On January 14, 2015, the Supreme Court of the United States heard oral argument in Wellness International Network, Limited v. Sharif, a case that gives SCOTUS the opportunity to finally clarify the constitutional limits of bankruptcy courts’ decision-making power raised by its 2011 decision in Stern v. Marshall. But as we saw with last year’s decision in Executive Benefits Insurance Agency v. Arkison, just because SCOTUS has an opportunity to resolve Stern uncertainty and restore clarity to bankruptcy litigation does not mean that it will do so. It therefore remains an open question whether clarity will be restored to bankruptcy litigation or whether Sharif, like Arkison, will be resolved on narrow grounds that leave the most important Stern questions unanswered and fodder for further litigation.

Review of Stern: New Limits on Bankruptcy Court Power

By statute, a bankruptcy court considering a dispute is permitted to do one of three things:

1. If a dispute falls within the bankruptcy court’s statutory “core” power, the bankruptcy court may issue a “final order” that disposes of the matter;
2. If a dispute falls within the bankruptcy court’s statutory “non-core” power, the bankruptcy court may propose findings of fact and conclusions of law, which are merely a recommendation to a district court as to what order it should enter; or
3. If a dispute does not fall within either the bankruptcy court’s “core” or “non-core” power, the bankruptcy court cannot consider the dispute at all.

In Stern, SCOTUS disrupted this framework by holding that bankruptcy courts are constitutionally prohibited from entering final orders with respect to certain disputes that Congress had statutorily designated as falling within the bankruptcy courts’ “core” power. Specifically, SCOTUS held that bankruptcy courts cannot enter final orders in matters that would require them to exercise “the judicial Power of the United States,” even if statutorily designated as “core.”

Unfortunately, exactly what types of disputes require exercise of the “judicial Power of the United States” is a famously murky area of the law. SCOTUS explained that entry of a final order involves the exercise of the judicial Power if the underlying dispute concerns “the stuff of the traditional actions at common law tried by the courts at Westminster in 1789”—a helpful explanation for experts in the standard practices of eighteenth century English courts, but less so for others.

Review of Arkison: A Missed Opportunity to Clarify Stern

Unsurprisingly, litigation over what type of claims gave rise to “Stern problems” erupted overnight. Three issues became especially prominent:

1. Does a fraudulent transfer claim raise a Stern problem?
2. If a claim does raise a Stern problem, can a bankruptcy court issue proposed findings of fact and conclusions of law as though the claim were “non-core” even though Congress declared it core and statutorily provided only for issuance of a final order?
3. Can litigants expressly or impliedly consent to a bankruptcy court entering a final order on a Stern problem claim, perhaps by litigating in the bankruptcy court without raising an objection?

In 2013, the Supreme Court granted certiorari in Executive Benefits Insurance Agency v. Arkison, a case with the potential to resolve all three of these critical questions.  After hearing oral argument in that case on January 14, 2014 (a year to the day before argument in Sharif), SCOTUS appeared ready to rein in bankruptcy courts’ power to enter final orders in fraudulent transfer litigation.  Ultimately, however, the court dodged the first and third questions on procedural grounds and ruled only that bankruptcy courts may issue proposed findings of fact and conclusions of law as to claims that raise Sterm problems.  Consequently, litigation over the scope of the Stern decision continues.  However, the Supreme Court’s upcoming decision in Sharif may answer some of the remaining questions.

Sharif: The Facts

In 2003, Sharif sued Wellness International in federal district court in Illinois, alleging that its business was an illegal “pyramid scheme.” Upon Wellness International’s motion, the Illinois district court dismissed the suit. That dismissal was subsequently affirmed by the Seventh Circuit. Undeterred, Sharif refiled the suit in federal district court in Texas. During the course of that litigation, Wellness International sought discovery from Sharif, but Sharif refused to produce the required materials. Consequently, the Texas district court granted summary judgment to Wellness International.

After its order dismissing the suit was affirmed by the Fifth Circuit, the Texas district court sanctioned Sharif and awarded Wellness International more than $650,000 in attorney’s fees. When Wellness International sought asset discovery in an effort to collect on its judgment, Sharif again refused to cooperate. As a result, Sharif was found in civil contempt, and was ultimately arrested.

After promising to provide the required discovery, Sharif was released from jail. Instead of producing the discovery materials, however, Sharif filed a chapter 7 bankruptcy petition in the US Bankruptcy Court for the Northern District of Illinois. In bankruptcy, questions quickly emerged regarding Sharif’s property, including $5,380,000 in property that Sharif had listed on a pre-bankruptcy loan application but omitted from his bankruptcy schedules. When questioned by the US trustee on the discrepancy, Sharif replied that he had lied on his loan application and that the assets at issue belonged to the “Soad Wattar Trust,” a trust purportedly created by his mother, of which his sister was purportedly the beneficiary, and of which he was purportedly the trustee. Sharif did not, however, produce trust documents to substantiate his claim.

Wellness International commenced an adversary proceeding against Sharif objecting to his bankruptcy discharge and seeking a declaratory judgment that the property purportedly owned by the Soad Wattar Trust was actually estate property. Sharif initially admitted that the claims fell within the bankruptcy court’s core power, but refused to comply with discovery orders entered by the bankruptcy court in connection with those claims. As a result, the bankruptcy court entered a default judgment against Sharif on all issues.

Sharif appealed and argued, belatedly and without citing Stern, that the bankruptcy court’s order should be treated merely as a report and recommendation. The district court declined to consider Sharif’s argument, and affirmed the bankruptcy court’s ruling.

On further appeal to the Seventh Circuit, Sharif argued that the bankruptcy court lacked constitutional authority to decide whether the property allegedly owned by the Soad Wattar Trust was actually estate property because that determination, while related to federal bankruptcy law, turned on substantive state law. The Seventh Circuit agreed with this argument, finding that the dispute was essentially a “state-law claim between private parties that is wholly independent of federal bankruptcy law and is not resolved in the [bankruptcy] claims allowance process.” Given that virtually all questions of whether property belongs to a debtor’s estate turn on state law, rather than federal bankruptcy law, this holding, if affirmed, could significantly curtail bankruptcy courts’ ability to effectively administer their cases.

Sharif at the Supreme Court

On July 1, 2014, just weeks after deciding Arkison, SCOTUS granted certiorari in Sharif and agreed to review two questions, which can be summarized as:

1. Does the presence of a substantive state property law issue mean that a bankruptcy court lacks constitutional authority to determine whether property belongs to a debtor’s estate?
2. Does the US Constitution permit bankruptcy courts to exercise the judicial Power of the US on the basis of litigant consent, and, if so, can that consent be implicit rather than explicit?

It is generally difficult to predict how SCOTUS will rule based solely on oral argument, and even more so in the context of bankruptcy cases, which rarely raise the type of issues that divide neatly along the Justices’ respective ideological lines. However, a few inferences can be drawn from the argument in Sharif.

As he did in Stern, as well as during oral argument in Arkison, Chief Justice Roberts again expressed strong concerns with allowing bankruptcy judges, as non “Article III” judges, to encroach on the traditional domain of the judicial branch. Look for him to cast a vote either affirming the Seventh Circuit, or overruling it on narrow grounds related to question 1, rather than on broad grounds related to question 2.

Justice Breyer appears prepared to resolve question 1 by holding that a bankruptcy court fundamentally possesses the power to decide what property belongs to a bankruptcy estate, regardless of the source of the underlying property law. In Justice Breyer’s apparent view, eliminating that power would fundamentally disrupt “the constitutional grant to Congress to make uniform laws of bankruptcy.”

Justices Scalia and Breyer appeared to disagree on whether SCOTUS should answer both questions, or whether the case should be resolved on the narrowest grounds possible. Justice Breyer, perhaps keen to resolve the ongoing uncertainty caused by Stern and its progeny, suggested that the court should answer both questions, even if the case could be resolved simply by answering only one or the other. Justice Scalia bluntly characterized that suggested approach as a mistake.

On question 2, Justices Sotomayor and Kagan appear to be leaning towards finding that litigants may consent to adjudication by a bankruptcy court. Both Justices favorably compared adjudication by bankruptcy courts with the arbitration system, in which district courts regularly enforce arbitration awards and which all parties agree is constitutional.

Conclusion

Sharif certainly has the potential to bring clarity to bankruptcy litigation by providing definitive answers to some of the many questions raised by Stern. But it is unclear whether SCOTUS will seize that opportunity in full, and, if it does, how it is likely to rule. Based on SCOTUS’s repeated grant of certiorari on Stern issues over a period of only a few years, it appears that at least some of the Justices want to provide that clarity. On the other hand, SCOTUS has a long tradition of resolving disputes on the narrowest grounds possible and Justice Roberts appears anxious to protect the constitutional “turf” of the Article III judiciary. Bankruptcy practitioners and investors with a stake in the outcome of bankruptcy litigation should continue to follow the case, while also recognizing that Sharif may not bring final answers to the Stern problem when it is decided in spring or early summer of this year.