Restructuring

Contributed by Blaire Cahn
The United States Bankruptcy Court for the Southern District of Texas in In re Waco Town Square Partners, L.P., et al. considered whether it had the authority to order a non-debtor to dismiss a state court lawsuit against a third party.  Finding that “when you snooze, you lose,” the bankruptcy court held that although it did not necessarily have the authority to order the non-debtor to dismiss all of the claims in its state court lawsuit, the non-debtor forfeited its right to challenge the bankruptcy court’s authority to do so by failing to file a timely objection.

Background
NSJS Limited Partnership commenced a lawsuit against Waco Town Square Partners II, LP (WTSP II) and certain other defendants in state court for, among other things, fraud and breach of contract. WTSP II subsequently commenced a chapter 11 proceeding. The confirmation order for WTSP II’s chapter 11 plan required NSJS to remove any derivative claims (i.e., claims belonging to WTSP II or its estate) from its state court complaint within 45-days or all of NSJS’s claims would be deemed derivative claims, which must be dismissed with prejudice. NSJS failed to amend its complaint within the 45-day period.
Nearly seven months after the confirmation order was entered, NSJS amended its complaint by removing WTSP II as a defendant and deleting any claims that were potentially derivative. WTSP II filed a motion for contempt against NSJS for violation of the confirmation order. Although the bankruptcy court denied the motion for contempt, it found that NSJS’s original complaint contained several derivative claims, which were not timely removed in accordance with the confirmation order, and ordered NSJS to dismiss its state court action. On appeal, the district court affirmed the bankruptcy court’s decision on the contempt motion and remanded the case as to the requirement that NSJS dismiss its state court action. The district court requested clarification on several issues, including the bankruptcy court’s authority to order a non-debtor to dismiss a lawsuit in state court and whether NSJS’s failure to amend its complaint timely was due to excusable neglect.
Analysis
In evaluating whether it had the authority to order NSJS to dismiss its state court lawsuit, the bankruptcy court first considered NSJS’s claims against WTSP II. The bankruptcy court noted that the determination of claims against the estate is a critical part of the federal bankruptcy power and explained that such claims are core proceedings under 28 U.S.C. § 157(b)(2)(B). Accordingly, the bankruptcy court found that it was permitted to issue a final order requiring NSJS to dismiss its state law claims as against WTSP II.
The bankruptcy court next considered claims that were property of WTSP II’s bankruptcy estate, such as alter ego claims. 28 U.S.C. § 1334(e) grants the district court exclusive jurisdiction over all property of the debtor and the bankruptcy estate. The bankruptcy court reasoned that NSJS interfered with the bankruptcy estate by commencing a lawsuit containing claims that were properly part of the bankruptcy estate. Because preventing interference with the bankruptcy estate is an essential bankruptcy matter, it falls within the “public rights” exception to Stern v. Marshall’s general rule that a bankruptcy court may not issue a final order or judgment on matters that are within the exclusive authority of Article III courts. As such, the bankruptcy court found that it also had the proper authority to order NSJS to dismiss these claims.
Finally, the bankruptcy court addressed claims filed by NSJS against third parties that were not property of the bankruptcy estate. The bankruptcy court acknowledged that it likely did not have the authority to order NSJS to dismiss these claims, but found that NSJS forfeited its right to challenge such authority by failing to object timely. Indeed, NSJS waited until almost a year after the original confirmation order was entered. With respect to subject matter jurisdiction, the Supreme Court has found on numerous occasions that a bankruptcy court’s final order may not be collaterally attacked on the basis of a jurisdictional challenge. The bankruptcy court reasoned that such rule should also apply in the context of a bankruptcy court’s constitutional authority to issue a final order. The bankruptcy court went on to point out that the majority in Stern acknowledged that a party may forfeit its right to challenge a bankruptcy court’s constitutional authority by failing to file a timely objection.
The bankruptcy court was also not persuaded that NSJS’s failure to amend its complaint was the result of excusable neglect. Although the bankruptcy court acknowledged that several factors relevant to a determination of excusable neglect weighed in favor of NSJS—the length of the delay did not prejudice the debtor and NSJS acted in good faith—NSJS failed to provide a valid justification for its delay.
Conclusion
The case is yet another reminder that a failure to adhere to procedural rules and deadlines could result in a waiver of substantive rights and remedies. Here, had NSJS timely challenged the constitutional authority of the bankruptcy court to require dismissal of those state law claims that were not property of the estate, it may well have preserved such claims in its state court action.