Choice of State Law in Bankruptcy Cases Part II

Choice of State Law in Bankruptcy Cases Part II

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Editor's Note: Part I appeared in the September 2005 issue.

Part I of this article discussed the application of a federal choice-of-law rule in bankruptcy cases where jurisdiction over state law claims is based on bankruptcy law and not state law. It discussed the flexible federal choice-of-law rule of Vanston Bondholders Protective Comm. v. Green, 329 U.S. 156, 67 S.Ct. 237 (1946), and the cases that have chosen to follow that rule. This part will discuss the cases that follow Klaxon Co. v. Stentor Electric Manufacturing Co., 313 U.S. 487, 61 S.Ct.1020 (1941), and apply the state choice-of-law rules where state law claims are at issue.

Despite the dicta in Vanston, the eloquent articulation by Judge Wiseman in SMEC and the sheer number of Ninth Circuit decisions in favor of federal choice of law, not all courts have chosen to follow the federal choice-of-law rules. Two circuit courts—the Fourth and the Second—have chosen to follow the rule of Klaxon. In this regard, they have endeavored to distinguish Vanston and rejected the logic of SMEC and the Ninth Circuit cases. These courts have seized upon Klaxon and its deference to state law, the power of the simplicity of the rule and the benefits of avoiding forum shopping between the state and federal courts of the forum state.

Merritt Dredging: The Fourth Circuit Rejects the Federal Rule

The first circuit to follow Klaxon v. Stentor was the Fourth Circuit, which applied the choice-of-law rules of the forum state in In re Merritt Dredging, 839 F.2d 203, 205-206 (4th Cir. 1988). In Merritt, Merritt Dredging Co., a South Carolina company, entered into an agreement with Compliance Marine Inc., a Louisiana corporation, for the use of a barge at a project in Mississippi. The agreement was prepared by Compliance, mailed to Merritt in South Carolina, changed by Merritt, executed by Merritt, mailed by Merritt to Compliance in Louisiana and executed by Compliance as modified. The barge was then delivered by Compliance to Merritt in Louisiana.

Under the agreement, Merritt hired the barge for $2,500 per month for three months with an option to renew at the same rate on a month-by-month basis. The agreement also contained an option to purchase for $30,000 with all of the "rent" paid to be applied toward the purchase price. Merritt made the payments for three months, exercised its renewal option and made payments for an additional five months. After failing to make payments for the next five months, Merritt filed bankruptcy in South Carolina under chapter 11. The case was converted to chapter 7, and the barge was sold for $20,000 with Compliance's lien, if any, to attach to the proceeds of sale. After the sale, Compliance sought payment of its claim from the proceeds of sale, and Merritt's trustee in bankruptcy objected.

The trustee argued that Merritt's interest in the barge was governed by South Carolina law, which treated Compliance's interest in the barge as that of a secured creditor that had not properly perfected its security interest and was therefore subordinate to the trustee. Compliance asserted that Louisiana law applied and rendered Compliance's interest in the barge under the agreement a true ownership interest that was therefore not property of the estate. The bankruptcy court ruled for the trustee, and the district court affirmed. Compliance appealed to the Fourth Circuit, which affirmed the ruling of the bankruptcy court and district court, holding that the choice-of-law rule of the forum state, South Carolina, was the proper law.

The court articulated the rationale for applying the choice-of-law rules of the forum state: enhancing predictability, deference to state law and avoidance of forum shopping and the potential for inconsistent results in a state and federal court of the forum:

We believe, however, that in the absence of a compelling federal interest which dictates otherwise, the Klaxon rule should prevail where a federal bankruptcy court seeks to determine the extent of a debtor's property interest. The argument for applying the Klaxon rule to state law questions arising in bankruptcy cases is compelling. A uniform rule under which federal bankruptcy courts apply their forum states' choice-of-law principles will enhance predictability in an area where predictability is critical. Most important, such a rule would accord with the model established by Erie and Klaxon. Both those cases make clear that federal law may not be applied to questions which arise in federal court but whose determination is not a matter of federal law... Such is the case with questions regarding the extent of a bankruptcy debtor's property interests. "Property interests are created and defined by state law. Unless some federal interest requires a different result, there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding" [citation omitted]... It would be anomalous to have the same property interest governed by the laws of one state in federal diversity proceedings and by the laws of another state where a federal court is sitting in bankruptcy. Because no overwhelming federal policy requires us to formulate a choice-of-law rule as a matter of independent federal judgment, we adopt the choice-of-law rule of the forum state, South Carolina.
839 F.2d at 206.

Applying South Carolina conflict-of-law rules, the court held that under the South Carolina adaptation of Uniform Commercial Code §1105, since the agreement did not specify which state's law should apply, the law of the state that bears an "appropriate relation" to the transaction should apply. The state with an "appropriate relation" is the one that has "the most significant relationship to the matter at issue and thereby most effectively facilitates commercial transactions." 839 F.2d at 206. After looking at the South Carolina contacts with the transaction at issue, the court concluded that South Carolina law, rather than Louisiana law, must control.

Ironically, although the Fourth Circuit was adamant that the Klaxon rule was the proper rule in all cases, it might have come to the same conclusion had it applied the federal choice-of-law rule, which also would have looked to the state with the most significant relationship to the transaction.

Gaston & Snow: The Second Circuit Joins the Fourth Circuit and Rejects the Federal Rule

The most cogent articulation of the rationale for following Klaxon and probably the foremost case so holding is the Second Circuit case of Bianco v. Erkins (In re Gaston & Snow), 243 F.3d 599 (2nd Cir. 2001). Gaston & Snow was a prominent law firm based in Boston, but it had offices in other locations, including New York. An involuntary chapter 11 petition was filed in New York against the firm in 1991. After a reorganization plan was confirmed, in 1993 the plan administrator filed an adversary proceeding against an Idaho couple, Robert and Bernadine Erkins, who were former clients of the firm. The suit was to recover $1.7 million for the breach of an oral contract for payment of legal services provided by the firm in connection with state court litigation in Idaho that was handled by litigators out of the firm's Boston office. The defendants counterclaimed against the firm and moved to transfer the proceedings to Idaho federal district court.

The resolution of the choice-of-law issue about which law applied to the action was crucial to the viability of the plan administrator's suit. The bankruptcy court denied the defendants' motion to transfer the proceedings to Idaho. The court later transferred the proceedings to federal district court in the Southern District of New York for a jury trial. The defendants argued that Idaho law should apply, which would mean that the trustee's suit would be barred under Idaho's four-year statute of limitations for an oral breach-of-contract claim. The plan administrator argued that New York law applied, and therefore the suit was validly brought within the six-year New York limitations period. The district judge agreed with the plan administrator and ruled that New York, not Idaho, law applied. Therefore, the suit could go forward.

The district judge applied New York choice-of-law rules as if he were hearing the case as a New York state court judge, without considering whether a bankruptcy court should apply the federal choice-of-law rules instead of the choice-of-law rules of the forum state. Under the New York state choice-of-law rules, the district judge applied New York law because the plaintiff was a New York resident. The district court rejected the defendants' argument that it was unconstitutional to apply New York's statute of limitations to them because they had no connection to New York.

The jury found in favor of the plan administrator on the oral breach-of-contract claim and awarded approximately $1.8 million. The parties agreed that Idaho law governed the award of pre-judgment interest, and the district court awarded an additional approximate $2.114 million.

The Second Circuit recognized that the choice-of-law rule was critical to the disposition of the case, since under the federal choice-of-law rule Idaho was the state with the most significant relationship to the case, and the statute of limitations would have run. On the other hand, under the forum state choice-of-law rule, New York law would apply under the New York borrowing statute2 and the New York statute of limitations would not have run.

After first noting the split of authority on the question of whether the federal or forum choice-of-law applies, the Second Circuit began its analysis by citing to Erie v. Tompkins and noting that a federal court may only displace state law with federal common law if a significant conflict between some federal policy or interest and the use of state law can be shown. See 243 F.3d at 606. The Gaston & Snow court found that no such federal policy or interest would be violated if the choice-of-law rules of the forum state were utilized in the case.

The Gaston & Snow court noted the Ninth Circuit's suggestion discussed above that there is a federal interest in national uniformity in bankruptcy cases regardless of where a bankruptcy court sits, which could not be subordinated to the differences in state choice-of-law rules. The court acknowledged that this concern existed in this case if New York law were applied to the defendants, but the court also noted the concern expressed in SMEC that application of the choice-of-law rules of the forum state could promote forum shopping by debtors.

Although the court was cognizant of the concerns expressed by these courts, it rejected them:

We recognize the concerns expressed by these courts, but do not believe they implicate significant enough federal interests to justify the creation of federal common law in this case. While an interest in uniformity can justify the creation of federal common law...Klaxon rejected the need for uniformity as a justification for displacing state conflicts rules... Regarding the federal interest in avoiding forum shopping, we believe there are only a limited number of cases in which this interest is implicated. Here, for example, where the debtor was brought into bankruptcy court through an involuntary petition, it is difficult to argue that any forum shopping occurred. Id.

The court then quoted the Fourth Circuit's discussion in Merritt Dredging that forum law must be applied under Klaxon and that such a rule would promote predictability. The Gaston court observed that the facts before it were slightly different than Merritt Dredging, since a diversity action could not have been brought against the defendants in New York because they are not subject to personal jurisdiction in New York, so the anomaly the Fourth Circuit sought to avoid of having a different result in diversity versus bankruptcy jurisdiction was not present.

After noting that it found the Fourth Circuit's analysis in Merritt Dredging persuasive, the Second Circuit emphasized that its holding was limited to cases where there was no federal interest at stake, warranting the application of a federal conflicts rule. The Second Circuit distinguished the Vanston case in which the Supreme Court held that allowing interest on interest would violate the Bankruptcy Act and that federal law governed. The Second Circuit rejected the contention that the broad statements in Vanston suggested that bankruptcy courts should not adopt the choice-of-law rules of the forum state:

Vanston contains some broad statements that may be read to suggest that bankruptcy courts should not adopt the choice-of-law rules of the forum state... We do not view these statements as requiring a federal rule in this case. Rather, Vanston made clear that application of a federal rule is not foreclosed by Erie where there is a significant federal interest. Vanston does not mandate that, where there is no such significant federal interest, the federal courts must nonetheless apply federal conflicts rules. To read Vanston in this way would create a conflict between Vanston and the Supreme Court's pronouncements on the creation of federal common law. Id. at 607.

The Second Circuit concluded that the district court was correct in determining that New York's choice-of-law rules applied. The court then went on to apply these rules. New York's borrowing statute mandated that the New York statute of limitations be applied to a cause of action that accrues in favor of a New York resident, in this case the trustee. The Second Circuit also rejected the defendants' argument that it was unconstitutional to apply the New York statute of limitations to them because they did not have sufficient contacts with New York, given that the defendants conceded that the New York bankruptcy courts had jurisdiction over them.

In summary, the court applied Klaxon for the following reasons: first, a perception that the constitutional imperative requires that the forum state's law, including choice-of-law rules, must be applied absent a compelling federal interest;3 second, that such a rule is both simple and promotes predictability; and third, a perception that the rule would discourage state vs. federal forum shopping to the extent that there is a choice of forum by the plaintiff.

Conclusion and Summary

There is a clear conflict among the circuits regarding the proper choice-of-law rule to be applied in bankruptcy cases involving state law claims of the estate. There are cases involving state law claims and the avoiding powers that apply a federal choice-of-law rule (e.g., SMEC), but there are also cases that apply the law of the forum state in which the bankruptcy court is located (e.g., Merritt Dredging and Gaston & Snow).

It does not appear that the cases are ultimately reconcilable. Both Merritt Dredging and Gaston & Snow raise questions regarding possible limitations based on their facts. Gaston & Snow suggests in dicta that forum law should apply where there is no risk of bankruptcy filing forum shopping because the bankruptcy case was filed as an involuntary one. In dicta, Merritt Dredging explains that forum law should be applied when state law property interests are at issue. However, these distinctions are neither compelling nor consistent with the reasoning or outcomes of the other cases.

The Gaston & Snow and Merritt Dredging cases provide legitimate justifications for the application of Klaxon. The application of the forum state's choice-of-law rules simplifies the choice-of-law analysis for the court and for the parties at the inception of a bankruptcy case, thus enhancing predictability. In addition, these cases follow the precedent established by Erie and Klaxon that state law, including choice-of-law rules, must be applied absent compelling federal interest. Moreover, these cases dismiss the dicta in Vanston on the ground that national uniformity is not a significant enough federal interest to trump the application of state law.

However, the weakness of the Klaxon rule is its propensity for anomalous results as in Gaston & Snow, where New York law was applied to Idaho residents who never transacted business in New York. While the Klaxon rule enhances predictability for the courts, defendants such as those in Gaston & Snow have no method of predicting which law ultimately will govern their disputes. Furthermore, the arguments in SMEC appear persuasive. First, the Vanston dicta strongly supports a federal rule for choice-of-law. Second, the federal rule's flexible approach avoids unfair doctrines that might result from the application of a mechanical rule, thus preserving the federal interest of uniformity. Third, the federal rule prevents forum shopping by the debtor in many cases and, more importantly, averts the unfair application of the law of a state to a nondebtor having little relationship with that state.

Finally, Erie does not require application of the forum state choice-of-law rules in bankruptcy. Where jurisdiction is based on bankruptcy, the policies of bankruptcy law should determine the choice of state law, not the choice-of-law of the forum state, as occurs when jurisdiction is based on diversity. A federal rule for choice-of-law in bankruptcy court would not only reflect the reality of the modern commercial world where transactions typically involve transactions by debtors with multistate locations that span the nation, but might also set a precedent for the increasingly global nature of the transactions that bankruptcy courts are required to address.


Footnotes

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

2 Under "borrowing statute," the forum state may choose whether the forum state's statute of limitation will apply, or whether another forum's statute will be "borrowed." See, e.g., Combs v. International Ins. Co., 354 F.3d 568, 605 (6th Cir. 2004); Alexander v. Beech Aircraft, 952 F.2d 1215, 1218 (10th Cir. 1991); Miller v. Prudential Bache Securities Inc., 884 F. 2d 128, 130 (4th Cir. 1989). Return to article

3 The Second Circuit rejected the notion that the federal interest in national uniformity, as discussed in Lindsey, was a sufficiently compelling federal interest to justify the application of a federal choice-of-law rule. Id. at 606. Return to article

Journal Date: 
Saturday, October 1, 2005