Supreme Court hears case on the limits of bankruptcy judges’ powers

January 14, 2014, 8:27 PM UTC

FORTUNE — The U.S. Supreme Court will hear a case today that will either help bankruptcy litigators recover their bearings after a 2011 High Court ruling threw them for a major loop — or force them to see their world turned further upside down.

The issues posed revolve around which bankruptcy litigation matters can properly be handled by bankruptcy judges — who have specialized training but lack the constitutional standing of U.S. district judges — and which must, as a matter of constitutional law, be presided over by full-fledged district judges.

The case, Executive Benefits Insurance Agency v. Arkison, also addresses subsidiary questions, including whether parties can ever consent to allowing bankruptcy judges to hear matters that would otherwise have to be heard by district judges and, if so, how formally and explicitly must they manifest their consent.

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Many practitioners thought many of these questions had been effectively put to rest 30 years ago, in 1984, when Congress, responding to a 1982 Supreme Court ruling, laid out a distinction between so-called “core” bankruptcy matters, which could be safely handled by bankruptcy judges, and “non-core” matters, which had to be heard by district judges.

Then, in 1989, a small chink in the armor appeared when the Supreme Court found that Congress’s 1984 line-drawing was not necessarily decisive and, indeed, that it contained at least one narrow error.

Practitioners hoped that error was arcane and atypical, but those hopes were unexpectedly dashed in 2011, when the Supreme Court heard Stern v. Marshall, the epic case between former Playmate of the Year Anna Nicole Smith — by then deceased — and the, by then also deceased, son of her deceased oil tycoon husband, J. Howard Marshall II. (The “Stern” in the caption was the executor for Smith, whose off-stage name was Vickie Lynn Marshall.)

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In tossing out a victory Smith had won in a Los Angeles bankruptcy court, the Court in Stern found that a broad category of litigation that had been thought until then to fall safely within the purview of bankruptcy judges — counterclaims advanced by a debtor to defend claims being made against it by creditors — could no longer be assumed to be such. That was so, moreover, even if none of the parties involved had voiced objections to letting a bankruptcy judge handle the disputes in question.

“It’s quite confusing,” says Earl Forte, a bankruptcy partner at White and Williams, and the author of The Fraudulent Transfer Handbook. “They’ve really made a mess of it.”

The whole idea of the scheme Congress set up, Forte explains, was that bankruptcy litigation was a complex, fast-moving, specialized area of practice that would get bogged down if it had to be handled by generalist U.S. district court judges on top of their already full and varied dockets of criminal and civil cases. So Congress created a separate system of bankruptcy courts, presided over by specialized judges who are supposed to handle the lion’s share of bankruptcy litigation with only light and occasional supervision from district court judges.

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The fly in the ointment is Article III, Section 1, of the Constitution. In order to ensure an independent federal judiciary, it specifies that federal judges must be appointed by the President with the approval of the Senate, that their terms will last for life (at least “during good behavior”) and that they will run no risk of ever seeing their salaries be diminished.

Bankruptcy judges meet none of Article III’s specifications. They are appointed by federal appeals courts for 14-year terms, and their salaries are subject to the whims of Congress.

In 1982, in a case called Northern Pipeline Construction Co. v. Marathon Pipe Line Co., the Supreme Court struck down portions of the bankruptcy court system as it then existed, finding that bankruptcy judges were routinely being allowed to decide the kinds of disputes that were, under the Constitution, only supposed to be decided by full-fledged district judges, appointed under the terms of Article III.

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Though the safest thing for Congress to have done at that point, Forte explains, would have been to require that all bankruptcy judges become Article III judges — being appointed by the President, with life tenure, and so on — critics opposed that approach as cumbersome and expensive, and some district judges thought it would dilute the talent pool for Article III judges, reducing the respect their decisions commanded.

In any event, Marathon Pipe Line appeared to leave open the possibility of less drastic solutions to the problem. The ruling was confusing — there was no majority opinion — but most justices appeared to agree that for various technical and historical reasons use of non-Article III bankruptcy judges would still be permissible if they were confined to hearing certain “core” bankruptcy matters. After all, the justices recognized, there were already a number of Congressionally created federal tribunals in existence — territorial courts in Guam or the Virgin Islands, for instance, or courts-martial in the military — that used judges who lack Article III protections and the Court was not purporting to invalidate any of those.

So in 1984 Congress set up a system that was designed to pass muster under Marathon Pipe Line, drawing distinctions between so-called “core” and “non-core” bankruptcy litigation matters, and giving bankruptcy judges the power to render final judgments only in the former. But that’s the system that’s now in danger of coming apart at the seams.

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Today’s case involves the 2006 bankruptcy of Bellingham Insurance Company in Washington State. In 2008 Peter Arkison, a trustee who had been appointed to recover assets for the estate, filed a so-called fraudulent transfer suit against Executive Benefits, alleging that about $400,000 of Bellingham’s assets had been wrongfully passed off to Executive Benefits before the bankruptcy, in effect, to keep them out of the hands of creditors.

Executive Benefits denied the allegation. The dispute was then heard before a bankruptcy judge. Executive Benefits never explicitly objected to having the bankruptcy judge resolve the dispute. On the other hand, at that time the law in the Ninth Circuit — which includes Washington State — was clear that fraudulent transfer claims of this type could properly be decided by a bankruptcy judge.

The bankruptcy judge ruled for the trustee on summary judgment. Executive Benefits then appealed to the district court, which affirmed, ostensibly applying a so-called “de novo” standard of review, meaning that it did not defer to the bankruptcy judge’s rulings, but decided the issues anew.

By the time Executive Benefits appealed to the Ninth Circuit, in 2012, the Stern v. Marshall ruling had come down, and it was now clear to all that the fraudulent transfer action the trustee had brought was a type of proceeding that Executive Benefits had a constitutional right to have heard by a district court judge, instead of by a bankruptcy judge. Executive Benefits sought reversal on those grounds. The Ninth Circuit affirmed nonetheless, finding, first of all, that Executive Benefits had impliedly consented to letting the bankruptcy judge decide the case. Alternatively, it reasoned, the fact that the district judge had affirmed the bankruptcy judge’s ruling on de novo review further cured any constitutional problem that might have occurred. Under the circumstances, it was as if the bankruptcy judge had done nothing more than what magistrate judges are permitted to do all the time: render proposed findings of fact and recommended conclusions of law that are ultimately decided by the district judge independently after de novo review.

Accordingly, the Court today is likely to decide whether Executive Benefit’s mere failure to object amounted to “implied consent” to having the bankruptcy judge decide the case. It may also decide the broader question of whether even the most explicit consent can ever alleviate a constitutional failing of the type that occurred here. Finally, it may address whether, in cases that must constitutionally be decided by district judges, whether bankruptcy judges can nevertheless be permitted to “recommend” findings of fact and conclusions of law, the way magistrates currently do.

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