The Third Circuit Seeks to Clarify Sovereign Immunity in Bankruptcy

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The application of sovereign immunity principles in bankruptcy cases has vexed the courts for decades. The U.S. Supreme Court’s opinions on the matter have not helped much. Although they have addressed the issue in specific contexts, they have not established clear guidelines that the lower courts may apply more generally. The Third Circuit took a crack at clarifying this muddy but important area of the law in the case of Venoco LLC (with its affiliated debtors, the “Debtors”).

Background

The Debtors operated off-shore and on-shore drilling operations. As a result of environmental issues, they abandoned certain of their off-shore operations. Invoking its police powers, the California Land Commission (the “Commission”) ultimately took over the relevant off-shore facility at issue in the case.

After a chapter 11 plan was confirmed, the liquidating trustee (the “Trustee”) sued the Commission and the State of California (together “California”) for inverse condemnation in taking over the off-shore facility, seeking just compensation for its value. California moved to dismiss based on sovereign immunity. The bankruptcy court denied the motion and the district court affirmed.

Sovereign Immunity Prior to Katz

In Central Virginia Community College v. Katz, 546 U.S. 356 (2006), the Supreme Court held that, by ratifying the Constitution, the States waived their sovereign immunity with respect to matters characteristically fundamental to the administration of the bankruptcy process, particularly those that implicate the bankruptcy court’s exercise of its in rem jurisdiction over the estate, the status of the debtor, and distributions to creditors. What has proven hard to quantify is exactly what that includes. Katz itself involved a preference action, so that much is certain. But what else?

Prior to Katz, courts in bankruptcy cases focused their sovereign immunity analysis on the meaning and proper scope of section 106 of the Bankruptcy Code. Section 106 purports to abrogate sovereign immunity in bankruptcy cases with respect to matters identified in the section. Granting certiorari in Tennessee Student Assistance Corp. v. Hood, 541 U.S. 440 (2004) to review a circuit split on the constitutionality of section 106, the Supreme Court essentially ducked the issue. It determined that it did not have to decide the constitutionality of the provision because, at least with respect to disputes regarding the debtor’s discharge, principles of sovereign immunity simply did not apply. The Court reasoned that such matters involved the in rem status of the debtor, rather than a claim against a state entity, and so fall outside the scope of the Eleventh Amendment.

Third Circuit’s Framework for Applying Katz

Katz did not define with precision the kinds of proceedings or issues that may be resolved in bankruptcy without violating principles of sovereign immunity. According to the Third Circuit in Venoco, however, the relevant types may be described functionally: those involving (i) exercise of exclusive jurisdiction over property of the estate, (ii) equitable distribution among creditors and (iii) the discharge of debts enabling a debtor to obtain a fresh start.

This framework requires courts to examine the function of the proceeding to determine whether a particular matter is exempt from sovereign immunity concerns. The first category concerns proceedings that affect property of the debtor or the estate, i.e., affect the res. Applying this part of the analysis, courts have found that states lack sovereign immunity in turnover actions, preference and fraudulent transfer matters, and contract disputes.

The second category involves matters that bear on the equitable distribution of the estate to creditors. Courts have held that violations of the automatic stay impact this function.

The third category simply encompasses the Court’s analysis in Hood, determining that States are bound by the bankruptcy discharge, whether or not they chose to participate in the bankruptcy case.

Application of the Framework

Applying the foregoing framework to the Trustee’s inverse condemnation claim, the Third Circuit found that it implicated two of the three relevant functions. First, it involved property of the estate — the off-shore facility at issue and the estate’s rights therein. While the Trustee sought a money judgement for the value of the facility, the form of judgement is not controlling; it is the substance that counts.

Second, the claim implicated the equitable distribution of the Debtors’ property. In support of its analysis, the Third Circuit cited references in prior proceedings in the bankruptcy court in which the parties acknowledged the significant value of the off-shore facility. And it noted that California filed a large claim in the bankruptcy case. If California were allowed to recover on its claim but avoid scrutiny over its actions regarding property of the estate, it would improve its position versus other creditors, thus impacting equitable distribution.

Finally, the Court rejected California’s argument that the bankruptcy court’s in rem jurisdiction ended on the effective date of the Debtors’ chapter 11 plan on the theory that the relevant res ceased to be property of the estate at that time. The Court held that the bankruptcy court’s in rem jurisdiction did not end on the plan’s effective date because the trust remained in existence and its primary function was to facilitate the equitable distribution of the value of the estate’s property to creditors.

California State Law Immunity Rejected as well

As a backup to its Eleventh Amendment claim, California also attempted to assert sovereign immunity under its own state constitution. The Third Circuit rejected this theory on two basic grounds. First, it rejected the argument because it has not been raised in the bankruptcy court and was therefore waived. Second, the Third Circuit observed that, because California was not immune from suit in its own courts, the issue was not one of immunity, but of forum selection.

Conclusion

The Third Circuit’s opinion in Venoco helps illuminate the rather murky area of sovereign immunity in bankruptcy proceedings. Whether it is adopted by courts outside of the Third Circuit, and whether the Supreme Court ultimately endorses its approach, remain to be seen.

Read the Venoco opinion >>

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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