Blurred Immunity: California Cannot Escape Adversary Proceeding on Grounds of Sovereign Immunity

Patterson Belknap Webb & Tyler LLP

Patterson Belknap Webb & Tyler LLP

In 2018, the liquidating trustee for Venoco, LLC and its affiliated debtors (collectively, the “Debtors”) commenced an action in the United States Bankruptcy Court for the District of Delaware seeking monetary damages from the State of California and its Lands Commission (collectively, the “State”) as compensation for the alleged taking of a refinery (the “Onshore Facility”) that belonged to the Debtors (the “Adversary Proceeding”).  The State moved to dismiss, claiming, among other things, sovereign immunity.  The Bankruptcy Court denied the motion to dismiss, and the District Court affirmed the denial.  The State appealed to the Third Circuit, and the Third Circuit affirmed. 

Writing for a unanimous three-judge panel, Circuit Judge Ambro began by observing that “States can generally assert sovereign immunity to shield themselves from lawsuits, but bankruptcy proceedings are one of the exceptions.  The Supreme Court held in Central Virginia Community College v. Katz, that, by ratifying the Bankruptcy Clause of the U.S. Constitution, states waived their sovereign immunity defense in proceedings that further a bankruptcy court’s exercise of its jurisdiction over property of the debtor and its estate (called “in rem jurisdiction”).[1]  So, the single question before the Court was whether, under Katz, the State could assert a defense of sovereign immunity in the Adversary Proceeding.

Judge Ambro said no.  He acknowledged that “Katz did not define the range of proceedings that further a bankruptcy court’s in rem jurisdiction,” but explained that it “did tell us bankruptcy’s three critical functions: [1] the exercise of exclusive jurisdiction over all of the debtor’s property, [2] the equitable distribution of that property among the debtor’s creditors, and [3] the ultimate discharge that gives the debtor a ‘fresh start’ by releasing him, her, or it from further liability for old debts.”[2] 

Based on this guidance, Judge Ambro concluded that to determine whether a state can assert sovereign immunity in a particular proceeding, courts must “ask whether a proceeding directly relates to one or more of these three functions.”[3]  Here, he concluded that the adversary proceeding furthers at least two of those three critical bankruptcy functions:

[T]he Adversary Proceeding furthers the Bankruptcy Court’s exercise of jurisdiction over property of the Debtors and their estates, as it seeks a ruling on rights in the Onshore Facility. [ . . . ]  The Adversary Proceeding also furthers the second critical function—facilitating equitable distribution of the estate’s assets.  The Onshore Facility is a significant asset for Venoco and its creditors.  Indeed, the liquidation analysis [included in the Debtor’s plan] acknowledged the [State] was ‘receiving significant value from the use of the Debtors’ assets’ and that the ‘value of the use of those assets [was] being negotiated between the parties.  Further, the [State] is a major creditor and filed a proof of claim against Venoco, so the [State has] a stake in how the Trust’s assets are liquidated and distributed.[4]

Finally, Judge Ambro was unmoved by the State’s insistence that “sovereign immunity is fundamental to our constitutional design and the exercise of eminent domain power is especially central to their sovereignty.” 

[B]ankruptcy is a different ball game, and the effect on state sovereignty is not the focus of our analysis.  The focus is instead on ensuring that sovereign immunity will not interfere with the bankruptcy court’s jurisdiction over the estate’s property as well as its orderly administration.  The driving principle of the Katz decision is that the Bankruptcy Clause has a unique history and is sui generis among Article I’s grants of authority, the result being that federal courts could impose on state sovereignty in bankruptcy proceedings.[5]

[1] Davis v. Cal. (In re Venoco LLC), 2021 U.S. App. LEXIS 15359, at *1-2 (3d Cir. May 24, 2021) (the “Opinion”) citing 546 U.S. 356, 378, 126 S. Ct. 990, 163 L. Ed. 2d 945 (2006).  We visited this important area of bankruptcy law just a year ago to report on the Supreme Court’s rousing affirmation of Katz in Allen v. Cooper, 140 S. Ct. 994 (2020). 

[2] Opinion at 13 (internal citations and quotations omitted). 

[3] Id. at 15-16. 

[4] Id. at 16-18.  Judge Ambro also expressed concern about giving the State an unfair advantage in the bankruptcy proceeding.  See id. (“And consider the consequences: If the [State] could assert sovereign immunity in the Adversary Proceeding, [it] would have a win-win—able to recover from the Trust on account of [its] claims against Venoco while preventing any judicial scrutiny over whether [it] can use the Onshore Facility without payment. And [it] would improve [its] status vis-à-vis other creditors solely owing to their status as a state that can invoke sovereign immunity, just the kind of result Katz wanted to avoid.”).

[5] Id. at 18 (internal citations and quotations omitted).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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