In Millennium Lab Holdings, Delaware District Court Judge Leonard Stark, on an appeal from a bankruptcy court order confirming a plan of reorganization, recently upheld a challenge to the bankruptcy court’s constitutional authority to release claims against non-debtor third parties under the plan.  Judge Stark’s opinion demonstrates the extent to which the constitutional questions raised by the Supreme Court six years ago in Stern v. Marshall continue to cast a shadow over the adjudication of bankruptcy cases.

In Stern, the Supreme Court raised separation of powers concerns regarding the authority of United States bankruptcy courts that had long been viewed as settled.  Congress established the U.S. bankruptcy courts pursuant to its power to establish uniform laws on bankruptcy under Article I of the Constitution, rather than under Article III.  A line of Supreme Court cases has limited the power of Congress to create courts pursuant to Article I, rather than under Article III, to territorial courts, military tribunals, and courts created to hear cases involving “public” rights (e.g., cases involving claims of citizens against the government).  Although claims of citizens against one another typically are “private” rights that must be heard by an Article III judge, the common understanding regarding bankruptcy courts is that matters pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” (emphasis added) constitute a type of “public” right which can be heard and decided by an Article I bankruptcy judge.

Prior to Stern, the statute passed by Congress in 1984 conferring jurisdiction on Article I bankruptcy courts was viewed as having established the appropriate constitutional limits of such courts.  Section 157 of title 28 of the United States Code provides that bankruptcy courts can issue final orders with respect to a variety of enumerated “core” matters, but that with respect to “non-core” matters, a bankruptcy court can only submit proposed findings of fact and conclusions of law, and that a final order on such matters must be entered by an Article III district court following a full, or “de novo,” review.  Although the Court never ruled on the constitutionality of the “core” and “non-core” bankruptcy jurisdictional construct, in other cases involving Article I tribunals the Court took an expansive and pragmatic view of the “public” rights doctrine, one that had appeared to be sufficiently broad to encompass the list of “core” bankruptcy matters set forth in the statute.

In Stern, however, the Court adopted a more constricted view of “public” rights.  It held that a matter listed as “core” under the statute, a debtor’s counterclaim against a creditor, nevertheless constituted a “private” right if it was not related to the creditor’s claim against the bankruptcy estate.  The Court ruled that it was therefore unconstitutional for Congress, by designating such counterclaims as “core” matters, to authorize a non-Article III court to render a final determination on them.

Stern, by making clear that bankruptcy court rulings regarding “core” matters could be subject to constitutional challenge, has created continuing uncertainty regarding the extent to which bankruptcy courts can issue final rulings.  The problem engendered by the ruling in Stern is this: the Court described the query for constitutional purposes as “whether the action at issue stems from the bankruptcy itself [i.e., Congress’s bankruptcy power under Article I].”  If the matter would exist under state law “without regard to any bankruptcy proceeding,” then it is a “private right” upon which an Article I bankruptcy judge cannot make a final ruling. Stern’s conundrum is that although the list of matters under 28 U.S.C. Section 157, such as ruling on claims against the bankruptcy estate or on the turnover of property to the estate, go to the “core” of “restructuring debtor-creditor relations,” the Supreme Court has expressly stated in other cases that parties’ rights in bankruptcy, such as for breach of contract or regarding title to property, are based on state law.  State law issues accordingly are intertwined with most “core” matters.  For purposes of ascertaining a bankruptcy court’s constitutional authority, which aspect of such adjudications should control?

Two follow-up Supreme Court cases and numerous lower court opinions have failed to clarify the questions raised by Stern regarding the constitutional limits of bankruptcy court authority. Millennium Lab Holdings is the latest case to demonstrate the extent to which the ambiguity of Stern remains unresolved.

The facts of Millennium Lab Holdings are complicated, but the issues faced by Judge Stark on appeal were fairly straight-forward.  Among them was whether the plan of reorganization could release the debtor’s insiders from claims of third parties absent such parties’ consent.  The debtor’s equity holders had been accused of orchestrating fraudulent activity in connection with the debtor’s Medicare and Medicaid reimbursement requests, and were named by certain of the debtor’s lenders as defendants in an action brought outside of the bankruptcy court.  Under the plan, the equity holders were to pay $325 million in exchange for a release of all claims held either by the debtor’s estate or directly by third parties such as the lenders.

The question of whether a bankruptcy court has statutory authority and subject matter jurisdiction to enjoin and release claims non-consensually against non-debtors has long been unclear, and some courts have ruled that bankruptcy courts have no power at all to resolve disputes between non-debtor parties.  Other courts, however, relying on the general equitable power provided under section 105 of the Bankruptcy Code, and the jurisdictional authority to hear proceedings “related to” a debtor’s case, have granted such releases.  Judge Laurie Silverstein, the bankruptcy judge in Millennium Lab Holdings, determined that non-consensual third party releases could be approved if necessary in connection with the confirmation of a plan of reorganization and where basic standards of fairness were satisfied.

The lenders argued on appeal that, regardless of whether the bankruptcy court had statutory and jurisdictional power, under Stern the releases were tantamount to resolving a “private” rights dispute between two non-debtor parties, and that the bankruptcy court therefore lacked constitutional authority to enter a final order resolving it.  Judge Stark agreed that constitutional authority had to be shown.  He rejected the debtor’s response that the releases could resolved by the bankruptcy court because they were a key component of the confirmation of the debtor’s plan of reorganization, which in turn could be viewed as a “public” right.  “Appellants appear to be entitled to Article III adjudication of these claims, and Stern dictates that no final order could be entered on such claims by an Article I court barring consent of the parties (which has not been provided here).”  He concluded, however, that the issue had not been properly presented or considered by the bankruptcy court, and remanded the case to Judge Silverstein so that she could make the determination in the first instance.

Judge Stark’s opinion in Millennium Lab Holdings highlights the ongoing uncertainty created by Stern.  “Core” matters invariably implicate “private” rights of parties under state law.  The Supreme Court at some point will need to address directly how Article I bankruptcy courts can fit within the scope of the “public” rights doctrine.  Until the Court resolves this ambiguity, which may require a strict limitation or even overturning of Stern, challenges to bankruptcy courts’ constitutional authority will continue.