In its historic 2011 ruling, the U.S. Supreme Court held in Stern v. Marshall that U.S. bankruptcy courts, which were not created under Article III of the U.S. Constitution, lacked constitutional authority to enter a final judgment on a debtor's state law counterclaim against one of its creditors.1 While the Supreme Court's decision made clear that bankruptcy courts generally lack authority to enter final orders on "state law action[s] independent of the federal bankruptcy law and not necessarily resolvable by a ruling on the creditor's proof of claim in bankruptcy," the court did not address the question of whether litigants may confer such authority on a bankruptcy court, either through express consent or waiver.2

Recently, the U.S. Court of Appeals for the Seventh Circuit became the third U.S. Court of Appeals to address this issue.3 In Wellness International Network v. Sharif, the Seventh Circuit held that the constitutional objection raised by the appellant to the bankruptcy court's ability to enter a final judgment on a state law claim could not be waived, and therefore the objection should have been considered on appeal to the district court despite the fact that it was not raised in an otherwise timely manner. In so holding, the Seventh Circuit joined the U.S. Court of Appeals for the Sixth Circuit, which similarly found in October 2012 that a Stern objection to the bankruptcy court's constitutional authority is not waivable, and took issue with a December 2012 decision from the U.S. Court of Appeals for the Ninth Circuit that reached the opposite conclusion.4

The Seventh Circuit also provided guidance on a separate issue left open after Stern, namely, under what circumstances a district court may treat a bankruptcy court order as a "report and recommendation," which following a determination that a bankruptcy court lacked authority to enter a final order, may be adopted by the district court without additional discovery. The Seventh Circuit stressed that no statutory authority exists for bankruptcy courts to propose findings of facts and conclusions of law in core proceedings, and therefore it is impermissible for a district court to construe constitutionally prohibited orders on core matters entered by a bankruptcy court as a report and recommendation subject to the district court's adoption as a final order.

Factual Background

More than a decade ago, Richard Sharif entered into a distributorship contract with Wellness International Network, and certain other parties (collectively, WIN) for the sale of health and wellness products. The following year, Sharif and certain co-plaintiffs brought a lawsuit against WIN, alleging that WIN was running a pyramid scheme. In the proceeding litigation, Sharif—in what would prove to be a pattern of behavior—failed to comply with discovery requests, resulting in the court granting summary judgment in favor of WIN and ordering Sharif to pay roughly $655,000 in attorney fees.

On Feb. 24, 2009, after Sharif refused to comply with post-judgment discovery requests aimed at locating his assets, he was held in civil contempt, and arrested. He then filed for Chapter 7 bankruptcy protection in the U.S. Bankruptcy Court for the Northern District of Illinois. WIN, the only creditor to file a proof of claim in the bankruptcy case, initiated an adversary proceeding intended to prevent discharge of Sharif's debts because of fraud and destruction of evidence. The final count of the complaint also sought a declaratory judgment that a trust, which Sharif claimed he was the trustee for and not a beneficiary of, was Sharif's alter ego and thus the trust's assets belonged to the bankruptcy estate.

In light of Sharif's repeated failure to comply with discovery requests in the adversary proceeding, the bankruptcy court entered a default judgment in favor of WIN on all counts. Sharif appealed the decision to the district court and on Aug. 9, 2011, he filed his initial appellate brief, which did not raise any jurisdictional arguments or otherwise challenge the ability of the bankruptcy court to enter the default judgment resolving the complaint in its entirety.

However, on Dec. 12, 2011, Sharif's sister filed a motion to "withdraw the reference" in the district court, relying primarily on the Supreme Court's decision in Stern.5 Sharif thereafter filed a motion for supplemental briefing in light of Stern and the Seventh Circuit's even more recent decision in In re Ortiz, which was decided two weeks prior to the filing of Sharif's motion and followed Stern in finding that a bankruptcy court lacked constitutional authority to enter a final order resolving a state law claim.6

The district court denied both motions on the grounds that Sharif had waived any arguments based on Stern by failing to raise such arguments earlier in the proceeding, and further affirmed the Bankruptcy Court's decision on the merits. Sharif appealed the decision to the Seventh Circuit. Although he raised several arguments on appeal, the Seventh Circuit stated that the "purple elephant" of the case is "whether the bankruptcy court had authority to enter a final judgment, and, if not, whether that is an issue that may be waived."7

Waiver of Statutory Objection

After laying out the facts summarized above, the Seventh Circuit distinguished the question of whether the bankruptcy court had constitutional authority to enter a final judgment on WIN's adversary complaint from the question of whether it had statutory authority to do so. Under sections 157 and 158 of title 28 of the U.S. Code, Congress granted bankruptcy courts the ability to hear and enter final orders and judgments in "all cases under title 11" and "all core proceedings."8 Bankruptcy courts may also hear non-core proceedings, but absent consent of the parties, may only issue "proposed findings of fact and conclusions of law" to be entered by a district judge after de novo review of any matters for which a party has filed a timely objection.

In Wellness International, Sharif's supplemental pleading conceded that the first four counts of the complaint, which requested a determination that certain debts could not be discharged, were core matters, and challenged only the statutory authority of the bankruptcy court to enter a final judgment on its alter-ego claim, which it contended was non-core. However, the Seventh Circuit declined to review the merits of this objection because it was not raised in the bankruptcy court or initially on appeal to this district court, and held that "unlike the murky issue of waiver surrounding the bankruptcy court's constitutional authority, it is clear that a party can waive an argument concerning the core/noncore status of a claim under §157."9 While this finding, and the related assumption that the appellant's alter-ego claim should be treated as a core matter, may seem of limited importance in light of the Seventh Circuit's subsequent conclusions with respect to the constitutional objections, the finding plays an important role in the Seventh Circuit's discussion of the appropriate remedy in this case, which is discussed in detail below.

Constitutional Objection

Unlike Sharif's statutory objection to the bankruptcy court's entry of a final order, the Seventh Circuit concluded that Sharif's constitutional objection, premised on the ability of non-Article III courts to enter final orders on issues of state common law, could not be waived. Citing Stern and older precedent, the Seventh Circuit noted that "any matter which, from its nature, is the subject of a suit at the common law" must be decided by Article III judges when litigated at the federal level.10 The Seventh Circuit further observed that when an objection is premised on "Article III limitations…notions of consent and waiver cannot be dispositive because the limitations serve institutional interests that the parties cannot be expected to protect."11

In so holding, the court distinguished constitutional provisions that protect the "personal interests" of citizens from constitutional provisions that "protect the larger structural interests of our constitutional government," and stressed that an objection premised on the latter could not be waived by an individual litigant. As Sharif's objection was rooted in Article III of the Constitution, "an inseparable element of the constitutional system of checks and balances that both defines the power and protects the independence of the Judicial Branch," Sharif did not, and could not, waive the objection despite his failure to raise it in an otherwise timely manner.12

As noted above, the Ninth Circuit reached a different conclusion in In re Bellingham Ins. Agency, finding that a constitutional objection to entry of a final order by a bankruptcy court could be waived.13 The Supreme Court granted certiorari in Bellingham in June 2013, and will have the opportunity, as early as next term, to resolve the growing circuit split on whether constitutional Stern objections are subject to a traditional waiver analysis.

Merits of Objection

Having resolved the constitutional waiver issue in Sharif's favor, the Seventh Circuit analogized WIN's alter-ego claim with the claims at issue in Stern and Ortiz, which involved "interests defined by state law that were not historically determined by the executive or legislative branches," and added that such claims "did not involve 'a particularized area of the law' where Congress had established a body with particular expertise to determine certain factual matters in an efficient and inexpensive manner."14

The Seventh Circuit further held that "WIN's alter-ego claim is a state-law claim between private parties that is wholly independent of federal bankruptcy law," which could not be resolved through the claims resolution process created under the Bankruptcy Code absent resolution of the underlying state law issues.15 As such, the Seventh Circuit held that the bankruptcy court "lacked constitutional authority to enter final judgment on WIN's alter-ego claim."16

Appropriate Remedy

After concluding that the bankruptcy court lacked authority to enter a final order on WIN's alter-ego claim, the Seventh Circuit considered whether the district court, on remand, could treat the final order as a report and recommendation subject to adoption by the district court, after resolution of any specific objections and without additional discovery.

Section 157(c)(1) of Title 28 of the U.S. Code specifically authorizes a bankruptcy judge to hear non-core matters and "submit proposed findings of fact and conclusions of law to the district court." The district court is further authorized to enter a final order "after considering the bankruptcy judge's proposed findings and conclusions and after reviewing de novo those matters to which any party has timely and specifically objected." Following Stern, several district courts have issued standing orders directing district court judges to construe bankruptcy court final orders with respect to core matters, which the bankruptcy court was constitutionally barred from entering, as reports and recommendations by the bankruptcy court to the district court subject to adoption in the same manner provided in section 157(c)(1) for non-core matters.17

However, the Seventh Circuit, adopting a very literal interpretation of section 157, concluded that because section 157(b)(1)—which controls the adjudication of core proceedings—only states that the bankruptcy court can "enter appropriate orders and judgments," there is no statutory authority for the court to enter proposed findings of fact and conclusions of law with respect to core matters. The court further reasoned that bankruptcy courts lack the statutory authority to preside over discovery in core matters because, although there is statutory authority for a district court judge to designate pretrial matters to a magistrate judge, no similar statutory authority authorizes the allocation of pretrial matters to bankruptcy judges. Therefore, if the district court determines that the alter-ego claim is a core matter, the only remedy, according to the Seventh Circuit, is to withdraw the reference and set a new discovery schedule.

Conclusion

Although the Seventh Circuit's conclusion with respect to the appropriate remedy may be sound from a strictly textual standpoint, it raises some troubling practical considerations. For example, the court's final conclusion—that a bankruptcy court cannot issue proposed findings of fact and conclusions of law in core matters—is arguably contrary to the intent of Congress, embodied in the overall framework of 28 U.S.C. §157, to enable bankruptcy judges to author reports and recommendation on issues arising in a bankruptcy case where the court is barred from entering a final order. Moreover, it is difficult to conceptualize why Congress would have sanctioned the issuance of reports and recommendations for non-core matters and not for matters core to a bankruptcy proceeding that are within a bankruptcy court's area of expertise. Finally, the court's holding could burden judicial resources by forcing district courts to commence discovery in adversary proceedings despite the fact that discovery may have already started or been completed in bankruptcy court.

As previously noted, the Supreme Court's decision to grant certiorari in Bellingham may provide clarity on the appropriate next steps following a determination that a bankruptcy court lacked constitutional authority to enter a final order, in addition to the waiver issues discussed above. In the interim, bankruptcy practitioners should continue to be mindful of how the facts of a particular case and relevant circuit precedent impact resolution of these two important issues left open by Stern.

John J. Rapisardi is a partner at O'Melveny & Myers and cochair of the global restructuring practice. Joseph Zujkowski is a counsel at the firm and an adjunct professor at Cardozo School of Law. Matthew P. Kremer, an associate at the firm, assisted in the preparation of this article.

Endnotes:

1. Stern v. Marshall, 131 S. Ct. 2594 (2011).

2. Id. at 2611.

3. Wellness Int'l Network v. Sharif, No. 12-1349, 2013 WL 4441926 (7th Cir. Aug. 21, 2013).

4. Compare In re Bellingham Ins. Agency, 702 F.3d 553, 566-70 (9th Cir. 2012) (finding that constitutional Stern objections are subject to ordinary waiver analysis), cert. granted, 133 S. Ct. 2880 (2013) (No. 12-1200), with Waldman v. Stone, 698 F.3d 910, 917-18 (6th Cir. 2012) (finding that constitutional Stern objections cannot be waived).

5. A motion to withdraw the reference is a motion seeking to withdraw a proceeding from a bankruptcy court to the corresponding district court from which it was referred (generally pursuant to a standing order).

6. See Ortiz v. Aurora Health Care (In re Ortiz), 665 F.3d 906 (7th Cir. 2011).

7. Wellness Int'l, 2013 WL 4441926, at *7.

8. Id. at *8 (noting that 28 U.S.C. §157(b)(2) sets forth a non-exhaustive list of 16 types of core proceedings).

9. Id.

10. Id at 9 (quoting Stern, 131 S. Ct. at 2609; Murray's Lessee v. Hoboken Land & Improvement, 59 U.S. 272, 284 (1855)).

11. Id. at 14-15 (quoting Commodity Futures Trading Comm'n v. Schor, 478 U.S. 833, 850-51 (1986)).

12. Id. at 9 (quoting N. Pipeline Constr. v. Marathon Pipe Line, 458 U.S. 50, 58 (1982)).

13. The Ninth Circuit reasoned that "the allocation of authority between bankruptcy courts and district courts does not implicate structural interests, because bankruptcy judges are 'officer[s] of' the district court and are appointed by the Courts of Appeals." Bellingham, 702 F.3d at 567 n. 9.

14. Wellness Int'l, 2013 WL 4441926, at *12-13.

15. Id. at 20.

16. Id.

17. See Amended Standing Order of Reference, 12 Misc. 00032 (S.D.N.Y. Jan. 31, 2012).