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Seventh Circuit Reaffirms that a State Entity May Not Assert Sovereign Immunity Defense in a Bankruptcy Case

By: Melanie Lee

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

            At the Constitutional Convention, the States agreed not to assert any sovereign immunity defense “in proceedings pursuant to ‘Laws on the subject of Bankruptcies.’”[1]  The agreement was made to “prevent competing sovereigns’ interference with discharge[ing]…” debts. [2]  The Seventh Circuit, in In re Bulk Petroleum, held that Kentucky could not assert sovereign immunity as a defense to a debtor’s request to an excise tax refund.[3] There, Bulk Petroleum Corp., prior to filing its chapter 11 petition, had lost its license as a “gasoline and special fuels dealer” in the state of Kentucky.[4]  As a gasoline and special fuels supplier, the debtor, pre-petition, was entitled to a refund for the excess fuel taxes it paid.[5]  The loss of the license did not require the debtor to cease business in Kentucky or permit the debtor to ignore its tax obligations.[6]  However, according to the Kentucky Department of Revenue (“KDOR”), only a “taxpayer” within the meaning of the statute was entitled to a refund.[7]  The KDOR refused to refund the fuel taxes to the debtor because the debtor “was unlicensed” and therefore, not a ’taxpayer.’[8]  The Seventh Circuit disagreed and found that while the debtor was unlicensed, the debtor was still required to pay the fuel taxes to its upstream suppliers.[9]  The suppliers were authorized to add the fuel tax to the debtor’s invoices because of their capacity as “trust officer[s] of the state” under Kentucky Revised Statute 138.280.[10]  Because this statute required suppliers to collect, hold, and turn over the tax collected to Kentucky, the court held that the debtor had paid the fuel tax, via its suppliers, despite being unlicensed.[11]  Consequently, the debtor was entitled to any excess tax paid on the gasoline, which ended up being sold outside of Kentucky.[12]  Despite having not been raised by either party, the Seventh Circuit considered the possibility of Kentucky asserting sovereign immunity, under the Eleventh Amendment, as a defense to the state having to issue the refund.[13]  According to the Seventh Circuit, that defense would have failed because the States “agreed in the plan of the [Constitutional] Convention not to assert any sovereign immunity defense they might have had in proceedings brought pursuant to ‘Laws on the subject of Bankruptcies.’”[14]

            A fundamental tenet of bankruptcy law in the United States is that the jurisdiction is “principally in rem,” based on the debtor and their estate, which should not normally interfere with “state sovereignty even when States’ interests are affected.”[15]  As the Supreme Court discussed in Central Virginia Community College v Katz, the States’ limited waiver of their sovereign immunity, in bankruptcy, has its foundation in a long line of bankruptcy complications and proceedings spanning all the way back to before the adoption of the United States Constitution.[16]  These complications, “peculiar to the American experience,” evolved from the “uncoordinated actions of multiple sovereigns, each laying claim to the debtor’s body and effects according to different rules,” and led to the states’ agreement to waive any sovereign immunity they might have been able to assert in bankruptcy cases.[17]  Moreover, as the Supreme Court explained in Katz, Congress maintains the power through the Bankruptcy Clause to treat states as any other creditor in bankruptcy proceedings without “alter[ing] the’ background principle’ of state sovereign immunity.”[18]

            The In re Bulk Petroleum decision was of particular importance because the Seventh Circuit determined that Kentucky would not have had sovereign immunity in the case even if it had asserted such a defense.[19]  Kentucky’s failure to raise the defense suggested that the state knew such a defense would likely not be successful.[20]  Though the Seventh Circuit could have decided the case at hand without the Supreme Court’s ruling in Katz, in a preemptive strike, the court chose to adopt the principals laid out in Katz without the matter having even been addressed by the parties.[21]  This was in clear contrast to the Eleventh Circuit decision in National Association of Boards of Pharmacy v Board of Regents of the University System of Georgia where the Court declined to extend the Supreme Court’s Katz decision abrogating state sovereign immunity beyond bankruptcy cases.[22]  The Seventh Circuit did not touch on whether it would read the Katz decision as reaching beyond bankruptcy cases.[23]    

 



[1] Bulk Petroleum Corp. v. Kentucky Dep’t of Rev. (In re Bulk Petroleum), No. 13-1870, 2015 WL 4591743, at *12 (7th Cir. July 31, 2015).

[2] Central Va. Cmty. Coll. v. Katz, 126 U.S. 356, 357 (2006).

[3] See In re Bulk Petroleum, 2015 WL 4591743 at *1.

[i4] See id.

[5] See id. at *5.

[6] See id.

[7] See id. at *1.

[8] See id.

[9] See id. at *7.

[10] See id. at *9.

[11] See id. at *7.

[12] See id.

[13] See id. at *12.

[14] See id.  

[15] See Central Va. Cmty. Coll. v. Katz, 126 U.S. 356, 369–70 (2006).

[16] See id. at 366.

[17] See id. at 366, 377.

[18] See id. at 376 (holding that adversary proceeding brought by Chapter 11 trustee to negate alleged preferential transfers by debtor to state agencies was not barred by state agencies’ sovereign immunity).  The Katz Court applied these principles in affirming the Sixth [NTD: Seventh?] Circuit’s holding that a Virginia educational institution, as an “arm of the state,” was not entitled to sovereign immunity when a bookstore with which it had dealings, filed for relief under chapter 11, and then sought to recover from preferential transfers of funds it had made to the state prior to its insolvency.  See id. at 360.

[19] See Bulk Petroleum Corp. v. Kentucky Dep’t of Rev. (In re Bulk Petroleum), No. 13-1870, 2015 WL 4591743, at *12 (7th Cir. July 31, 2015).

[20] See id.

[21] See id.

[22] F.3d 1297, 1314 (11th Cir. Feb. 24, 2011).

[23] In re Bulk Petroleum, 2015 WL 4591743, at *12.