October/November 2004

Sovereign Immunity in Bankruptcy
Supreme Court

Does Congress have the authority to revoke state sovereign immunity in bankruptcy proceedings?

The Supreme Court declined to decide whether Congress has the authority to revoke state sovereign immunity in bankruptcy proceedings. The Supreme Court declined to decide whether a bankruptcy court’s exercise of personal jurisdiction over a State would be valid under the Eleventh Amendment. Tennessee Student Assistance Corp. v. Hood, 124 S.Ct. 1905, 158 L.Ed.2d 764, 43 Bankr.Ct.Dec. 1, Bankr. L. Rep. P 80,098, 4 Cal. Daily Op. Serv. 4219, 2004 Daily Journal D.A.R. 5871, 17 Fla. L. Weekly Fed. S 277 (2004).

Syllabus
Respondent Hood had an outstanding balance on student loans guaranteed by petitioner Tennessee Student Assistance Corporation (TSAC), a state entity, at the time she filed a Chapter 7 bankruptcy petition. Hood’s general discharge did not cover her student loans, as she did not list them and they are only dischargeable if a bankruptcy court determines that excepting the debt from the order would be an “undue hardship” on the debtor, 11 U.S.C. § 523(a)(8). Hood subsequently reopened the petition, seeking an “undue hardship” determination. As prescribed by Federal Rules of Bankruptcy Procedure 7001(6), 7003, and 7004, she filed a complaint and, later, an amended complaint, and served them with a summons on TSAC and others. The Bankruptcy Court denied TSAC’s motion to dismiss the complaint for lack of jurisdiction, holding that 11 U.S.C. § 106(a) abrogated the State’s Eleventh Amendment sovereign immunity. The Sixth Circuit Bankruptcy Appellate Panel affirmed, as did the Sixth Circuit, which held that the Bankruptcy Clause gave Congress the authority to abrogate state sovereign immunity in § 106(a). This Court granted certiorari to determine whether the Bankruptcy Clause grants Congress such authority.

Held: Because the Bankruptcy Court’s discharge of a student loan debt does not implicate a State’s Eleventh Amendment immunity, this Court does not reach the question on which certiorari was granted. Pp. 1909-1915.

(a) States may be bound by some judicial actions without their consent. For example, the Eleventh Amendment does not bar federal jurisdiction over in rem admiralty actions when the State does not possess the res. California v. Deep Sea Research, Inc., 523 U.S. 491, 507-508, 118 S.Ct. 1464, 140 L.Ed.2d 626. A debt’s discharge by a bankruptcy court is similarly an in rem proceeding. The court has exclusive jurisdiction over a debtor’s property, wherever located, and over the estate. Once debts are discharged, a creditor who did not submit a proof of claim will be unable to collect on his unsecured loans. A bankruptcy court is able to provide the debtor a fresh start, even if all of his creditors do not participate, because the court’s jurisdiction is premised on the debtor and his estate, not on the creditors. Because the court’s jurisdiction is premised on the res, however, a nonparticipating creditor cannot be personally liable. 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, see, e.g., New York v. Irving Trust Co., 288 U.S. 329, 333, 53 S.Ct. 389, 77 L.Ed. 815. And when the bankruptcy court’s jurisdiction over the res is unquestioned, the exercise of its in rem jurisdiction to discharge the debt does not infringe a State’s sovereignty. TSAC argues, however, that the individualized process by which student loan debts are discharged unconstitutionally infringes its sovereignty. If a debtor does not affirmatively secure § 523(a)(8)’s “undue hardship” determination, States choosing not to submit themselves to the court’s jurisdiction might receive some benefit: The debtor’s personal liability on the loan may survive the discharge. TSAC misunderstands the proceeding’s fundamental nature when it claims that Congress, by making a student loan debt presumptively non dischargeable and singling it out for an individualized determination, has authorized a suit against a State. The bankruptcy court’s jurisdiction is premised on the res, not the persona; that States were granted the presumptive benefit of nondischargeability does not alter the court’s underlying authority. A debtor does not seek damages or affirmative relief from a State or subject an unwilling State to a coercive judicial process by seeking to discharge his debts. Indeed, this Court has endorsed individual determinations of States’ interests within the federal courts’ in rem jurisdiction, e.g., Deep Sea Research, supra. Although bankruptcy and admiralty are specialized areas of the law, there is no reason why the exercise of federal courts’ in rem bankruptcy jurisdiction is more threatening to state sovereignty than the exercise of their in rem admiralty jurisdiction. Pp. 1909-1913.

(b) With regard to the procedure used in this case, the Bankruptcy Rules require a debtor to file an adversary proceeding against the State to discharge student loan debts. While this is part of the original bankruptcy case and within the bankruptcy court’s in rem jurisdiction, it requires the service of a summons and a complaint, see Rules 7001(6), 7003, and 7004. The issuance of process is normally an indignity to a State’s sovereignty, because its purpose is to establish personal jurisdiction; but the court’s in rem jurisdiction allows it to adjudicate the debtors’ discharge claim without in personam jurisdiction over the State. Section 523(a)(8) does not require a summons, and absent Rule 7001(6) a debtor could proceed by motion, which would raise no constitutional concern. There is no reason why service of a summons, which in this case is indistinguishable in practical effect from a motion, should be given dispositive weight. Dismissal of the complaint is not appropriate here where the court has in rem jurisdiction and has not attempted to adjudicate any claims outside of that jurisdiction. This case is unlike an adversary proceeding by a bankruptcy trustee seeking to recover property in the State’s hands on the grounds that the transfer was a voidable preference. Even if this Court were to hold that Congress lacked the ability to abrogate state sovereign immunity under the Bankruptcy Clause, the Bankruptcy Court would still have authority to make the undue hardship determination Hood seeks. Thus, this Court declines to decide whether a bankruptcy court’s exercise of personal jurisdiction over a State would be valid under the Eleventh Amendment. If the Bankruptcy Court on remand exceeds its in rem jurisdiction, TSAC would be free to challenge the court’s authority. Pp. 1913-1915.

319 F.3d 755, affirmed and remanded.
REHNQUIST, C. J., delivered the opinion of the Court, in which STEVENS, O’CONNOR, KENNEDY, SOUTER, GINSBURG, and BREYER, JJ., joined. SOUTER, J., filed a concurring opinion, in which GINSBURG, J., joined. THOMAS, J., filed a dissenting opinion, in which SCALIA, J., joined.

Accounting Malpractice/Bankruptcy
Third Circuit

Is accounting malpractice claim “related to” jurisdiction of bankruptcy court?

The Third Circuit held that that accounting malpractice claims asserted by litigation trust established under debtors’ confirmed Chapter 11 plan against accounting firm that provided tax advice and accounting services to trust did not come within the post confirmation“related to” jurisdiction of bankruptcy court. In re Resorts International, Inc., 372 F.3d 154, 43 Bankr.Ct.Dec. 46 (3rd Cir. 2004).

This appeal addresses the scope of “related to” jurisdiction of the bankruptcy court for post confirmation claims brought on behalf of a litigation trust against an accounting firm. The trustee sued the accounting firm Price Waterhouse & Co. for professional negligence and breach of contract for work it performed for the trust. According to the Trustee, Price Waterhouse’s erroneous reports were relied on by the bankruptcy court to the Litigation Trust’s detriment. Price Waterhouse alleged lack of jurisdiction that the Litigation Trust, a legally distinct entity, is not a continuation of the bankruptcy estate for jurisdictional purposes. Moreover, Price Waterhouse contended the debtor is only tangentially affected by this malpractice action after it assigned away its interests in the litigation claims, and the Litigation Trust beneficiaries traded their creditor status to attain rights to the Trust’s assets.

The Court of Appeals found lack of subject matter jurisdiction. The accounting malpractice claims asserted by litigation trust established under debtors’ confirmed Chapter 11 plan against accounting firm that provided tax advice and accounting services to trust did not come within the post confirmation“related to” jurisdiction of bankruptcy court. This was found even though resolution of claims would effect former creditors of estate who had exchanged their creditor status for right to share in assets of trust, and though litigation trust’s assets were once assets of estate, where resolution of malpractice claims would not affect estate, would have only incidental effect on reorganized debtor, and would not interfere with implementation of reorganization plan. 28 U.S.C.A. §§ 157, 1334.

Securities Claims/Bankruptcy
Second Circuit

Can a federal district court exercise bankruptcy jurisdiction over generally non removable claims brought under the Securities Act of 1933?

Appellants in the case are state and private pension funds that bought WorldCom bonds. Addressing an issue of apparent first impression for the courts of appeals, the Securities Act’s anti removal provision does not preclude removal of actions that are “related to” a bankruptcy case under the bankruptcy removal statute. California Public Employees’ Retirement System v. Worldcom, Inc., 368 F.3d 86, Fed. Sec. L. Rep. P 92,814, 43 Bankr.Ct.Dec. 15, Bankr. L. Rep. P 80,094 (2nd Cir 2004).

WorldCom sought Chapter 11 protection in the Southern District of New York on July 21, 2002. Once WorldCom filed for bankruptcy, the automatic stay provision of the Bankruptcy Code, 11 U.S.C. § 362, took effect, preventing litigation against WorldCom from going forward. The Bondholders’ litigation strategy was carefully considered. By limiting their complaints to claims under the 1933 Act, the Bondholders sought to take advantage of Section 22(a) of the Act, which states that, with one exception that is not relevant here, “[n]o case arising under this subchapter and brought in any State court of competent jurisdiction shall be removed to any court of the United States.” 15 U.S.C. § 77v(a) (emphasis added). In other words, the Bondholders crafted their complaints in order to avoid removal of their actions to federal court and consolidation of those actions in a single venue.

This case involves a direct conflict between two unambiguous statutes--Section 22(a) of the Securities Act of 1933, which bars removal of individual Securities Act claims, and 28 U.S.C. § 1452(a), which permits removal of claims that are “related to” a bankruptcy case. The Court did not agree with the Bondholder plaintiffs that Section 22(a) of the Securities Act is more “specific” than the bankruptcy removal provision, nor did it believe that Congress granted the plaintiffs an absolute choice of forum when it amended the Securities Act in 1998. Instead, the Court resolved the conflict between the statutes by contrasting the bankruptcy removal statute, which contains no exception for claims arising under an Act of Congress that prohibits removal, with the general removal statute, which applies “[e]xcept as otherwise expressly provided by an Act of Congress.” 28 U.S.C. § 1441(a) (emphasis added). Based on this analysis of the federal jurisdictional scheme as a whole, the Court concluded that Section 22(a) does not preclude removal of individual actions that are “related to” a bankruptcy case under Section 1452(a).

Fair Debt Collection Practices Act (FDCPA)/Bankruptcy
Seventh Circuit

Does the Bankruptcy Code preempt the Fair Debt Collection Practices Act (FDCPA)?

Disagreeing with the Ninth Circuit, the Seventh Circuit held that the Bankruptcy Code does not preempt the Fair Debt Collection Practices Act (FDCPA) and that debtors may sue for a violation of the FDCPA. Randolph v. IMBS, Inc., 368 F.3d 726 (7th Cir. 2004).

Three debtors brought separate actions against collection agencies, alleging that agencies’ negligent attempts to collect debts after debtors had filed for bankruptcy violated Fair Debt Collection Practices Act, 15 U.S.C.A. § 1692e(2)(A). In each case, the collection agency attempted to collect a debt after the filing of a bankruptcy petition by the debtor. A debtor dunned after filing for bankruptcy has a potential remedy which is to ask the bankruptcy judge to hold the other party in contempt of either the automatic stay or the discharge injunction. This option is available against both creditors and debt collectors, but only if the violation is “willful”. See § 362(h); cf. § 524(a)(2). Willfulness entails actual knowledge that a bankruptcy is under way or has ended in a discharge. If a willful violation can be shown, both actual and punitive damages are available, while violations of the FDCPA generally lead to small penalties and never to punitive damages. In these three cases, which were consolidated on appeal, the district courts held that remedies under the Bankruptcy Code are the only recourse against post-bankruptcy debt collection efforts--that the Code trumps the FDCPA when they deal with the same subject, even when the two statutes are consistent. On this view, negligent attempts to collect from debtors during or after bankruptcy cannot yield liability. That position has the support of one circuit, see Walls v. Wells Fargo Bank, N.A., 276 F.3d 502, 510-11 (9th Cir.2002).

The Seventh Circuit held that the Bankruptcy Code of 1986 does not work an implied repeal of the FDCPA, any more than the latter Act implicitly repeals itself. Considering one of the debtor’s two claims: the first, under § 1692c(a), depended on the debt collector’s “knowledge” of the bankruptcy; the second, under § 1692e(2)(A), invoked a strict liability rule with a potential due-care defense. The Court stated they have been able to address both of these independently, without saying that it would undercut the scienter requirement § 1692c(a) to permit no-fault liability under § 1692e(2)(A). They are simply different rules, with different requirements of proof and different remedies. Just so with § 1692e(2)(A) and § 362(h) of the Bankruptcy Code. To say that only the Code applies is to eliminate all control of negligent falsehoods. Permitting remedies for negligent falsehoods would not contradict any portion of the Bankruptcy Code, which therefore cannot be deemed to have repealed or curtailed § 1692e(2)(A) by implication. To the extent that Walls holds otherwise, the Court did not follow it.

Violation of Automatic Stay
Ninth Circuit

Is a debtor entitled to damages for emotional distress due to violation of automatic stay?

The Ninth Circuit agreed with the Seventh Circuit in holding that a debtor is not entitled to damages under § 362(h) due to violations of the automatic stay. In re Dawson, 367 F.3d 1174, Bankr. L. Rep. P 80,101, 4 Cal. Daily Op. Serv. 4271, 2004 Daily Journal D.A.R. 5935 (9th Cir. 2004). The First Circuit is the only other circuit to consider this question, and it decided the issue the other way.

Chapter 13 debtors filed adversary complaint against mortgagee, alleging violation of automatic stay and seeking emotional distress damages. The Bankruptcy Court found a violation but declined to award damages. The United States District Court affirmed on the damages issue, and debtors appealed. The Court of Appeals, held that debtors could not recover damages for emotional distress caused by creditor’s automatic stay violation. Affirmed.
Debtor’s relied on the text of 11 U.S.C. § 362(h): “An individual injured by any willful violation of a stay provided by this section shall recover actual damages, including costs and attorneys’ fees, and, in appropriate circumstances, may recover punitive damages.” (Emphasis added.) Emotional distress damages, they alleged, are one type of “actual damages.”

The Court was not persuaded by the argument for two reasons. First, the text of § 362(h) suggests that it is aimed at economic damages. In § 362(h), “actual damages” are said to “includ[e] costs and attorneys’ fees,” which are kinds of economic harm. Moreover, and more importantly, the term “actual damages” is used in a variety of federal statutes, not directly related to tort claims, and has been interpreted to refer to economic harm alone. The second reason for the Court’s disagreement is a decision in the of the Seventh Circuit. In Aiello v. Providian Financial Corp., 239 F.3d 876, 878 (7th Cir.2001), a creditor threatened to charge a Chapter 7 debtor with fraud if she refused to reaffirm her debt. The debtor refused; the creditor did not bring a fraud action; but the debtor filed a class action against the creditor, seeking damages for emotional distress. Id. On appeal from the bankruptcy court, the district court held that damages for emotional distress are available under 11 U.S.C. § 362(h), but only when the violation of the stay is “egregious.” Aiello v. Providian Fin. Corp., 257 B.R. 245, 250-51 (Bankr.N.D.Ill.2000). Because the violation was not “egregious” and there was little evidence of emotional distress, the district court refused to award damages for emotional distress; and, because the debtor had not suffered “actual damages” within the meaning of the statute, she could not represent the putative class. Id. at 253.

The First Circuit is the only other circuit to consider this question, and it decided the issue the other way. See Fleet Mortgage Group, Inc. v. Kaneb, 196 F.3d 265, 269 (1st Cir.1999) (“[W]e note that emotional damages qualify as ‘actual damages’ under § 362(h).”).

Collateral Estoppel/Bankruptcy
Seventh Circuit

Can a default judgment in a state court be the basis for collateral estoppel in a subsequent bankruptcy?

The Court of Appeals held that underlying finding of fraud made against debtor in Indiana state court proceeding which culminated in entry of a default judgment against debtor was entitled to collateral estoppel effect in subsequent dischargeability bankruptcy proceeding. In re Catt, II, 368 F.3d 789, 43 Bankr.Ct.Dec. 13, Bankr. L. Rep. P 80,121 (7th Cir. 2004).

One might presume that findings made in default proceedings would never be given collateral estoppel (issue preclusion) effect because they are not based on a “full and fair” hearing--a standard formulation of the criterion for whether findings are entitled to such effect. How could a hearing that is not “full and fair” comport with due process? Yet a significant minority of states, Indiana among them, allow findings made in default proceedings to collaterally estop, provided that the defaulted party could have appeared and defended if he had wanted to. Small v. Centocor, Inc., 731 N.E.2d 22, 28 (Ind.App.2000); see also Stephan v. Rocky Mountain Chocolate Factory, Inc., supra, 136 F.3d at 1136 (holding that a Colorado default judgment had issue-preclusive effect in bankruptcy discharge proceedings); In re Cantrell, 329 F.3d 1119 (9th Cir.2003) (same, California default judgment); In re Caton, 157 F.3d 1026, 1028-29 (5th Cir.1998) (same, Illinois default judgment). For in such a case the party has in effect forfeited his right to a full and fair hearing. The Court noted that surprisingly, there is no uniform agreement on the criteria for giving findings collateral estoppel effect. The Supreme Court has said that they are entitled to such effect as long as there was an opportunity for a full and fair hearing, e.g., Parklane Hosiery Co. v. Shore, 439 U.S. 322, 332-33, 99 S.Ct. 645, 58 L.Ed.2d 552 (1979), which suggests that findings made in a default proceeding might well have such effect.

The district court must conduct an inquiry in order to ascertain the amount of damages with reasonable certainty. The inquiry here was perfunctory. But all that the creditor wants to use the judgment for is the underlying finding of fraud, and under Indiana law they could have used it for that purpose even if there had been no hearing in the state court at all. The finding thus bound the bankruptcy judge.

Financial Accommodation/Bankruptcy
Seventh Circuit

Is a credit card processing agreement a “financial accommodation” and, thus, it can not be assumed by debtor?

The Seventh Circuit held that (1) a parties’ credit card processing agreement was not a “financial accommodation” and so could be assumed by debtor, and (2) the bankruptcy court properly declined to condition approval of the assumption on debtor’s setting aside a reserve to ensure its ability to cover charge backs in the event the debtor stopped flying. In re United Airlines, Inc., 368 F.3d 720, 42 Bankr.Ct.Dec. 276, Bankr. L. Rep. P 80,095 (7th Cir. 2004). See also, In re Thomas B. Hamilton Co., 969 F.2d 1013 (11th Cir.1992).

The debtor is United Airlines. Prior to bankruptcy, National Processing had signed a contract to handle the transactions of United’s customers who pay with VISA or MasterCard credit cards. Debtors in bankruptcy may enforce most executory contracts that predate their petitions. The Bankruptcy Code has some exceptions, however. Section 365(c)(2) (11 U.S.C. § 365(c)(2)) is one: a debtor may not assume “a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor.” National Processing contended that a credit card merchant agreement is a “financial accommodation” that cannot be assumed in bankruptcy.

The Court explained the credit card processing system. Issuing banks (that is, the banks that issued the credit cards to United’s passengers), the inter-bank networks, and the merchant bank (National Processing and National City Bank, which transact with United and other merchants) all collect fees for their services; these are deducted from the balance remitted to the merchant. Charge backs are reversals of transactions. If the passenger has a refundable ticket and does not fly, United will credit the passenger’s card; similarly, if United cancels the flight and the passenger does not rebook, a charge back will occur. If United were to ground its fleet or substantially curtail its service, charge backs would exceed new sales, and the daily balances in the system would go negative. United would owe the difference to National Processing, which would distribute proceeds to the issuing banks and their customers. If United could not pay, however, then the merchant bank, the issuing bank, or the customer would bear the loss. National Processing contended that the rules of the VISA and MasterCard national associations allocate that loss to the merchant bank. This means, National Processing contended, that it has guaranteed United’s (contingent) debts to the passengers, and because a guaranty is a “financial accommodation” National Processing insists that the credit-card-processing agreement cannot be assumed. National Processing’s lead argument was that the credit-card system operates like a revolving line of credit.

The Court rejected National’s argument and reasoned that neither National Processing nor National City Bank lends to United. Any loan is made by the issuing bank, not the merchant bank; the loan is to the issuing bank’s customer (United’s passenger), not to United. National Processing does not deposit anything into United’s account at National City Bank until after the issuing bank has made the loan to its customer and placed the funds in the inter-bank system on the customer’s behalf. By acting as an intermediary, National Processing no more makes a “financial accommodation” to United than does any other participant in this process--the Internet service provider through which data flows, the courier that moves paper records, the Federal Reserve wire transfer apparatus, and the other contributors to a financial network. National Processing functions as a conduit, not a lender, in this transaction.

National Processing asked the bankruptcy judge to condition approval on United’s willingness to set aside a reserve of several hundred million dollars to ensure that it could cover charge backs in the event it stopped flying. The Court held that this was not required. Section 365(a) requires judicial approval but does not say that approval must be (or even should be) contingent on steps that reduce the other side’s risk to zero. Congress did include such a provision elsewhere in § 365, but only for circumstances in which the debtor was in default. Section 365(b)(1). United has never defaulted on its obligations under the agreement.