Executive Summary
Earlier this year, the Third Circuit Court of Appeals provided us a good reminder of the importance of the Bankruptcy Clause being enshrined in the U.S. Constitution: “States can generally assert sovereign immunity to shield themselves from lawsuits, but bankruptcy proceedings are one of the exceptions.” Eugene Davis v. State of California (In re Venoco), 998 F.3d 94 (3d Cir. 2021). The U.S. Supreme Court had previously held in Central Virginia Community College v. Katz, 546 U.S. 356 (2006) that under the U.S. Constitution, states waived their sovereign immunity defense in any proceeding that furthers a bankruptcy court’s in rem jurisdiction . In Venoco, the Third Circuit applied Katz and held that a state cannot assert a sovereign immunity defense in bankruptcy proceedings that seek to enforce debtors’ property rights and facilitate the fair distribution of assets to creditors because such proceedings further the bankruptcy court’s in rem functions. The Third Circuit also refused to limit the breadth of Katz to a particular type of bankruptcy proceeding, extending Katz to cover post-confirmation and post-effective date claims.
And recently (October 4, 2021), the Supreme Court of the United States solidified Venoco as the law of the land in the Third Circuit by denying a petition for a writ of certiorari to review the Third Circuit’s Venoco decision.
In Venoco, the trustee for a post-confirmation liquidation trust filed an adversary proceeding against the State of California and its Lands Commission (together, the “State”), alleging inverse condemnation and arguing that the trust was entitled to just compensation for the taking of its property. The State filed a motion to dismiss, arguing, inter alia, that the Eleventh Amendment barred the suit against the State on the basis of sovereign immunity. The Bankruptcy Court, the District Court, and the Third Circuit all disagreed, holding that Katz precluded the assertion of sovereign immunity in the proceeding because the post-confirmation adversary proceeding furthered the Bankruptcy Court’s in rem jurisdiction.
By rejecting the State’s sovereign immunity defense, the Third Circuit adopted an expansive view of Katz. Going forward in the Third Circuit, Katz will presumably apply to any bankruptcy proceeding that implicates one of the three critical bankruptcy court functions outlined in Katz, regardless of when it occurs in a bankruptcy case, with an emphasis on function over form: “(1) the exercise of exclusive jurisdiction over all of the debtor’s property; (2) the equitable distribution of that property among the debtor’s creditors; and (3) the ultimate discharge that gives the debtor a ‘fresh start’ by releasing him, her, or it from further liability for old debts.” Venoco, 998 F.3d at 104(quoting In re Diaz, 647 F.3d 1073, 1084 (11th Cir. 2011) (quoting Katz, 546 U.S. at 363–64)).
Factual Background and Procedural History
The Executive Summary provided a short version of the facts. The next few paragraphs provide a longer version, or you can skip to the next section.
Prepetition, Venoco and its affiliated debtors extracted and refined hydrocarbons in the South Ellwood Field (the “Field”) off the coast of California, to which it had the drilling rights pursuant to leases with the State. Venoco conducted its drilling operations in the Field from an offshore oil platform (the “Offshore Platform”), which it also leased from the State. After Venoco extracted the hydrocarbons offshore, it transported them to an onshore refining facility (the “Onshore Facility”) that Venoco owned.
On April 17, 2017, Venoco filed its second chapter 11 bankruptcy (and the one relevant to In re Venoco), quitclaimed its leases in the Field, and relinquished its interest in the Offshore Platform. Following the relinquishment, out of concern for public safety and the environment, the California Lands Commission (the “Commission”) assumed responsibility for decommissioning the Offshore Platform and plugging the abandoned wells with the agreement to pay Venoco for the continued use of the Offshore Platform and the Onshore Facility. The Commission and Venoco eventually entered into a Gap Agreement, whereby the Commission agreed to pay $100,000 per month for access and use of Venoco’s Onshore Facility. Following execution of the Gap Agreement, Venoco and the Commission attempted to negotiate a sale of the Onshore Facility to the Commission, but those negotiations were not successful. The State thereafter ceased paying under the Gap Agreement and asserted that its police powers authorized the State to continue using Venoco’s Onshore Facility in its decommissioning pursuit without compensating Venoco.
Ultimately, Venoco confirmed a plan of liquidation, under which a post-confirmation liquidation trust was established, which took title to, among other things, Venoco’s Onshore Facility, as well as any claims Venoco may have had against the State. The liquidation plan became effective on October 1, 2018.
Venoco terminated the Gap Agreement on October 15, 2018 due to the State’s continued lack of payment, and the liquidation trustee filed an adversary proceeding against the State in Bankruptcy Court for inverse condemnation of the Onshore Facility. The State filed motions to dismiss, claiming sovereign immunity from the suits.
The Honorable Kevin Gross of the United States Bankruptcy Court for the District of Delaware denied the State’s motions to dismiss. The District Court permitted the appeal solely on Judge Gross’s rejection of the State’s sovereign immunity defense, which it affirmed.
Legal Reasoning
In In re Venoco, the Third Circuit (the “Court”) affirmed the Bankruptcy Court’s and District Court’s rejection of the State’s sovereign immunity defense.
First, the Court examined the framework and decision of Katz. The Court made three “non-controversial” observations about the Supreme Court’s holding in Katz. First, when the states ratified the Constitution’s Bankruptcy Clause, states waived their ability to raise a sovereign immunity defense in bankruptcy proceedings where the in rem jurisdiction of the bankruptcy courts was implicated. Second, Katz’s ruling does not apply to all bankruptcy proceedings. Third, the Katz ruling does not apply only to technically in rem proceedings; it also bars sovereign immunity in proceedings that are “ancillary to and in furtherance of the [bankruptcy] court’s in rem jurisdiction.” Id. (quoting Katz, 546 U.S. at 372).
The Court then summarized the three points, distilling them to what it interpreted as the core of the Katz holding: “States cannot assert a defense of sovereign immunity in proceedings that further a bankruptcy court’s in rem jurisdiction no matter the technical classification of that proceeding.” Id. Because Katz did not explicitly define which proceedings further a bankruptcy court’s in rem jurisdiction, the Court examined a bankruptcy court’s three critical functions, as set forth by the Supreme Court in Katz: “(1) the exercise of exclusive jurisdiction over all of the debtor’s property, (2) the equitable distribution of that property among the debtor’s creditors, and (3) the ultimate discharge that gives the debtor a ‘fresh start’ by releasing him, her, or it from further liability for old debts.” Id. (quoting In re Diaz, 647 F.3d 1073, 1084 (11th Cir. 2011) (quoting Katz, 546 U.S. at 363–64)). The Court emphasized the need to place function over form in determining whether a proceeding in question furthers any of these three functions and thus furthers the bankruptcy court’s in rem jurisdiction.
Applying the three identified functions to the case, the Court found that the proceeding in Venoco involved two of these critical functions. First, the proceeding directly furthered the Bankruptcy Court’s exercise of exclusive jurisdiction over the debtor’s property. In so finding, the Court stressed form over function and found irrelevant that the proceeding was for money damages and not for the reclamation of property. Second, the Court found that the proceeding furthered the equitable distribution of the estate’s assets. The Court found the “significant value” of the Onshore Facility to be particularly persuasive and stressed that the State had filed a proof of claim in the proceeding and thus had an interest in how the assets of the trust were liquidated and distributed. Id. at 106.
Notably, the Court also rejected the State’s argument that Katz was inapplicable because the proceeding related only to post-confirmation, post-effective date claims regarding property that was now owned by the trust, reasoning that: (1) the Bankruptcy Court retained substantial control over the trust’s assets, which were in essence a continuation of the estate; and (2) the trust existed primarily to facilitate the equitable distribution of the debtor’s property among the debtor’s creditors.
Conclusion and Takeaways
In Venoco, the Third Circuit rejected the State’s request to interpret Katz narrowly, including its “parade of horribles” warning that a broad interpretation would result in sovereign immunity being waived in every proceeding brought by a post-confirmation trustee. Instead, the Third Circuit broadly interpreted Katz to apply in “function and not form” to bankruptcy court proceedings that involve in rem jurisdiction. Id. at 104, 106, 108. In addition, the Third Circuit specifically extended Katz to apply to both post-confirmation and post-effective date claims.
As disputes with states arise often in bankruptcy proceedings, and especially decommissioning disputes in energy company bankruptcies, this opinion can serve as a useful tool in the arsenal of debtors against governmental entities.
** Summer associate Kathryn Rider assisted with the drafting of this post.
