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Choice of State Law in Bankruptcy Cases Part I

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Most bankruptcy lawyers have not heard, much less used, the words "Erie Doctrine" or "Klaxon Co. v. Stentor" since law school. For many of us, these names dredge up painful memories of weighty classes on federal jurisdiction. We leave these classes recognizing that choice of law is a concept fundamental to our federal and state law system. However, as bankruptcy lawyers, we have come to believe that we no longer need to pay attention to choice-of-law concepts. We delude ourselves into thinking that federal and state choice-of-law issues seldom arise in our day-to-day practice. After all, we are usually practicing before a federal court, interpreting federal law and following federal procedures. In fact, nothing could be further from the truth. The reality is that choice of law is an everyday issue in our practice, and we apply federal and state choice-of-law rules without even realizing that we are doing so.

Let us take a simple example. A trustee in a Delaware bankruptcy case files an objection to a landlord claim for damages arising from the breach of a lease of California real property on the grounds that the landlord has failed to mitigate damages by releasing the property. Ask a bankruptcy lawyer what law we should look at in determining whether the landlord has failed to mitigate, and the answer is invariably: "Why, California law, of course." Everyone knows that mitigation is a state law issue, and in real property matters the law of the state where the property is located should apply. It is too easy. It is so easy, in fact, that we do not recognize that we are applying choice-of-law analysis to reach the result. The choice-of-law analysis is as follows. First, we ask the "Erie" question: "Is mitigation a question of federal law or state law?" The proceeding is in federal bankruptcy court, and an objection to claim is a matter of federal bankruptcy law, but the defense of mitigation does not seem to invoke any strong federal policy. We therefore conclude that state law will apply.

Having determined that state law applies, we need to know which state's law applies. In turn, this depends on the particular choice-of-law rule applied by the court. Should the bankruptcy court apply the choice-of-law rules of Delaware, the forum state of the bankruptcy, in deference to state law, as in diversity cases, or should the bankruptcy court apply a federal choice-of-law rule because the matter arises in a bankruptcy case? The end result—application of California substantive law—may well be the same, but in many instances it will not be.

Let us take another example, which is a little harder. A trustee sues in New York bankruptcy court to collect an account receivable. The complaint is a simple cause of action for breach of contract. The trustee is a resident of New York, but the debtor had offices in several states, the defendant is a nonresident and the entire transaction giving rise to the debt occurred outside New York. The contract does not specify a choice of law. The defendant asserts the statute of limitations as a defense. The court is posed with two questions: (1) which state's law applies, and (2) which rule should determine which state's law applies—the federal choice-of-law rule or a state choice-of-law rule? In other words, should a New York bankruptcy court apply the choice-of-law rules of a New York state court, or should it apply the federal choice-of-law rules? This is the question explored by this article.

Under the ruling of Erie Railroad Co. v. Tompkins, 304 U.S. 64 (1938), where jurisdiction is based on diversity of citizenship, the federal courts must apply state law. Under Klaxon Co. v. Stentor Electric Manufacturing Co., 313 U.S. 487 (1941), the federal courts must also apply the choice-of-law rules of the forum state in diversity cases. Does the same rule apply in bankruptcy cases where jurisdiction over state law claims is based on bankruptcy law and not state law?

If federal law applies, then under federal common law, federal choice-of-law rules would apply. Federal choice-of-law rules apply the law of the jurisdiction with the most significant relationship with the action. See, e.g., Advani Enterprises Inc. v. Underwriters at Lloyds, 140 F.3d 157, 162 (2nd Cir. 1998). Federal choice-of-law rules afford no special deference to the law of the state in which the bankruptcy court sits. Under the rule of Klaxon, the choice-of-law rules of the forum state will apply.

The Supreme Court has yet to decide whether the rule of Klaxon should apply in bankruptcy cases involving state law claims. Dicta in a later Supreme Court case, Vanston Bondholders Protective Comm. v. Green, 329 U.S. 156 (1946), provides support for a federal choice-of-law rule. However, the issue has split the circuits. Some courts, such as the Ninth Circuit, advocate the use of the federal choice-of-law rule. See, e.g., Lindsay v. Beneficial Reinsurance Co. (In re Lindsay), 59 F.3d 942, 948 (9th Cir. 1995); see, also, Vanston, supra; Limor v. Weinstein & Sutton (In re SMEC), 160 B.R. 86, 89-91 (M.D. Tenn. 1993). Other courts, including the Second and Fourth Circuits, follow the forum state choice-of-law rule of Klaxon. See In re Merritt Dredging Co., 839 F.2d 203 (4th Cir. 1988); Bianco v. Erkins (In re Gaston & Snow), 243 F.3d 599 (2nd Cir. 2001). These cases distinguish Vanston and favor the more certain rule of Klaxon, which gives deference to state law. See Merritt, 839 F.2d at 205-06; Gaston & Snow, 243 F.3d at 604-07. Other circuits have declined to resolve the question. See In re Morris, 30 F.3d 1578, 1581-82 (7th Cir. 1994); Woods-Tucker Leasing Corp. of Georgia v. Hutcheson-Ingram Dev. Co., 642 F.2d 744, 747-49 (5th Cir. 1981). See, also, In re Crist, 632 F.2d 1226, 1229 (5th Cir. 1980) ("when disposition of a federal question [in a bankruptcy case] requires reference to state law, federal courts are not bound by the forum state's choice-of-law rules, but are free to apply the law considered relevant to the pending controversy").

To shed light upon this question, this article will first review basic choice-of-law principles commonly known as the "Erie Doctrine" and Klaxon Co. v. Stentor, and will then analyze and discuss the Vanston Bondholders case. Next, this article will review cases supporting a federal choice-of-law rule and then discuss cases applying Klaxon. Finally, this article will discuss whether and how the various cases can be reconciled and will conclude that the flexibility of the federal rule is more compatible with the modern world of multi-state commerce.

A Law School Primer on Basic Federal/State Choice-of-law Issues: The Erie Doctrine and Klaxon Co. v. Stentor

Any discussion of choice of law must inevitably begin with the landmark case of Erie Railroad Co. v. Tompkins, 304 U.S. 64 (1938). In Erie, the Supreme Court decided that a federal court should apply "substantive" state law when exercising jurisdiction based on diversity of citizenship of the parties while continuing to apply federal rules of procedure. The Supreme Court rejected the notion, alive and well before 1938, that the federal courts could create federal common substantive law in diversity cases. In our dual court system, the federal courts are restricted in their ability to create federal common law to displace state-created rules, and the situations in which a federal court may do so are severely limited. See O'Melveny & Myers v. FDIC, 512 U.S. 79, 87 (1994). Before federal courts can create federal common law, there must be "a significant conflict between some federal policy or interest and the use of state law." Atherton v. FDIC, 519 U.S. 213, 218 (1997).

When a federal court makes this threshold decision of whether to apply federal or state law, that "choice-of-law" decision is in itself a "federal" choice of law that must be made by the federal court. Just as a federal court has "jurisdiction to determine jurisdiction," it has the power to decide which substantive law it will apply—state or federal.

In Klaxon Co. v. Stentor Electric Manufacturing Co., 313 U.S. 487 (1941), the Supreme Court extended the rule of Erie v. Tompkins, applying state substantive law in diversity cases to the choice-of-law rules of the forum state. In Klaxon, the Supreme Court held that since the choice-of-law rules of the forum state (that is, the choice of law as to which state's law should apply, not whether state or federal law applies) were part of the substantive law of the forum state, the exact same federal choice-of-law principles of Erie v. Tompkins apply when deciding issues of substantive law, and therefore a federal court exercising its diversity jurisdiction should apply the choice-of-law rules of the state.

At first, it may appear that the rule of Klaxon should apply in bankruptcy cases where state law claims are at issue. After all, if a bankruptcy court opts to apply substantive state law, even if jurisdiction is based on bankruptcy law, then that state's choice-of-law rules should apply as well. However, because the source of power is bankruptcy jurisdiction rather than diversity jurisdiction, there is a potential for federal policies to conflict in bankruptcy cases that is not present in diversity jurisdiction. These policies were recognized in the only subsequent Supreme Court case discussing the choice-of-law issue.

Vanston Bondholders: Support for a Federal Choice-of-law Rule?

In Vanston Bondholders Protective Comm. v. Green, 329 U.S. 156 (1946), the Supreme Court was confronted with a claim by one creditor against a debtor for "interest on unpaid interest." 329 U.S. at 159. The debtor's other creditors argued that the instrument allowing for interest upon interest was invalid under the laws of the states with a connection to the transaction and also under federal law. Thus, in order to determine the validity of the instrument, it was necessary for the Court to first decide whether state or federal law would determine the validity of the instrument. The Court determined that federal law governed because it would violate the policy of the Bankruptcy Act to allow interest on interest. Thus, the Court did not have to make a choice of state laws to decide the claim before it.

Although the Supreme Court did not reach the question of whether Klaxon applied, the Court's discussion of the issue has been cited as support for a federal choice-of-law rule. The Court observed in dicta that commercial obligations of the sort that arise in the bankruptcy court context often have multi-state aspects that would be more aptly addressed by a flexible federal choice-of-law rule. As Justice Black, delivering the majority opinion, explained:

[O]bligations...often have significant contacts in many states, so that the question of which particular state's law should measure the obligation seldom lends itself to simple solution. In determining which contact is the most significant in a particular transaction, courts can seldom find a complete solution in mechanical formulae of the conflicts of law. Determination requires the exercise of an informed judgment in the balancing of all the interests of the states with the most significant contacts in order best to accommodate the equities among the parties to the policies of those states. 329 U.S. at 161-162.

The Court went on to distinguish bankruptcy jurisdiction from diversity jurisdiction for choice-of-law purposes. In addition to the statements set forth above, Justice Black noted, at least in the area of allowance and determination of claims, that bankruptcy courts must consider factors such as bankruptcy law and equitable principles that extend far beyond the mere consideration of state law claims. As Justice Black stated:

In determining what claims are allowable and how a debtor's assets shall be distributed, a bankruptcy court does not apply the law of the state where it sits. Erie R.R. v. Tompkins...has no such implication. That case decided that a federal district court acquiring jurisdiction because of diversity of citizenship should adjudicate controversies as if it were only another state court... But bankruptcy courts must administer and enforce the Bankruptcy Act as interpreted by this Court in accordance with authority granted by Congress to determine how and what claims shall be allowed under equitable principles. 329 U.S. at 162-63.

Thus, the Court twice distinguished the diversity approach to conflicts of law from the approach that should prevail in bankruptcy cases; courts should first look at federal law, and if federal law is not dispositive, then the courts should look to the law of the state with the most significant relationship to the case.

While the statements in Vanston were simply dicta and the facts related to a core area of bankruptcy law, allowance and determination of claims, which arguably presents a relatively strong case for uniformity, Vanston is clear authority for restricting Klaxon to nonbankruptcy contexts. Not surprisingly, subsequent courts rejecting Klaxon have cited Vanston as a strong indication that the Supreme Court would not apply Klaxon. Conversely, every court following Klaxon has had to distinguish Vanston.

Cases Choosing Federal Choice-of-law Rules

In the wake of Vanston, several courts have opted for a federal choice-of-law rule. Some courts have expressly relied upon Vanston, others have not. The vast majority of the reported decisions choosing the federal choice of law are in the Ninth Circuit.

Ninth Circuit Follows a Federal Choice Rule: Lindsay

The Ninth Circuit has proven to be the most ardent supporter of a federal choice-of-law rule. Ironically, the leading case, Lindsay v. Beneficial Reinsurance Co. (In re Lindsay), 59 F.3d 942, 948 (9th Cir. 1995), does not mention or even cite Vanston. In Lindsay, plaintiffs brought suit in bankruptcy to have a foreclosure sale set aside as a fraudulent conveyance. The bankruptcy court found for the plaintiffs, and its ruling was affirmed by the district court. On appeal, the Ninth Circuit reversed as a matter of law due to an intervening Supreme Court case holding that if a defendant complied with real property foreclosure procedures, the foreclosure could not as a matter of law be a fraudulent conveyance. See BFP v. Resolution Trust Corp., 511 U.S. 531 (1994). Since the defendant in BFP had in fact complied with the applicable state law, the court reversed the judgment of the district court as to the fraudulent-conveyance issue and affirmed on the matters involving summary judgment.

On appeal, in order to decide whether under BFP the defendant had complied with applicable state law, the Ninth Circuit first had to determine which state's law should govern the foreclosure. If the rule of Klaxon were applied, the conflicts rules of the forum state, California, would apply. If the federal choice-of-law of rule applied, then the law of the state with the most significant contacts would apply.

Applying the federal choice-of-law rule, the Ninth Circuit found that Texas law applied because the real estate foreclosed upon was situated in Texas. This was not a difficult decision for the court, given its finding that the security of land title in Texas was a matter that was the proper subject of Texas law. Since the bankruptcy court found that the foreclosure sale complied with Texas law, the Ninth Circuit ruled that the foreclosure should be upheld.

In holding that a federal choice-of-law rule should apply, the Ninth Circuit stated, without any real discussion, that in federal-question cases with exclusive federal jurisdiction such as bankruptcy, federal choice-of-law rules should apply. In support of its holding, the court cited to several prior Ninth Circuit cases reaching the same conclusion, such as In re Holiday Airlines Corp., 620 F.2d 731, 733-35 (9th Cir. 1980), In re Cochise College Park Inc., 703 F.2d 1339, 1348 n.4 (9th Cir. 1983), and Chuidian v. Phillippine Nat'l. Bank, 976 F.2d 561 (9th Cir. 1992). Presumably, the court was influenced by the fact that there was no state court jurisdiction, and therefore there could be no forum shopping. The Ninth Circuit also noted that in cases of exclusive federal jurisdiction, the risk of forum shopping between federal and state court, which is avoided by applying state law, has no application because the case can only be litigated in federal court. Therefore, the value of national uniformity of approach under federal choice-of-law rules need not be subordinated to differences in state choice-of-law rules.

More recently, in Liberty Tool & Manufacturing v. Vortex Fishing Systems Inc. (In re Vortex Fishing Systems Inc.), 277 F.3d 1057 (9th Cir. 2002), putative bankruptcy creditors filed an involuntary bankruptcy petition against the debtor. The bankruptcy court dismissed the petition based on findings that the creditors were not bona fide creditors and that the debtor was generally paying its debts as they came due. The Bankruptcy Appellate Panel for the Ninth Circuit affirmed.

On appeal, the creditors contended that their debts, plus debts of third parties, were sufficient bona fide debts to support the petition. The creditors argued that Montana law was applicable to their claims and, under Montana law, their claims were not barred by the statute of limitations. The debtor argued, among other things, that Texas law applied to the agreements between the parties and, under Texas law, the creditors' claims clearly were barred by the applicable statute of limitations.

In reviewing this issue, the Ninth Circuit first noted without discussion that under Lindsay federal choice-of-law rules were the appropriate state-of-choice law rules, and therefore the Restatement Second of Choice of Law should apply. The Ninth Circuit then determined that there was a bona fide dispute as to which state law—that of Montana, Texas or other states—should apply, and for this reason and others, the lower courts were correct in determining that the creditors' claims themselves were subject to bona fide dispute. Thus, the Ninth Circuit is clearly on the side of federal choice-of-law rule.

SMEC: The Policy of the Federal Choice-of-law Rule Articulated

Although the Ninth Circuit has decided the largest number of cases in support of the federal choice-of-law rule, it has not presented the most persuasive argument for that rule.2 The most extensive discussion of Vanston and articulation of the policies in favor of federal choice of law is found in Limor v. Weinstein & Sutton (In re SMEC), 160 B.R. 86, 89-91 (M.D. Tenn. 1993), a district court decision in the circuit in which Vanston originated.

In SMEC, Datascope Corp., a large manufacturer of medical devices, one of which was an intra-aortic balloon catheter (IAB), filed a patent infringement suit in a federal district court in New Jersey against Schiff Medical Equipment Co. Inc. (SMEC), a Tennessee corporation that manufactured and sold medical devices related to the treatment of cardiac disorders. After almost nine years of litigation in August 1990, Datascope ultimately obtained a judgment against SMEC for approximately $4.6 million.

In December 1990, SMEC filed for bankruptcy in the Middle District of Tennessee, and the case was converted from chapter 11 to chapter 7 in February 1991. In August 1992, the trustee in bankruptcy filed an action for legal malpractice alleging $6 million in damages against Weinstein and Sutton, SMEC's former New Jersey patent counsel. The reference was withdrawn from the bankruptcy court, and the adversary proceeding went forward in the district court.

Defendants moved for summary judgment, asserting that Tennessee law should be applied and under that law the complaint was time-barred. The trustee denied these assertions, and the district court was required to decide first which choice of law it should apply, sitting by virtue of its bankruptcy jurisdiction. After deciding which choice of law should control, the district court was then required to apply the chosen malpractice law to decide whether the claim was time-barred. The issue was of critical importance in that if New Jersey law, as opposed to Tennessee law, were applied, the action would not be time-barred.

After noting that the issue was an open question on which courts were divided, the district court held that a federal choice of law was appropriate and summarized the factors favoring a federal choice-of-law rule.

The court first cited to the dicta of Vanston, discussed at length above, favoring the federal choice-of-law rule. Several courts have taken these statements as a strong indication of how the court would rule on the conflicts question if confronted with it. See In re Kaiser Steel Corp., 87 B.R. 154, 158 (Bankr. D. Colo. 1988). In other words, the first argument is that Vanston is a strong enough indication of the Supreme Court's views on federal choice of law that it should be followed.

The court then observed that the rationale of Vanston requires a rule of the most significant contacts, not a mechanical rule, as the most appropriate test for dealing with the complexities of the modern commercial world. As Judge Wiseman stated:

[T]he logic of Vanston is compelling. In a diversity case, it is presumed that the forum state has the greatest interest in seeing its laws applied. In a federal bankruptcy case incorporating state law, this presumption is untenable. There is no necessary reason to believe that the forum state is the state with the greatest interest in a bankruptcy proceeding. In fact, in today's business world, the location of a debtor may bear little relation to the location of his or her property interests or to the corpus of his or her business dealings. A choice-of-law rule that looks to the state with the greatest interests in the proceeding acknowledges the complex nature of property and transactions and thereby protects state interests. Oftentimes the forum state will be the state with the greatest interests, but there is no need for such a presumption. 160 B.R. at 90.

Next, the court noted that a federal rule discourages forum shopping and prevents the unfairness of applying a rule whose only connection is that it is chosen by virtue of the debtor's choice of the forum in which to file bankruptcy. Thus, the federal rule avoids the possible unfair application of a state's law to a nondebtor who had little relationship with that state.

This rule also helps prevent forum shopping by debtors. Rather than allow debtors in the shadow of bankruptcy to restructure or relocate their business dealings in such a way as to gain the benefit of a certain forum's laws, this rule imposes on debtors the laws under which they primarily acted. Likewise, creditors and other parties are not subjected to, or given the benefit of, an unjustified quirk of legal procedure that imposes on them laws under which they rarely or never transacted. Id. at 90-91.

In this context, the SMEC court is referring to forum shopping by the debtor as to different states' laws, not forum shopping between federal and state court, which was the original concern of Erie v. Tompkins.

Finally, the court acknowledged the benefits of the Klaxon rule but concluded that these benefits were outweighed by the advantages of the flexibility of a federal rule:

It is true that a bright-line rule, such as the forum state rule, has its benefits, most notably its ease of application. But these benefits are bought at the cost of particularity. The special circumstances of a case that may argue against application of the forum state's laws are not given consideration. Preserving particularity, and protecting states' interests and fairness thereby, is ample justification for imposing on courts the possibly more difficult choice of law that may accompany the most significant contacts test.

In sum, the choice-of-law test that this district court sitting in bankruptcy will apply is the most significant contacts test. Were the Sixth Circuit to address this issue today, it would most likely endorse this test. The Supreme Court's Vanston opinion and the test's logic argue strongly for its adoption. Id. at 91.

Applying the federal rule, the Supreme Court had to determine which state had the most significant contacts with the case. The Court noted that since the defendants were located in New Jersey and most of the actions leading to the claim occurred in New Jersey, New Jersey had a strong interest in regulating the conduct of legal business occurring within its borders. Moreover, while SMEC was incorporated in Tennessee and the bankruptcy was filed there, little of the defendant's legal activity occurred there, so Tennessee had little interest in applying its malpractice law. In addition, the Court noted that it was questionable whether a Tennessee state court could have exercised personal jurisdiction over the defendants had SMEC filed a malpractice action before going bankrupt.

Since New Jersey law applied, the action was not time-barred, and because the plaintiff had presented sufficient evidence to proceed with its case, the defendant's motion for summary judgment was denied.

To summarize, the cases that have followed the federal choice-of-law rules have done so for three reasons: First, the Supreme Court decision in the Vanston case supports the federal rule; second, a flexible rule requiring the law of the state with the most significant contacts to be applied is fairer and better policy than a mechanical rule applying the law of the state where the bankruptcy is filed; and third, the federal rule discourages state-vs.-state forum shopping by a debtor (or that forum shopping is irrelevant to the extent that the issues may only be litigated in federal court, not state court) and avoids the application of a state's law to a nondebtor who had little relationship with that state.

The second part of this article will explore the cases that apply Klaxon and argue that the federal rule articulated in Vanston is preferable to application of the choice-of-law rules of the forum state under Klaxon.


Footnotes

1 Mr. Glassman is a member of the California and District of Columbia bars and a shareholder of Greenberg Traurig LLP in Los Angeles. The author expresses appreciation for the valuable assistance of Adam Starr and Eve Triffo of Greenberg Traurig LLP in preparing this article. Return to article

2 This is attributable in large part to the glaring absence of any citation to Vanston in the Ninth Circuit cases. Return to article

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Thursday, September 1, 2005

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