction "closes the so-called ‘gap’ created by Stern claims."  Arkison, slip op. at 9.  The Court reasoned that because Stern did not invalidate the entire statutory scheme, "core" claims that can no longer be finally adjudicated by bankruptcy courts under 28 U.S.C. § 157(b) can still be adjudicated under the procedures of  28 U.S.C. § 157(c)(1) that on their face are reserved for claims that are "non-core."  The Court reasoned that there is "’nothing in the statute’s test or historical context’ that makes it ‘evident’ that Congress would prefer to suspend Stern claims in limbo.’"  Id. at 10 (quoting Free Enterprise Fund v. Public Company Accounting Oversight Bd., 561 U.S. 477, 509 (2010)).

Background on Bankruptcy Court Jurisdiction

The statutory scheme prescribed by 28 U.S.C. § 157 that governs the jurisdiction of bankruptcy courts was summarized by the Court in Arkison as follows:

"[M]atters that may be referred to the bankruptcy court [are divided by the statute] into two categories: ‘core’ and ‘non-core’ proceedings.  It is the bankruptcy court’s responsibility to determine whether each claim before it is core or noncore.  For core proceedings, the statute contains a nonexhaustive list of examples . . . .  The statute authorizes bankruptcy judges to ‘hear and determine’ such claims and ‘enter appropriate orders and judgments’ on them.  A final judgment entered in a core proceeding is appealable to the district court, which reviews the judgment under traditional appellate standards . . . .

As for ‘non-core’ proceedings–i.e., proceedings that are ‘not . . . core’ but are ‘otherwise related to a case under title 11’–the statute authorizes a bankruptcy court to ‘hear [the] proceeding,’ and then ‘submit proposed findings of fact and conclusions of law to the district court.’  The district court must then review those proposed findings and conclusions de novo and enter any final orders or judgments.  There is one statutory exception to this rule: If all parties ‘consent,’ the statute permits the bankruptcy judge ‘to hear and determine and to enter appropriate orders and judgments’ as if the proceeding were core.

Put simply: If a matter is core, the statute empowers the bankruptcy judge to enter final judgment on the claim, subject to appellate review by the district court.  If a matter is non-core, and the parties have not consented to final adjudication by the bankruptcy court, the bankruptcy judge must propose findings of fact and conclusions of law.  Then, the district court must review the proceeding de novo and enter final judgment."

Arkison, slip op. at 6-7 (citations omitted).

The Stern Gap

In Stern, the Supreme Court identified a constitutional infirmity in the statutory scheme that governs bankruptcy court jurisdiction.  The Court held that some of the claims expressly defined in the statute as "core" are claims that the Constitution reserves for adjudication by Article III courts.  Stern, 131 S. Ct. at 2620.[2]  Thus, the Court found that the statute is unconstitutional to the extent that it gives bankruptcy courts the authority to enter final judgments over such claims.  Id.  Therefore, after Stern, the procedure for adjudicating claims identified as "core" but which the bankruptcy court could not finally adjudicate was uncertain.  In Arkison, the Court defined the problem as follows:   

"By definition, a Stern claim may not be adjudicated to final judgment by the bankruptcy court, as in a typical core proceeding.  But the alternative procedure, whereby the bankruptcy court submits proposed findings of fact and conclusions of law, applies only to non-core claims.  See §157(c)(1).  Because §157(b) does not explicitly authorize bankruptcy judges to submit proposed findings of fact and conclusions of law in a core proceeding, the argument goes, Stern created a ‘gap’ in the bankruptcy statute.  See [Exec. Benefits Ins. Agency v. Arkison (In re Bellingham Ins. Agency), 702 F.3d 553, 565 (9th Cir. 2012)].  That gap purportedly renders the bankruptcy court powerless to act on Stern claims . . . thus requiring the district court to hear all Stern claims in the first instance."

Arkison, slip op. at 9.

As a result of this "gap," some courts had observed that any action taken by a bankruptcy court in connection with a claim that was later determined to be a Stern claim would be rendered a nullity.  See, e.g., Wellness Int’l Network, Ltd. v. Sharif, 727 F.3d 751, 777 (7th Cir. 2013) (observing that if the claim in question was determined to be a Stern gap claim, the district court "shall order that the reference . . . to the bankruptcy court be withdrawn and conduct fresh discovery proceedings in the district court").  Since some of these courts also held that the right to object to the jurisdiction of the bankruptcy court on Stern grounds is not waived by failing to raise the objection before the bankruptcy court, parties could not know whether proceedings before a bankruptcy court would be rendered a nullity before or even after a bankruptcy court issued a ruling.  See, e.g., id. at 773.  Similarly, a reviewing district court would have the same uncertainty. 

The Supreme Court Closes the Stern Gap

In Arkison, the Supreme Court closed the Stern gap and held that, for claims that are identified as  "core," but on which a bankruptcy court cannot enter final orders under Article III of the Constitution (i.e., "Stern" claims), "the bankruptcy court simply treats the claims as non-core: The bankruptcy court should hear the proceeding and submit proposed findings of fact and conclusions of law to the district court for de novo review and entry of judgment."  Arkison, slip op. at 10.    

The Arkison holding also provides guidance for the situation where the bankruptcy court improperly enters a "final" order on a claim over which it does not have final jurisdiction because of Stern.  In such a circumstance, the Arkison Court endorsed an approach where the district court "relabel[s] the bankruptcy order as mere proposed findings of fact and conclusions of law" and reviews the bankruptcy order de novo.  Id. at 12-13.

The Supreme Court Side-Steps Questions of Waiver and Implied Consent

In its ruling, the Supreme Court expressly declined to address a related issue hotly debated among the Courts of Appeal–"whether Article III permits a bankruptcy court, with the consent of the parties, to enter a final judgment on a Stern claim."  Arkison, slip op. at 4 n.4.  Compare Frazin v. Haynes & Boone, L.L.P. (In re Frazin), 732 F.3d 313, 320 n.3 (5th Cir. 2013) (Stern problem "cannot be ameliorated by . . . consent or waiver"), Wellness Int’l Network v. Sharif, 727 F.3d 751, 773 (7th Cir. 2013) ("a litigant may not waive an Article III, § 1, objection to a bankruptcy court’s entry of final judgment in a core proceeding"), and Waldman v. Stone, 698 F.3d 910, 918 (6th Cir. 2012) ("Waldman’s objection thus implicates not only his personal rights, but also the structural principle advanced by Article III.  And that principle is not Waldman’s to waive."); with Peterson v. Somers Dublin Ltd., 729 F.3d 741, 747 (7th Cir. 2013) (criticizing the panel decision in Wellness and characterizing the issue in Wellness as "forfeiture rather than waiver," but declining to resolve "whether waiver and forfeiture should be treated the same way"); Exec. Benefits Ins. Agency v. Arkison (In re Bellingham Ins. Agency), 702 F.3d 553, 566 (9th Cir. 2012) ("The waivable nature of the allocation of adjudicative authority between bankruptcy courts and Article III courts is well established.").

However, by (i) closing the Stern gap, and (ii) endorsing de novo review by the district court of an improperly entered "final order" as to a Stern claim as a cure of any Constitutional error, the Court in Arkison reduced the practical impact of this debate by providing a clear mechanism for adjudicating Stern claims using the procedures applicable to non-core claims which is not dependent upon the parties’ express or implied consent to bankruptcy court jurisdiction.

Impact for Bankruptcy Court Litigants

Parties involved in bankruptcy-related litigation over "core" claims that, pre-Stern, would have been adjudicated to final judgment by the bankruptcy court, but now because of Stern, cannot be adjudicated to final judgment in the bankruptcy court, will no longer be caught up in the limbo created by the "Stern gap."   Hence, Arkison means that a litigant may not stalemate litigation and the adjudication of claims by interjecting so-called Stern claims and then arguing that there is (or was) no way for the bankruptcy court to properly conduct any proceedings to adjudicate them.  Similarly, the existence of "Stern claims" should not serve as the basis to withdraw the reference on the grounds that the bankruptcy court has no power to do anything as to those claims.   

Also, where there is a concern that the opposing party may argue in the future that the claims in question are "Stern claims," it is imprudent to rely on the opposing party’s consent as a basis for bankruptcy court jurisdiction to enter a final judgment.  Instead, parties to litigation involving potential "Stern claims" should strongly consider asking the court to enter proposed findings of fact and conclusions of law pursuant to Federal Rule of Bankruptcy Procedure 9033 instead of a final judgment.

   [1]   See, e.g., Wellness Int’l Network, Ltd. v. Sharif, 727 F.3d 751, 777 (7th Cir. 2013) (observing that if the claim in question was determined to be a Stern "gap" claim, the district court "shall order that the reference . . . to the bankruptcy court be withdrawn and conduct fresh discovery proceedings in the district court").

   [2]   The Stern court held that a bankruptcy court could not enter a final order on a counterclaim for tortious interference against a creditor of the estate.  Stern, 131 S. Ct. at 2618.  Cf. 28 U.S.C. § 157(b)(2)(C) (identifying "counterclaims by the estate against persons filing claims against the estate" as "core" proceedings as to which the bankruptcy court is authorized to enter final orders).

Gibson, Dunn & Crutcher LLP 

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Business Restructuring and Reorganization Practice Group, or the authors:

Craig H. Millet – Orange County (949-451-3986, [email protected])
Michael Rosenthal – New York (212-351-3969, [email protected])
Jeremy L. Graves – Denver (303-298-5760, [email protected])
Matthew G. Bouslog – Orange County (949-451-4030, [email protected])

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