United States: Supreme Court Rules That States are Not Immune From Avoidance Actions

Originally published in the White & Case Insolvency Notes, February 2006

On January 23, 2006, the Supreme Court issued a 5-4 ruling in Central Va. Community College v. Katz, 126 S.Ct. 990 (2006). The Court ruled that the power granted to Congress to establish "uniform Laws on the subject of Bankruptcies throughout the United States" included the power to determine that States should be subject to avoidance actions like any other creditors. Justice Stevens, writing for the majority, joined by justices O’Connor, Souter, Ginsberg and Breyer, carefully analyzed the Framers’ original intent and determined that they had intended with the Bankruptcy Clause to "authorize limited subordination of state sovereign immunity in the bankruptcy arena." 126 S.Ct. at 996. In rendering its opinion, the majority acknowledged that its decision was at odds with "statements in both the majority and the dissenting opinions in Seminole Tribe of Fla. v. Florida, 517 US 44 (1996)", but noted that the Court was not bound to follow dicta from a prior case in which the point at issue had not been fully debated. Id.

Bernard Katz was appointed liquidating supervisor for a company that operated college bookstores in a number of State schools.¹ Katz initiated adversary proceedings against four Virginia State schools pursuant to certain of the avoidance provisions of the Bankruptcy Code (specifically, Sections 502, 544 and 547).² The defendants argued that each was an instrumentality of the State of Virginia and entitled to sovereign immunity under the 11th Amendment to the Constitution, which states that the "judicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by citizens of another state." The Defendants further argued that Section 106(a) of the Bankruptcy Code, which purports to abrogate a State’s sovereign immunity with respect to a wide range of Bankruptcy Code provisions, violated the 11th Amendment. The 6th Circuit held, contrary to the opinion of the majority of its sister Circuits, that Congress had validly abrogated the defendants’ sovereign immunity pursuant to Section 106(a) of the Bankruptcy Code and that the action against the State schools could continue. The Supreme Court granted certiorari in Katz to resolve the split of authority with respect to the constitutionality of Section 106(a) of the Bankruptcy Code.

The majority began its discussion by highlighting the problems inherent in the "patchwork of insolvency and bankruptcy laws [which was] peculiar to the American experience." Id. at 998. In the years preceding the Constitutional Convention, several of the States had enacted their own insolvency laws, each of which were different. Moreover, each State was its own sovereign, and the rulings of a court of one State were not necessarily accorded comity by the other States. As a result, a debtor could find himself in the unenviable position of receiving a discharge in of his debts in one State, but being placed in debtors prison in another.³

The majority found that Bankruptcy Clause was enacted pursuant to a "general agreement on the importance of authorizing a uniform federal response to" the inequitable results found in the present scheme of State insolvency laws. Id. at 999-1000. Relying mostly on historical essays, the majority concluded that the Framers of the Constitution were aware of the hazards of competing insolvency statutes and as a result proposed to both specifically include insolvency laws within the scope of "full faith and credit"⁴ and add to the Constitution a clause allowing Congress to "establish uniform laws upon the subject of bankruptcies, and respecting the damages arising on the protest of foreign bills and exchange." Id. at 999 (internal quotations omitted). The Bankruptcy Clause was subsequently altered and added to the "Naturalization Clause of what later became Article I."⁵ Id.

The majority next turned its attention to bankruptcy jurisdiction. The Court, first, reaffirmed its recent opinion in Tenn. Student Assistance Corp. v. Hood, 541 US 440 (2004), wherein the Court decided that an action by a debtor to discharge his or her student loans was in rem, and therefore could proceed against a State notwithstanding the principles of sovereign immunity.⁶ The Court continued explaining that the Framers would have understood bankruptcy jurisdiction as a "unitary concept" that would encompass "more than simple adjudications of rights in the res." Id. at 1000. As a result, the majority opined that the Framers would have understood that a bankruptcy court had the power to "issue ancillary orders enforcing their in rem adjudications." Id.

The Court then explained that the "interplay between in rem adjudications and orders ancillary thereto is evident" in the case of an action to avoid a preference. Id. at 1001. The Bankruptcy Code separates the concepts of avoidance and recovery.⁷ Thus, "[t]he Section 547 determination, standing alone, operates as a mere declaration of avoidance" and falls within the purview of the bankruptcy court’s in rem jurisdiction while an action to recover the property transferred might involve "in personum process." Id. The Court, however, concluded that it is not necessary to address whether recovery of a preference pursuant to Section 550 of the Bankruptcy Code was in rem because the Framers would have understood the Bankruptcy Clause "to give Congress the Power to authorize courts to avoid preferential transfers and recover the transferred property." Id. at 1002.

The majority then explained that in the first bankruptcy law, enacted in 1801, Congress granted the Federal courts habeas power, which allowed the Federal courts to order the release of a debtor from State prison if he or she were incarcerated after receiving a discharge in bankruptcy. The majority found the lack of objection to Congress’s grant of habeas power, which is clearly beyond a bankruptcy court’s in rem jurisdiction, evidenced that the States "acquiesced in a subordination of whatever sovereign immunity they might otherwise have asserted in proceedings necessary to effectuate the in rem jurisdiction of the bankruptcy courts." Id. at 1005. Ultimately, the Court held that "the States agreed in the plan of the [Constitutional] Convention not to assert any sovereign immunity defense they might have had in proceedings brought pursuant to ‘Laws on the subject of Bankruptcies.’" Id. at 1004 (internal citations omitted). As such, the majority held that Congress’s power to treat the "States in the same way as other creditors insofar as concerns ‘Laws on the Subject of Bankruptcies’" arises from the Bankruptcy Clause itself. Id. at 1005.

The dissent relies almost entirely on the Supreme Court’s established precedent with respect to sovereign immunity to argue that Congress’s powers pursuant to the Bankruptcy Clause should be treated no differently than Congress’s remaining Article I powers.⁸ The dissent was also not convinced by the historical argument set forth in the majority opinion. Rather the dissent concluded that Section 106(a) of the Bankruptcy Code is unconstitutional and that the opinion of the 6th Circuit should be reversed.

The Supreme Court’s opinion in Katz has both political and legal significance. As to the opinion’s political significance, Katz is the final opinion for which Justice O’Connor will be the swing vote. The majority and dissent voted down party lines. Justice O’Connor broke the tie, siding with the more liberal justices on the grounds that this result comported with the Framers’ intent.⁹

More importantly, though, this decision leaves open a significant question of bankruptcy law. The majority holds that States have ceded their sovereign immunity with respect to "Laws on the subject of Bankruptcies." However the majority does not accurately define the characteristics of such a law. Moreover, the majority opinion does "not mean to suggest that every law labeled a ‘bankruptcy’ law could, consistent with the Bankruptcy Clause, properly impinge upon state sovereign immunity." Katz, 196 S.Ct. at 1005 n.15. Bankruptcy trustees typically bring actions pursuant to State laws - including suits for breaches of fiduciary duties and other tort actions - in order to maximize the distribution to unsecured creditors. Because such causes of action do not arise pursuant to "laws on the subject of bankruptcies", a State may well still be able to assert its sovereign immunity to escape prosecution – even where a bankruptcy trustee brings such actions.

However, Section 544 of the Bankruptcy Code presents a more interesting problem. Section 544 expressly authorizes a Bankruptcy trustee to bring avoidance actions pursuant to State law. Clearly, if such a suit were brought outside of bankruptcy, a State would be able to assert its defense of sovereign immunity. However, Section 544 operates in the same manner as Section 547 – an order pursuant to Section 544 only serves as a designation that the transaction is avoided and recovery of the assets transferred is subject to Section 550. As noted above, the Court in Katz considered an order requiring return of property that was the subject of an avoided transaction to be ancillary to a bankruptcy court’s in rem jurisdiction, and therefore not subject to challenge pursuant to a State’s sovereign immunity. Therefore, it is quite possible that courts will allow debtors to bring a State law avoidance action pursuant to Section 544, notwithstanding a State’s sovereign immunity.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.