Supreme Court Preview Of Bankruptcy Cases In October 2003 Term

Monday, March 1, 2004 - 01:00

The United States Supreme Court has granted certiorari for six bankruptcy cases during the term that began on October 6, 2003. In contrast, the Court reviewed a total of only three bankruptcy cases during the preceding two terms. The Court's decision in several of the bankruptcy cases on this year's calendar will have a significant impact on bankruptcy practice. Moreover, the Court's decision in Hood v. Tennessee Student Assistance Corporation (In re Hood), 319 F.3d 755 (6th Cir. 2003), cert. granted, 124 S. Ct. 45 (2003), will have a profound impact not only on bankruptcy law, but also on Constitutional law and the balance of power between the states and the federal government. Following is a brief description of each of the bankruptcy cases the Court has agreed to hear during its current term, starting with the two cases in which the Court issued decisions in January of this year.

Time Limit For Objections To Discharge Is Not Jurisdictional

In Kontrick v. Ryan, 124 S. Ct. 906 (2004), the Supreme Court held that the time limit for objecting to a debtor's discharge is not jurisdictional. Therefore, a debtor forfeits the right to assert that an objection to discharge was untimely if he fails to raise the issue before the bankruptcy court renders a decision on the merits of the objection.

Under chapter 7 of the Bankruptcy Code, all of a debtor's property, except assets exempt by statute, is liquidated to satisfy the debtor's debts to the extent possible. The goal is to afford the debtor a "fresh start" by granting a discharge of all remaining unpaid debts. However, section 727(a) of the Bankruptcy Code provides that a debtor will be denied a discharge under certain specified circumstances. Bankruptcy Rule 4004(a) provides that, in a chapter 7 case, a complaint objecting to the debtor's discharge under section 727(a) must be filed no later than 60 days after the first date set for the meeting of creditors. In Kontrick, a creditor who had filed a timely complaint objecting to the debtor's discharge filed an amended complaint after the 60-day deadline. The debtor responded to the amended complaint without objecting to its untimeliness. After the bankruptcy court ruled on the merits and denied the debtor's discharge, the debtor argued that the bankruptcy court lacked jurisdiction over the creditor's amended objection because the amended complaint was untimely filed. The lower courts ruled against the debtor, and the case eventually went to the Supreme Court to resolve a split among the circuits.

Explaining the distinction between subject-matter jurisdiction rules and claims-processing rules, the Supreme Court stated that time bars are affirmative defenses under claims-processing rules and generally are forfeited if they are not raised in an answer or other responsive pleading. While lack of subject-matter jurisdiction is preserved so that it can be raised at any time, even on appeal, affirmative defenses are forfeited if not raised before a decision is rendered. Accordingly, the Supreme Court concluded that no reasonable construction of Bankruptcy Rule 4004(a) would allow the debtor to succeed on his affirmative defense claim of untimeliness after he litigated and lost the discharge case on its merits. Bankruptcy Rule 4004(a) is not jurisdictional and, therefore, it is subject to equitable defenses such as waiver.

Compensation Of Chapter 7 Debtor's Attorneys

In Lamie v. United States Trustee, 124 S. Ct. 1023 (2004), the Supreme Court held that in a chapter 7 proceeding, section 330(a)(1) of the Bankruptcy Code does not authorize the payment of attorneys' fees unless the attorney was appointed by the chapter 7 trustee pursuant to Bankruptcy Code section 327. The ruling means that attorneys retained by a chapter 11 debtor in possession with bankruptcy court approval cannot be compensated for any services performed after the case is converted to chapter 7 unless the chapter 7 trustee appoints the attorneys in the chapter 7 proceedings.

The Court's decision in Lamie, based on what it found to be the plain meaning of the statute, resolves a split among the circuits regarding the meaning of Bankruptcy Code section 330(a) after the 1994 amendments to the Code.

Sovereign Immunity

Arguably the most important bankruptcy case that will come before the Court during the current term is Hood v. Tennessee Student Assistance Corporation (In re Hood). In Hood, the Sixth Circuit concluded that Congress's authority to make uniform laws on bankruptcy, granted in Article I of the U.S. Constitution, carries with it the power to abrogate the states' sovereign immunity. Accordingly, the Sixth Circuit held that Congress properly exercised its powers when it enacted section 106(a) of the Bankruptcy Code, which abrogates the sovereign immunity of a governmental unit with respect to the application of certain enumerated sections of the Bankruptcy Code that govern many core matters of bankruptcy administration and claim adjudication.

The five other circuit courts of appeals that have considered the constitutionality of section 106(a) have held that its enactment was a violation of the Eleventh Amendment to the Constitution, in light of the Supreme Court's decision in Seminole Tribe v. Florida, 517 U.S. 44, 116 S. Ct. 1114, 134 L. Ed. 2d 252 (1996). In Seminole, 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, which provides generally that the sovereignty of the states shall be immune from suits unless the states consent or there was a "surrender of this immunity in the plan of the [constitutional] convention."

Following the Supreme Court decisions in Seminole and subsequent cases, each of the Third, Fourth, Fifth, Seventh, and Ninth Circuit Courts of Appeals has held that under Seminole, Congress may not validly abrogate state sovereign immunity by relying on its Article I Bankruptcy Clause powers. Rejecting this conclusion, the Sixth Circuit created a split among the circuits, reasoning that when the Framers of the Constitution granted Congress exclusive jurisdiction to make uniform laws on bankruptcy, they necessarily ceded sovereignty to the federal government with respect to laws on bankruptcy, since the establishment of uniform laws is incompatible with state sovereignty in the same area.

Cramdown Interest Rate

The Court has agreed to review the Seventh Circuit's decision in a chapter 13 case, In re Till, 301 F.3d 583 (7th Cir. 2002), cert. granted sub nom. Till v. SCS Credit Corp., 123 S. Ct. 2572, 156 L. Ed. 2d 601 (2003), in which the Seventh Circuit clarified a previous decision that adopted the "forced loan" approach for determining the rate of interest that must be applied to confirm a "cramdown" plan over the objection of a secured creditor. Under chapter 11, 12, or 13 of the Bankruptcy Code, a court can confirm a debtor's proposed plan over the objection of a secured creditor if certain requirements are satisfied. Among other things, the plan must provide that the secured creditor will retain the lien securing its claim and that the value, as of the effective date of the plan, of the deferred payments to be distributed on account of the secured claim will be no less than the allowed amount of the claim.

To ensure that deferred payments under a plan will equal the present value of the creditor's claim, the stream of payments must include interest at a rate that will compensate the creditor for the delay in receiving the amount it would have received on the effective date of the plan if the claim had been paid in cash at that time. In other words, the plan must compensate the creditor for the "time value" of money. Courts have adopted various approaches to determine the proper rate of interest.

In Till, the Seventh Circuit elaborated on the approach it had previously endorsed in a chapter 12 case, stating that the interest rate should be the same rate the creditor would obtain if it made a new loan to a similarly situated debtor in the same industry (though not in bankruptcy). This approach has been called the "forced loan" or "coerced loan" approach. In Till, the Seventh Circuit elaborated on the means to establish that rate.

Given the frequency with which the cramdown rate of interest must be determined as well as the diverse approaches adopted by various courts, a Supreme Court decision on this issue could eliminate much litigation and promote a more uniform approach throughout the country.

Partners' Tax Liability

In United States v. Galletti (In re Galletti), 314 F.3d 336 (9th Cir. 2002), cert. granted, 123 S. Ct. 2606 (2003), the Internal Revenue Service ("IRS") sought to collect a partnership's unpaid employment taxes directly from the individual general partners, but the United States Court of Appeals for the Ninth Circuit held that the IRS could not collect the partnership's tax deficiency directly from the partners without first making assessments against the individual partners or obtaining judgments against them.

To collect tax deficiencies, within three years after the tax returns are due, the IRS must assess the taxpayer or file suit to collect the taxes. If taxes are assessed within the three-year period, the IRS has ten years from the assessment date to collect the taxes. In Galletti, the IRS had timely assessed the partnership; however, it had not assessed the general partners or brought suit against them.

When the general partners filed chapter 13 cases more than three years after the taxes were due, the IRS filed proofs of claim for the partnership's tax deficiency in the individual partners' chapter 13 cases. The Ninth Circuit affirmed the lower court rulings disallowing the IRS's proofs of claim as time-barred. In this case, the statutes of limitations had run, so it was too late for the IRS either to make assessments against the partners or to obtain a judgment against them. The IRS appealed the decision to the Supreme Court.

Enforceability Of SpendthriftClause Under ERISA

Hendon v. Yates (In re Yates) 287 F.3d 521 (6th Cir. 2002), cert. granted sub nom. Raymond B. Yates, M.D., P.C. Profit Sharing Plan v. Hendon, 123 S. Ct. 2637, 156 L. Ed. 2d 654 (2003) highlights a split among the circuits concerning whether a sole proprietor or sole shareholder of a business must be considered an employer, and not an employee, for purposes of ERISA. Although this issue arose in a bankruptcy case, and the Court's decision will determine a bankruptcy trustee's ability to recover funds as a voidable preference under the Bankruptcy Code, the legal question that will control the outcome is not a matter of bankruptcy law.

The Bankruptcy Code's avoiding powers enable a trustee to recover certain prebankruptcy transfers of the debtor's property for the benefit of the bankruptcy estate's creditors. Although the Bankruptcy Code's definition of property of the bankruptcy estate is broadly inclusive, section 541(c)(2) excludes "a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law."

In Yates, a chapter 7 trustee sought to recover as a preferential payment a loan repayment made by a debtor to his wholly-owned corporation's profit sharing/pension plan in which he was a participant. The Sixth Circuit had to determine the enforceability under applicable nonbankruptcy law of the profit sharing/pension plan's spendthrift clause, which prohibited voluntary or involuntary alienation of participants' beneficial interests. If the clause is "enforceable under applicable nonbankruptcy law," the spendthrift clause would be enforceable in bankruptcy and would shield the transfer from the trustee's reach.

Relying on Sixth Circuit precedent, a three-judge panel of the Sixth Circuit concluded that the spendthrift clause in the profit sharing/pension plan was not enforceable by the debtor because the Sixth Circuit has held that the sole shareholder of a business is an employer, not an employee. As an employer, such person lacks standing under ERISA's enforcement provisions. This conclusion, the appellants argued, is contrary to a plain reading of ERISA, the decisions of eight other circuits, and conflicts with advisory opinions of the Department of Labor.

Jacqueline B. Stuart is Counsel in the Business Finance and Restructuring Department in the New York City office of Weil, Gotshal & Manges LLP.

Please e-mail the author at jacqueline.stuart@weil.com with questions about this article.