Stern v. Marshall Updates – DC Bankruptcy Court Has Jurisdiction to Hear State Law Counterclaims

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In GB Herndon, the District of Columbia Bankruptcy Court determined that it had constitutional authority to determine state common law counterclaims and state law claims against nondebtor codefendants. Adams Nat’l Bank v. GB Herndon & Assocs., Inc. (In re GB Herndon & Assocs., Inc.), 459 B.R. 148 (Bankr. D.D.C. 2011).   The case involved a routine contract dispute.  Adams National Bank lent money to the debtor to finance the construction of a housing complex.  The debtor and its guarantors failed to meet their obligations, first under the original loan agreement, then under a forbearance agreement, and the bank sued in state court for breach of contract.

The debtor and its codefendants asserted counterclaims for breach of contract, tortious interference with contract, and breach of the duty of good faith and fair dealing. The bank also initiated an extra-judicial foreclosure, which led the debtor to file for chapter 11 relief, thus staying both the foreclosure sale and the state court breach of contract proceedings. The debtor subsequently removed the state court action to the bankruptcy court, and after a hearing on the bank’s summary judgment motion, the bankruptcy court dismissed the counterclaims asserted by the debtor and its nondebtor codefendants.

On June 23, 2011, the date on which Stern v. Marshall was decided by the Supreme Court, the bankruptcy court entered judgment in favor of the bank and against the defendants. Thereafter, the debtor and the nondebtor co-defendants moved for relief from the judgment under Rule 59(e) or 60(b) and argued that under Stern v. Marshall the bankruptcy court lacked the constitutional authority to determine the state law counterclaims.

Similar to Stern, the central issue in GB Herndon was whether the bankruptcy court had the constitutional authority to determine the counterclaims or whether Article III required that the counterclaims be adjudicated by an Article III judge. The court distinguished between two distinct interests that Article III protects. The first of these interests is a litigant’s individual right to have claims decided by an Article III judge.  The court concluded that this interest did not provide an adequate basis for denying the bankruptcy court authority over the counterclaims because the individual right is waivable.

The court analogized the facts to those in Commodity Futures Trading Comm’n v. Schor, 478 U.S. 833 (1986), a case in which the respondent first demanded that his state law counterclaims be heard in front of an administrative agency, but then challenged the agency’s jurisdiction once the agency had ruled against him. Relying on Schor’s holding that the respondent there had waived his right to an Article III adjudication by choosing to litigate in a non-Article III forum, the bankruptcy court ruled that the defendants similarly had waived this right. In its notice of removal, the debtor characterized the state court action as a “core proceeding,” and none of the defendants challenged either that characterization or the bankruptcy court’s authority to adjudicate the counterclaims.

Notably, the court stated that Stern v. Marshall did not represent a “wholesale change in the law” that would warrant relief from the judgment because Stern affirmed a 2010 Ninth Circuit decision and therefore, during the proceedings before the bankruptcy court, there had been precedent to support an argument that the court lacked core jurisdiction over the state law counterclaims, which the debtor’s experienced bankruptcy counsel had failed to raise.

The bankruptcy court next addressed the second interest that Article III protects, a separation-of-powers, or structural, interest. Although the court observed that Stern did not decide the issue of whether this interest bars bankruptcy courts from entering final judgments on state common law counterclaims when consent is given, it expressed concern that the lengthy discussion of structural issues in Stern might lead some to conclude incorrectly that, in the eyes of the Supreme Court, “even bankruptcy judge adjudications with the consent of the parties would run afoul of Article III.” GB Herndon, 459 B.R. at 158-59.

The bankruptcy court rebutted such a reading of Stern in several ways. First, it reflected that if structural interests barred bankruptcy court adjudications of state common law counterclaims even with the parties’ consent, then the Supreme Court could simply have decided Stern on this more categorical basis, and would not have needed to wrestle with the individual parties’ rights to an Article III adjudication. Second, the court noted cases in which the Supreme Court and various courts of appeals have upheld the exercise of the Article III judicial power by other types of non-Article III judges, such as magistrate judges, with the consent of the parties. Third, the court emphasized that any separation-of-powers concerns should be mitigated by the fact that, as with decisions of magistrate judges, decisions of bankruptcy judges are reviewable by Article III courts.

The bankruptcy court went on to conclude that even without consent, it would have jurisdiction to determine the counterclaims. Because a ruling on the bank’s claims would require a determination of the enforceability of the forbearance agreement and a ruling on the counterclaims, the action was within the exception to the Article III requirement that common law claims be heard by an Article III court. Moreover, even if they had not waived their right to be heard by an Article III court, the nondebtor codefendants, who raised no counterclaims beyond those asserted by the debtor, would be bound by the ruling against the debtor as a matter of issue preclusion.