Preference Action Against State Agencies Is Not Barred by Sovereign Immunity

(March 2006, Bankruptcy Bulletin)

Michelle V. Larson

The Eleventh Amendment of the United States Constitution immunizes the states, and accordingly state agencies, which are deemed “arms of the State,” from the “indignity” of suits initiated by individual citizens. The Bank­ruptcy Clause found in Article I of the Constitution empowers Congress to establish “uniform Laws on the subject of Bankruptcies throughout the United States.” In Central Virginia Community College v. Katz, the United States Supreme Court addressed the interplay between these provisions. The court declined as it had before to answer the broader constitutional question of whether the Bankruptcy Code’s purported abrogation of the states’ sovereign immunity contained in section 106 of the Bankruptcy Code is constitutional, ruling instead that an adversary proceeding brought by a chapter 11 trustee to recover alleged preferential transfers that a debtor made to state agencies was not barred by the states’ sovereign immunity because the Bankruptcy Clause gives Congress the right to subordinate to the goal of formulating a uniform bankruptcy law the sovereign immunity defenses that might otherwise have been asserted in bankruptcy proceedings.

Sections 547(b) and 550(a) of the Bankruptcy Code

Section 547(b) of the Bankruptcy Code permits a debtor in possession or trustee to avoid (i.e., annul) and recover any transfer of an interest of the debtor in property made by the debtor to a creditor on account of pre-existing debt while the debtor was insolvent if the transfer occurred within 90 days before the filing of the debtor’s bankruptcy petition (one year for insiders) and allows the creditor to receive more than it would have received in a hypothetical chapter 7 liquidation. This avoiding power prevents a debtor from preferring one creditor over another by transferring money or property in which other creditors are also entitled to share while the debtor is insolvent and approaching bankruptcy. Section 550(a) of the Bankruptcy Code gives the trustee or debtor in possession the authority to recover the subject of a preferential transfer for the benefit of the estate.

Background

Prior to filing bankruptcy, Wallace’s Bookstores, Inc. (“Wallace’s”) did business with certain Virginia universities that are considered “arms of the State” and therefore typically entitled to sovereign immunity against suit by private citizens. Bernard Katz (“Katz”), the court-appointed liquidating trustee of Wallace’s, filed suit in the bank­ruptcy court pursuant to sections 547(b) and 550(a) of the Bankruptcy Code to avoid and recover alleged preferential transfers made to each of the universities by Wallace’s.

The universities moved to dismiss the avoidance proceedings on the basis of sovereign immunity. The bank­ruptcy court denied the motions to dismiss. The denial was affirmed by the district court and by the United States Court of Appeals for the Sixth Circuit on the author­ity of the Sixth Circuit’s prior deter­mination in Hood v. Tennessee Student Assistance Corporation that Congress had abrogated the states’ sovereign immu­nity in bankruptcy proceedings.

The Supreme Court’s Prior Decisions in Seminole Tribe and Hood

In 1996, the Supreme Court, in Semi­nole Tribe of Fla. v. Florida, addressed the question of valid abrogation of state sovereign immunity. The Seminole Tribe decision involved the Indian Gaming Regulatory Act passed by Congress (pursuant to the Indian commerce clause), which allowed an Indian tribe to sue a state in federal court to compel a state to negotiate with the tribe toward the formation of a gaming compact. The Supreme Court held that an Article I power, Congress’s power to regulate commerce with Indian tribes, could not be used to circumvent the Eleventh Amendment, unless it could be demonstrated that there was “a surrender of this immunity in the plan of the [Constitutional] convention.”

Following the Supreme Court’s deci­sion in Seminole Tribe, a majority of circuit courts, including the Third, Fourth, Fifth, Seventh, and Ninth Circuit Courts of Appeal, unanimously held that the enactment of section 106(a) of the Bank­ruptcy Code, which abrogates a state’s sovereign immunity under various Bankruptcy Code sections pursuant to the Bankruptcy Clause was a violation of the Eleventh Amendment. The Sixth Circuit rejected this conclusion in Hood and created a split amongst the circuits, reasoning that when the Framers of the Constitution granted Congress exclusive jurisdiction to make uniform laws on bankruptcy, they necessarily subordinated state sovereign immunity in the bankruptcy arena.

The Supreme Court granted certiorari in Hood to resolve the lingering sovereign immunity dispute. The majority’s opinion in Hood, however, declined to rule on the constitutionality of section 106(a) of the Bank­ruptcy Code, holding instead that sovereign immunity was not actually implicated.

At issue in Hood was the dischargeability of student loan debt based upon “undue hardship.” The Supreme Court held that, although an “undue hardship” determination is commenced by an adver­sary proceeding (as opposed to a simple motion), an “undue hardship” determination does not equate to a “suit” for Eleventh Amendment purposes. Rather, an adversary proceeding to establish undue hardship more closely resembles a simple motion. Because it is well-settled that states can be served with a motion in a bankruptcy case and ordinarily states are bound by discharge orders, the Supreme Court concluded that the bankruptcy court’s in rem jurisdiction (i.e., a proceeding against the debtor’s property and not an affirmative suit against a person) allowed the bankruptcy court to adjudicate the dischargeability of the student loan without offending the states’ sovereign immunity.

The Supreme Court’s Decision in Katz

The majority in Katz acknowledged that statements in both the majority and dissenting opinions in Seminole Tribe reflect an assumption that the holding in Seminole Tribe would apply to the Bank­ruptcy Clause and, therefore, the Eleventh Amendment would bar any preferential transfer action against a state. Nevertheless, the majority concluded that “[c]areful study and reflection” convinced them that that assumption was erroneous. Moreover, the majority added that it was not bound to follow its own dicta from a prior case (Seminole Tribe) in which the point now at issue was not fully debated.

Rather, the Supreme Court began its analysis by noting as it had in Hood that bankruptcy jurisdiction, at its core, is in rem, with the court’s jurisdiction coming not from the creditors, but from the debtor and its estate. Accordingly, the court concluded that in rem jurisdiction does not in the usual case invade a state’s sovereignty “even when states’ interests are affected.”

The court also examined the history of the adoption of the Bankruptcy Clause, the reasons it was inserted into the Constitution, and the legislation that was both proposed and enacted immediately following the ratification of the Constitution. The court discussed the history of discharges in bankruptcy proceedings, noting that the term “discharge” had a dual meaning; it referred both to the release of debts and the release of a debtor from prison. The majority found that the Framers, in adopting the Bankruptcy Clause, plainly intended to give Congress the power to address the rampant injustice resulting from states’ refusal to respect one another’s discharge orders, which left debtors at the mercy of non-uniform state laws authorizing imprisonment as a remedy for the non-payment of debt, notwithstanding the debtor’s discharge in bankruptcy obtained from a court in a different state. Accordingly, the court found that in ratifying the Bankruptcy Clause, the states acquiesced (on a limited basis) to the subordination of whatever sovereign immunity they might have otherwise asserted in proceedings necessary to effect the in remjurisdiction of the bankruptcy courts. The court concluded that orders directing the turnover of preferential transfers are ancillary to the bankruptcy court’s in rem jurisdiction, and as such, although they may implicate states’ sovereign immunity from suit, the states agreed in the plan of the Constitutional Convention to subordinate that immunity in the context of the Bankruptcy Clause. The court concluded that the enactment of section 106 of the Bank­ruptcy Code was not necessary to authorize the bank­ruptcy court’s juris­diction over the preference proceedings at issue in the case. The court cautioned, however, that it was not sug­gesting “that every law labeled a ‘bank­ruptcy’ law could, consistent with the Bankruptcy Clause, properly impinge upon state sovereign immunity.”

The Supreme Court noted that its decision in Katz does not speak to the question of whether Congress has abro­gated states’ sovereign immunity in proceedings to recover preferential transfers. Rather, the Katz decision is responsive to whether Congress’s determination that states be amenable to such proceedings is within the scope of its power to enact “Laws on the subject of Bankruptcies.” The majority concluded that it clearly is.

The Dissent

Justices Thomas, Scalia and Kennedy and Chief Justice Roberts dissented. The dissent indicated that under the Constitution, states are not subject to suit by private parties for monetary relief absent the states’ consent or valid congressional abrogation. The dissent noted that it is settled jurisprudence that nothing in Article I of the Constitution, includ­ing the Bankruptcy Clause, establishes these pre-conditions.

With respect to the majority’s historical analysis of the Framer’s intent, the dissent believed that the majority’s opinion confuses two distinct attributes of sovereignty: (1) the authority of a sovereign to enact legislation regulating its own citizens and (2) sovereign immunity against suit by private citizens. According to the dissent, history confirms that the adoption of the Constitution merely established federal power to legislate in the area of bankruptcy law and did not manifest an intention to waive the states’ sovereign immunity against suit. The dissent pointed out that abrogation of sovereign immunity in suit is not necessary to the enactment of nationally uniform bankruptcy laws.

Additionally, the dissent took issue with the majority’s historical analysis, which suggested that the Framers contemplated that the states would subject themselves to private suits, pointing out that the first permanent national bank­ruptcy law was not passed until over a century after the adoption of the Bank­ruptcy Clause. Likewise, the dissent questioned the majority’s interpretation of the Framers’ concern over discharge orders, stating the same implicates nothing more than the application of “full faith and credit” as opposed to states’ sovereign immunity.

Lastly, the dissent concluded that it is impossible for the majority to reach the conclusions that it did without overruling established sovereign immunity jurisprudence, including Seminole Tribe. The dissent concluded that “[n]othing in the text, structure or history of the Constitution indicates that the Bankruptcy Clause, in contrast to all other provisions of Article I, manifests the States’ consent to be sued by private citizens.”

Conclusion

The Katz decision is an important one because it is the second consecutive opinion in a line of Supreme Court decisions contemplating the interplay between state sovereign immunity and bankruptcy. While the Supreme Court again declined to answer the broader constitutional question of whether the enactment of section 106 of the Bank­ruptcy Code is constitutional, the court hinted that in certain circumstances involv­ing the court’s in rem juris­diction, states agreed not to raise any sovereign immunity defenses they might otherwise have. After Katz, circuit courts likely will continue to be divided over the issue of sovereign immunity, making it likely that the question of the constitutionality of the abrogation of sovereign immunity may again reach the Supreme Court in the future.

Central Virginia Cmty. Coll. v. Katz, 126 S.Ct. 990, 2006 WL 151985 (2006).

Tennessee Student Assistance Corp. v. Hood, 541 U.S. 440, 124 S. Ct. 1905 (2004).

Seminole Tribe of Fla. v. Florida, 517 U.S. 44, 116 S. Ct. 1114 (1996).