In its recently-issued opinion Central Virginia Comm. College v. Katz, 126 S.Ct. 990 (2006), the U.S. Supreme Court revisited the issue of sovereign immunity and the Bankruptcy Code, and held that an action to avoid and recover preferential transfers from a state agency pursuant to Code §§547 and 550 was not barred by the doctrine of sovereign immunity. If read broadly, Katz suggests that the sovereign-immunity defense may be significantly curtailed in bankruptcy proceedings. However, the dissent in Katz calls into question the historical underpinnings and justification of the majority's opinion. Left unclear is whether the Court will expand its ruling in Katz and the extent to which the Court's holding will apply to other issues arising in bankruptcy proceedings involving governmental units. This article will (1) briefly describe the state of Supreme Court jurisprudence on the sovereign immunity defense in bankruptcy cases prior to the Katz decision, (2) discuss the Court's opinion in Katz and (3) address certain issues that are likely to arise in the wake of the Court's ruling in Katz.

Background

Article I §8 of the U.S. Constitution provides that Congress shall have the power to establish "uniform laws on the subject of bankruptcies throughout the United States." U.S. Const. Art. I, §8, cl. 4 (the "Bankruptcy Clause"). The Constitutional basis for this assertion of the sovereign-immunity defense is found in the Eleventh Amendment to the Constitution, which provides that "[t]he judicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by citizens of another state, or by citizens or subjects of any foreign state." U.S. Const. Amend XI. Pursuant to its authority to establish federal bankruptcy laws, Congress has attempted to abrogate the sovereign-immunity defense in §106(a) of the Code, which provides that "sovereign immunity is abrogated as to a governmental unit to the extent set forth in this section...." 11 U.S.C. §106(a).²

Prior to the Katz ruling, the Supreme Court had offered limited guidance concerning the scope of the sovereign-immunity defense in bankruptcy proceedings. In the context of another Article I power conferred on Congress, the Court addressed sovereign immunity in Seminole Tribe of Florida v. Florida, 517 U.S. 44 (1996), in which the Court held that the Constitution's Indian Commerce Clause, U.S. Const. Art. I, §8, cl. 3, did not empower Congress to abrogate the state's sovereign immunity from a suit involving Indian casino gambling despite the clear congressional intent to do so in the Indian Gaming Regulatory Act, 25 U.S.C. §2710, et seq. Seminole Tribe, 517 U.S. at 47. The Seminole Tribe opinion sets forth the standards by which the courts will adjudicate a sovereign-immunity defense and any attempted congressional abrogation thereof. In Seminole Tribe, the Court started with the proposition that under the Eleventh Amendment to the Constitution, a state is sovereign and is not susceptible to private suit absent the state's consent. Id. at 54. However, without a state's consent to private suit, Congress may abrogate the sovereign-immunity defense in certain limited circumstances (Id. at 59), provided that two tests are satisfied. First, Congress must express "in a clear legislative statement" a specific intention to abrogate sovereign immunity. Id. at 55. Second, provided the clear statement of intent by Congress is present, the abrogation of sovereign immunity must be "passed pursuant to a constitutional provision granting Congress the power to abrogate" sovereign immunity. Id. at 59. As noted in Seminole Tribe, the Court has held that the Constitution does not bestow such authority often or broadly. Only in the context of the Fourteenth Amendment has the Court found the requisite constitutional authority for Congress to abrogate states' sovereign immunity. Id.

The Supreme Court also dealt with the sovereign-immunity issue in the bankruptcy context in Tennessee Student Assistance Corp. v. Hood, 541 U.S. 440 (2004). In Hood, the Court held that a discharge proceeding was not a "private civil suit" against a state for Eleventh Amendment purposes, and therefore, the state's sovereign-immunity defense was not implicated. Although the Court declined to address the question of whether Congress' attempted abrogation of sovereign immunity in §106 was authorized, the Hood case stands for the proposition that the Eleventh Amendment does not bar courts from exercising in rem jurisdiction against a state or an agency of a state. Id. at 445. Said another way, a court's jurisdiction is focused and premised on the debtor and the debtor's estate, or a particular res, rather than on an estate's creditors. Id. at 447. As such, with respect to most issues, a court exercises in rem, as opposed to in personam, jurisdiction. In Hood, the Court held that a ruling in a discharge proceeding will bind a state agency and does not infringe upon a state's sovereignty because a debtor does not seek monetary damages or affirmative relief from the state. Id. Because a discharge proceeding does not constitute a "private civil suit," a state's Eleventh Amendment rights are not implicated, and the state cannot claim sovereign immunity from the effect of a discharge order. Id. Prior to the Supreme Court's Katz decision, the circuit courts were in conflict with respect to whether or not the Eleventh Amendment barred preference actions from being prosecuted against states or their instrumentalities.³

In Katz, a chapter 11 trustee brought an adversary proceeding to avoid and recover preferential transfers under Code §§547 and 550 against a Virginia community college that is considered an arm of the state entitled to sovereign immunity.⁴ Katz, 126 S.Ct. at 994. The college moved to dismiss the preference action on sovereign-immunity grounds, but the court denied its motion. Id. at 995. The district court and Sixth Circuit affirmed the bankruptcy court's decision on the grounds that Congress had abrogated the state's sovereign immunity in bankruptcy proceedings pursuant to Code §106. Id. The Supreme Court, in a five-to-four decision, held that states do not enjoy immunity from preference proceedings, but not for the same reason as the lower courts; the Supreme Court did not address the issue of whether Congress had validly abrogated immunity from suit by enacting §106. Id. Rather, the Court held that it need not reach the issue of Congressional abrogation because the states had effectively waived their sovereign-immunity defense by ratifying the Constitution containing the Bankruptcy Clause. Id. Building on the in rem theme it relied upon in Hood, the Court held that the intent of the Framers of the Constitution in including the Bankruptcy Clause, together with the history behind such clause, evidenced that the Bankruptcy Clause provision was intended to constitute a waiver by the states of the sovereign-immunity defense in connection with bankruptcy proceedings that are ancillary to the Court's in rem bankruptcy jurisdiction. Id. at 1005.

In reaching its holding, the five-justice majority in Katz relied heavily on the historical context in which the Bankruptcy Clause was included in the Constitution. To the majority in Katz, the inclusion of the Bankruptcy Clause "reflects the states' acquiescence in a grant of congressional power to subordinate to the pressing goal of harmonizing bankruptcy law sovereign-immunity defenses that might have been asserted in bankruptcy proceedings." Id. at 997. After engaging in a discussion of the primary purpose for early bankruptcy laws, the Katz Court found that compelling the states to honor another state court's discharge orders was the primary motivation behind the Bankruptcy Clause and the Bankruptcy Act of 1800. To the majority, "the Framers, in adopting the Bankruptcy Clause, plainly intended to give Congress the power to redress the rampant injustice resulting from states' refusal to respect one another's discharge orders." Id. at 1004.

From this historic artifact, the Court fashioned a limited waiver by the states of sovereign immunity in bankruptcy proceedings. Id. The Court held that the "history of the Bankruptcy Clause, the reasons it was inserted in the Constitution, and the legislation both proposed and enacted under its auspices immediately following ratification of the Constitution demonstrate that it was intended not just as a grant of legislative authority to Congress, but also to authorize limited subordination of state sovereign immunity in the bankruptcy arena." Id. The Court in Katz, therefore, concluded that since the Bankruptcy Clause was intended to make the bankruptcy laws uniform, the Bankruptcy Clause subordinated the states' sovereign immunity rights in bankruptcy, and the states acquiesced in that result by ratifying the Constitution. Id.

The scope of the Court's ruling is best set out in footnote nine of the opinion, which in pertinent part reads as follows:

That does not mean, however, that the state sovereign-immunity implications of the Bankruptcy Clause necessarily mirror those of the Commerce Clause. Indeed, the Bankruptcy Clause's unique history, combined with the singular nature of bankruptcy courts' jurisdiction, discussed infra, have persuaded us that the ratification of the Bankruptcy Clause does represent a surrender by the states of their sovereign immunity in certain federal proceedings. That conclusion is implicit in our holding in Tennessee Student Assistance Corporation v. Hood, 541 U.S. 440, 124 S.Ct. 1905, 158 L.Ed.2d 764 (2004).

Building on this "singular jurisdiction" theme, the Court recognized that its previous holding in Hood had turned on the distinction between in rem and in personam jurisdiction. In Hood, the Court had held that the bankruptcy court's jurisdiction focused on the res of the debtor's estate, and therefore, a debtor's action in bankruptcy seeking to discharge debts owed to a state did not constitute a "private civil suit" that would impact states' sovereign immunity. Hood, 541 U.S. at 447.

In Katz, however, the Court was faced with an action against a state agency seeking to avoid and recover monies transferred to the agency. Katz, 126 S.Ct. at 990. Without saying so, the Court places a tremendous amount of emphasis on the fact that the plaintiff in Katz had not asked for a money judgment. This is an important distinction because a preference action could easily be characterized as a "private civil suit" against the state, rather than a purely in rem proceeding. Katz, 126 S.Ct. at 1001. The Court recognized this distinction and stated that "the trustee, in order to marshal the entirety of the debtor's estate, will need to recover the subject of the transfer... A court order mandating turnover of the property, although ancillary to and in furtherance of the court's in rem jurisdiction, might itself involve in personam process." Id. at 1001 (emphasis added).

In so doing, the majority in Katz retreated somewhat from the in rem/in personam distinction and held that in ratifying the Bankruptcy Clause, the states waived their sovereign immunity with respect to matters ancillary to the bankruptcy court's in rem jurisdiction (i.e., preference actions). Id. "Whatever the appropriate appellation, those who crafted the Bankruptcy Clause would have understood it to give Congress the power to authorize courts to avoid preferential transfers and to recover the transferred property... Insofar as orders ancillary to the bankruptcy courts' in rem jurisdiction, like orders directing turnover of preferential transfers, implicate states' sovereign immunity from suit, the states agreed in the plan of the Convention not to assert that immunity." Id. at 1001-1002. Here, the Court seems to be using the word ancillary in the sense of "in aid of" or "in furtherance of."

It is perhaps no coincidence that Katz was decided by a bare majority of the court. It is particularly interesting to note that the decision was announced on the day Justice O'Connor retired from the Court. The dissent in Katz was joined by four of the Justices and called into question the majority's interpretation of the historical underpinnings of the Bankruptcy Clause. Specifically, the dissenting opinion states that the history of the ratification of the Bankruptcy Clause "merely established federal power to legislate in the area of bankruptcy law and did not manifest an additional intention to waive the states' sovereign immunity against suit." Id. at 1006. Seeing no meaningful distinction between the different powers granted in Article I of the Constitution, the dissenting opinion states that nothing in the text of the Bankruptcy Clause indicates a desire by the states to have waived their sovereign immunity to suits in the bankruptcy context. Id. at 1007. The dissenting Justices referenced Seminole Tribe in support of their conclusion that "the Eleventh Amendment restricts the judicial power under Article III, and Article I cannot be used to circumvent the constitutional limitations placed on federal jurisdiction." Katz, 126 S.Ct. at 1007 (quoting Seminole Tribe, 517 U.S. at 72-73). In addition, the dissenting opinion relied on the fact that none of the other clauses in Article I had been found to express an intention to subrogate sovereign immunity, and that there was nothing special about the Bankruptcy Clause that supports a finding of waiver of immunity. Katz, 126 S.Ct. at 1007. The dissent went on to critique the majority's reasoning with respect to the historical context of the Bankruptcy Clause.

First, the dissenting Justices held that the Framers' desire for national uniformity does not, by itself, evidence an intention by the states to waive sovereign immunity from suit. Id. at 1008. The dissent noted that although uniformity was also a motivation behind other provisions in Article I pertaining to interstate commerce and patent protection, the Court had not found a similar waiver of states' sovereign immunity. Id. Second, the dissent criticized the majority's holding that the Framers urgently desired a national bankruptcy scheme, noting that "states were free to act in bankruptcy matters for all but 16 years of the first 109 years after the Constitution was ratified...[a]nd when Congress did act, it did so only in response to a major financial disaster, and it repealed the legislation in each instance shortly thereafter." Id. at 1009. Third, the dissent held that the majority placed far too much emphasis on Congress' early provision for habeas corpus relief in bankruptcy and the pre-ratification practice whereby state courts often failed to honor other courts' discharge orders. Id. at 1010. The dissent held that "none of these observations comes close to demonstrating that under the Bankruptcy Clause, the states may be sued by private parties for monetary relief." Id. As for the fact that habeas corpus relief was made available under the first Bankruptcy Act of 1800, the dissent noted, "[t]he availability of habeas relief in bankruptcy...does not support the respondent's effort to obtain monetary relief in bankruptcy against state agencies today. The habeas writ was well established by the time of the Framing, and consistent with then-prevailing notions of sovereignty." Id. at 1011. As for the historical argument based on the states' prior refusal to recognize other states' discharge orders, the dissent held that this historical concern was adequately addressed by the Full Faith and Credit Clause of the Constitution, without the need to infringe upon the states' sovereign immunity. Id. at 1012.

The Katz decision is clearly correct. Bankruptcy is different from interstate commerce or patents. A bankruptcy law that cannot affect the rights and claims of states and their instrumentalities would be neither uniform, effective or fair. However, the dissent's opinion in Katz raises significant doubts that the Bankruptcy Clause was intended by the Framers to constitute a waiver by the states of their sovereign immunity in connection with bankruptcy proceedings. Furthermore, the majority opinion leaves much room for debate regarding whether, under Katz, the states will be deemed to have waived the sovereign-immunity defense in other bankruptcy-related proceedings not involving a preference or some similar matter "ancillary" to the Court's in rem jurisdiction. Katz, 126 S.Ct. at 1005, n. 15 ("[w]e do not mean to suggest that every law labeled a 'bankruptcy' law could, consistent with the Bankruptcy Clause, properly impinge upon state sovereign immunity"). With this caveat, the precise holding of Katz—that states have waived sovereign immunity with respect to their involvement "in proceedings necessary to effectuate the in rem jurisdiction of the bankruptcy courts" (Id. at 1005)—leaves unresolved the issue of which types of bankruptcy proceedings the sovereign-immunity defense will be unavailable.⁵

It is likely that much future litigation will revolve around the meaning of the ambiguous phrase "proceedings necessary to effectuate the in rem jurisdiction of the bankruptcy courts." Furthermore, the Court reached its decision with only a bare majority, which majority included Justice O'Connor, who has since retired and has been replaced by Justice Alito. Pundits and scholarly observers predict that Justice Alito will favor states' rights more rigorously than his predecessor. Thus, it is possible, perhaps even likely, that the Katz case may be limited in its application when this issue is next considered by the Court.

In the modern bankruptcy arena, governmental units including states almost always have at least some interest in bankruptcy proceedings. They are not only recipients of transfers avoidable under chapter 5 of the Code, they may be taxing authorities or have regulatory interests in the bankruptcy estate, among other interests. Thus, as a practical matter, the waiver of sovereign immunity of the type provided in Katz may go a long way in facilitating the public policy of a nationally uniform system of bankruptcy laws. See Katz, 126 S.Ct. at 1002. Absent a waiver or abrogation of states' sovereign immunity in the bankruptcy context, the discharge and fresh-start aspirations of the Code, as well as the turnover of property to the estate, could go unfulfilled. However, bankruptcy proceedings often involve issues other than discharge and turnover of estate property. For instance, courts have exercised 'related to' jurisdiction over non-bankruptcy causes of action and issues. See 28 U.S.C. §1334(b). As such, it is easy to envision a situation where the bankruptcy process could be misused to divest a state of its sovereign immunity from proceedings having little to do with bankruptcy law. These competing considerations, as well as other issues, remain unresolved by the holding in Katz. Thus, although the Katz decision squarely addresses the issue of sovereign immunity in preference proceedings, that opinion by no means disposes of the question of the availability of a sovereign immunity defense in other types of bankruptcy proceedings.

 

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Footnotes

1 Mr. Stratton gratefully acknowledges the assistance of James C. Carignan in the preparation of this article. Mr. Carignan is an associate in the bankruptcy and restructuring group in the Wilmington, Del., office of Pepper Hamilton.

2 Bankruptcy Code §106(a) purports to abrogate sovereign immunity with respect to, among others, proceedings involving "§§105, 106, 107, 108, 303, 346, 362, 363, 364, 365, 366, 502, 503, 505, 506, 510, 522, 523, 524, 525, 542, 543, 544, 545, 546, 547, 548, 549, 550, 551, 552, 553, 722, 724, 726, 728, 744, 749, 764, 901, 922, 926, 928, 929, 944, 1107, 1141, 1142, 1143, 1146, 1201, 1203, 1205, 1206, 1227, 1231, 1301, 1303, 1305 and 1327...." 11 U.S.C. §106(a)(1).

3 See, e.g., Richardson v. Mt. Adams Furniture (In re Greene), 980 F.2d 590, 598 (9th Cir. 1992) (holding that the bankruptcy court's jurisdiction over property of the estate and to hear adversary proceedings did not defeat Indian tribe's immunity from suit by chapter 7 trustee to recover preferential transfers); Schlossberg v. Maryland Comptroller of the Treasury (In re Create Goldsmiths of Washington, D.C. Inc.), 119 F.3d 1140, 1146 (4th Cir. 1997) (holding that Code provision purporting to abrogate states' sovereign immunity was unconstitutional, and as such, the state of Maryland had sovereign immunity from preference action); Hoffman v. Connecticut Dept. of Income Maintenance (In re Willington Convalescent Home Inc.), 850 F.2d 50, 54 (2d Cir. 1988) (holding that turnover actions and preference actions were outside the scope of Code's waiver of sovereign immunity and therefore were barred by the Eleventh Amendment); but, see Lee v. Schweiker, 739 F.2d 870, 873 (3d Cir. 1984) (holding that bankruptcy court's rejection of Social Security Administration's sovereign-immunity defense to suit for recovery of overpayments was "undoubtedly correct").

4 Apparently, the plaintiff did not seek a money judgment against defendant, a fact that assumes surprising significance in the Katz decision.

5 Given the extensive and explicit waiver found in §106(a), a broad construction of "ancillary" could lead to the conclusion that the defense has little or no life left in bankruptcy proceedings. As discussed, infra, this result is far from certain.