Whose Choice of Law Governs in Bankruptcy Cases?

Contributed by Edward Wu
If a creditor from California files a proof of claim in the Bankruptcy Court for the Southern District of New York with respect to a prepetition cause of action it commenced in Florida state court based on an injury that occurred in Texas and the debtor is a Delaware corporation, what law should the Bankruptcy Court apply to resolve the claim?  The answer turns on the applicable choice of law rules, but whose?  Is it federal or state choice of law rules that govern?  If the latter, which state?
A prior decision of the Second Circuit Court of Appeals seemed to suggest that, generally, the applicable choice of law rules are that of the state in which the bankruptcy case is pending.  Recently, in the case of In re Coudert Brothers LLP, the Second Circuit further clarified the jurisprudence in this area by holding that, where a proof of claim is wholly derived from a claim pending in an out-of-state action commenced prepetition, the bankruptcy court is to apply the choice of law rules of the state where the prepetition action was commenced.
Coudert Brothers was an international law firm, and the claimant, Statek Corporation, had been one of its clients.  For over a decade, Statek was controlled by Hans Frederick Johnston, who fraudulently used Statek for his own purposes and looted Statek’s assets.  Although Statek retained and paid Coudert Brothers, the law firm allegedly counseled and assisted Johnston in hiding and laundering Statek’s assets.  Among other things, the law firm allegedly assisted Johnston by creating secret shell corporations, assisting in West Indian real estate purchases, and coordinating the removal from the United States of a multi-million dollar art and stamp collection.
After Johnston’s crimes were discovered, Statek commenced a malpractice action against Coudert Brothers in Connecticut state court.  Thereafter, the law firm filed for chapter 11 protection in the Southern District of New York, and Statek filed a proof of claim as to its malpractice claim.  The plan administrator sought to disallow Statek’s claim on the ground that the statute of limitations had run.  The bankruptcy court, relying upon the Second Circuit’s decision in In re Gaston & Snow, applied the choice of law rules of New York to Statek’s claim.  Similar to other states, New York has enacted an anti-forum shopping “borrowing statute,” which provides that the claim of a non-resident of New York is to be governed by the shorter of either New York’s statute of limitations or the statute of limitations of the place where the claim accrued.  Statek, a non-resident of New York, conceded that its claim was untimely under New York law.  Accordingly, the bankruptcy court disallowed the claim on the ground that it was time-barred.  On appeal to the District Court, Statek argued that the applicable choice of law rules should have been those of Connecticut, the state in which Statek filed its prepetition malpractice action.  The district court, however, affirmed the ruling below, at which time an appeal to the Second Circuit ensued.
The Second Circuit began its analysis by noting that where a federal court’s jurisdiction is based upon diversity of citizenship between the parties, the well-established rule is that it shall apply the choice of law rules of the state in which it sits.  Only recently did the Second Circuit resolve in Gaston & Snow that state choice of law rules also generally govern a bankruptcy court’s adjudication of state law claims.  As bankruptcy is a form of federal question rather than diversity jurisdiction, certain bankruptcy courts in other circuits have applied federal rather than state choice of law rules, but this approach has been rejected by the Second Circuit.  In Gaston & Snow, the Second Circuit stated that federal choice of law rules constitute a species of prohibited federal common law capable of displacing state law without authorization from Congress.  Due to the principle of separation of powers between Congress and the Judiciary, displacing state law in this manner is to be avoided unless there exists a significant conflict between a federal policy or interest and the use of state law.  On this reasoning — which mirrors the reasoning that guides federal courts sitting in diversity to apply state choice of law rules — the Second Circuit adopted the general rule in Gaston & Snow that bankruptcy courts are to apply state choice of law rules.
While certain broad language in Gaston & Snow might be interpreted as requiring bankruptcy courts to apply the choice of law rules of the forum state, the Second Circuit stated in Coudert Brothers that Gaston & Snow did not resolve which state’s choice of law rules apply; it regarded that question as an issue of first impression.  To address this issue, the Second Circuit again looked toward the development of federal court jurisdiction outside of the bankruptcy context.  According to the court, before the present choice of law rules for diversity jurisdiction were resolved in favor of applying state law, forum shopping between the state and federal court systems was a rampant problem.  If the law applied by a federal court within a particular state was more favorable to plaintiffs than the law applied by the state’s own courts, plaintiffs often manufactured diversity jurisdiction, such as by re-incorporating out of state.  With the present requirement that federal courts sitting in diversity apply the forum state’s choice of law rules, concerns relating to such “intra-state forum shopping” have been mitigated.  In contrast, forum shopping between states, or “inter-state forum shopping,” was not addressed and was largely regarded as an undesirable yet unavoidable consequence of the federal system.
Over time, perceptions on inter-state forum shopping began to change such that it was no longer regarded as a necessary evil, but rather, a right to be protected for the benefit of plaintiffs.  Accordingly, the U.S. Supreme Court decided in Van Dusen v. Barrack that where defendants obtain a change of venue under 28 U.S.C. § 1404(a), the choice of law rules to be applied by the new forum are those of the state where the plaintiff originally filed the claim, so as not to disturb plaintiff’s “venue privilege.”  It is this protected privilege of plaintiffs to shop selectively for favorable law that the Second Circuit regarded as the distinguishing factor between Coudert Brothers and Gaston & Snow.  Because Gaston & Snow was analogous to a non-transfer diversity case, New York choice of law rules were the correct rules to apply to the claim filed by the trustee for the estate since the trustee filed its claim in the Bankruptcy Court for the Southern District of New York.  In Coudert Brothers, on the other hand, Statek did not choose to litigate in New York, but, instead, exercised its venue privilege in favor of Connecticut.   The Second Circuit reasoned that fundamental issues of fairness would be violated if a debtor could use the Bankruptcy Code, a device of federal law, to choose the forum and its accompanying choice of law to achieve a result that the debtor could not have obtained as a defendant under the state law of the forum originally chosen by Statek.  A contrary result, the court noted, also would lead to the ironic result that New York’s anti-forum shopping borrowing statute would be applied to disallow a claim of a party that did not shop for New York as a forum.
The Court summarized its holding in Coudert Brothers as requiring bankruptcy courts to apply the choice of law rules of the state where the underlying prepetition complaint was filed when “(1) the claim before the bankruptcy court is wholly derived from another claim already pending in a parallel, out-of-state, non-bankruptcy proceeding; and (2) the pending original, or ‘source,’ claim was filed in a court prior to the commencement of the bankruptcy case.”