Bankruptcy cases often involve more than just liquidating the debtor’s assets or restructuring its debts. Often, a debtor will initiate litigation in the bankruptcy court to avoid and recover certain payments or other transfers made before the case began.
While bankruptcy courts are specialized courts, meaning that bankruptcy judges generally are considered best suited to decide bankruptcy-related claims, they may not have authority to fully resolve every claim.
Under the Constitution, bankruptcy courts have limited authority to finally decide certain types of claims—some of which, such as fraudulent transfer claims, often arise in bankruptcy.
U.S. Supreme Court precedent and a recent decision from Delaware have increased litigants’ confusion about where their fraudulent transfer cases belong.
Fraudulent Transfer Basics
Creditors can sometimes pursue fraudulent transfer claims under state law even before a bankruptcy filing, but these claims arise more often in bankruptcy cases. The prototypical fraudulent transfer claim arises when the debtor deliberately gives property away to keep it out of creditors’ reach.
However, the actual scope of fraudulent transfer liability is much broader. For example, fraudulent transfer claims can be based on questionable business transactions that the debtor participated in while already in financial distress.
Thus, a company’s pre-bankruptcy transactions are often closely scrutinized to determine whether they give rise to fraudulent transfer claims.
Bankruptcy Courts vs. Federal District Courts
Debtors or their representatives often bring fraudulent transfer claims in bankruptcy courts, as opposed to federal district courts. Bankruptcy courts are not necessarily disadvantageous for defendants. Some handle cases at a faster pace than district courts, and many bankruptcy judges are highly capable and experienced with litigation. Even if a legal error occurs, parties have the right to appeal final decisions to a federal district court and then to a court of appeals.
A defendant’s preferred forum may also hinge on whether it will seek a jury trial. Only in rare circumstances can bankruptcy courts hold jury trials. Thus, if the defendant has a right to a jury trial—and if the case actually goes to trial—a federal district court, not a bankruptcy court, will likely try it.
Under established Supreme Court precedent, a fraudulent transfer defendant waives the right to a jury trial by filing a proof of claim against the debtor’s estate. If the defendant has not filed a proof of claim, however, it has a constitutional right to a jury trial.
Defendants may have other reasons to favor federal district courts over bankruptcy courts as well. Perhaps most importantly, they may be concerned about conceding a “home turf advantage” to the debtor; whether or not it is true, bankruptcy judges are sometimes perceived as being debtor-friendly. Defendants in especially large or complex fraudulent transfer cases may also favor district courts, which may have more experience handling complex commercial litigation.
Limits on Bankruptcy Courts’ Authority
Because of the differences between bankruptcy courts and district courts, parties often disagree about who should preside over their case. Further complicating matters, the Supreme Court has limited the authority of bankruptcy judges, beginning with Stern v. Marshall in 2012, to enter final judgments in some cases.
In reaching this conclusion, the Supreme Court relied heavily on its prior case law relating to jury trial rights for fraudulent transfer defendants—strongly suggesting that, absent the parties’ consent, a bankruptcy court cannot enter a final judgment on a fraudulent transfer claim unless the defendant previously filed a proof of claim.
Most lower courts, including the Ninth Circuit, have taken exactly that position. But they have not been unanimous. Recently, in Paragon Offshore, a bankruptcy judge in Delaware—one of the nation’s most prolific and influential bankruptcy courts—reached the opposite conclusion.
According to Paragon Offshore, the right to a jury trial and the scope of a bankruptcy court’s constitutional authority to enter a final judgment are distinct issues, and the Supreme Court has never actually held that bankruptcy courts cannot finally adjudicate all fraudulent transfer claims.
The result of Paragon Offshore is perplexing, but it is not completely unique, in Delaware or elsewhere. At least two other Delaware bankruptcy judges agree with its reasoning. Needless to say, these opinions have the potential to muddy the waters for many litigants faced with fraudulent transfer claims in bankruptcy courts, both in Delaware and in other jurisdictions.
It is unclear how this confusion will be resolved. The Supreme Court is unlikely to weigh in and clarify its own precedent unless and until there is a split of opinion among federal appellate courts. If upheld on appeal, Paragon Offshore could lead to such a circuit split, but that process would likely take multiple years. In the meantime, litigants will have to grapple with this issue on a case-by-case, judge-by-judge basis.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Melanie Gray, a partner in Winston & Strawn’s Houston office, chairs the firm’s Bankruptcy Litigation practice where she focuses on complex bankruptcy cases.
Katy Preston, an associate in Winston & Strawn’s Houston office, focuses on complex commercial and bankruptcy litigation.