Restructuring

As we all wait with bated breath for the United States Supreme Court to give us further guidance (we hope, at least) on what Stern v. Marshall really means, we continue to watch with interest (and update our loyal blog readers) as the lower courts grapple with its application.  We’ve previously covered the circuit split between the Sixth and Seventh Circuit Courts of Appeals, on the one hand, and the Ninth Circuit Court of Appeals, on the other hand, regarding whether a debtor can consent or waive an objection to the bankruptcy court’s authority, the issue that is now before SCOTUS, and recently speculated whether the Fifth Circuit, in a single parenthetical in one of its cases, had decided to join the Stern party.  Now, we are certain it has.
In a recent decision, Frazin v. Haynes & Boone, L.L.P. (In re Frazin), No. 11-10403 (5th Cir. Oct. 1, 2013), citing Stern’s holding that a bankruptcy court does not have constitutional authority to issue a final judgment regarding state-law counterclaims that are not necessarily resolved in the claims-allowance process, even when they arise in a core proceeding, the Fifth Circuit expressly overruled pre-Stern circuit precedent that held that bankruptcy courts have the authority to enter final judgments in all core proceedings.  Notably, the Fifth Circuit also weighed in (albeit in a footnote) on the issue of whether a debtor could consent to the “jurisdiction of the bankruptcy court” or “waive[] any objection to the contrary” by filing claims in the bankruptcy case and failing to object to the bankruptcy court’s authority.  Siding with the Sixth and Seventh Circuits and against the Ninth Circuit, the Fifth Circuit held that a private party’s consent or waiver cannot cure the constitutional structural concerns implicated by a bankruptcy court’s lack of constitutional authority to enter a final order on a claim pursuant to Stern.
A Beanie Baby Bargain Comes Apart at its Seams
It all started with a Beanie Baby.  Or rather, hundreds of thousands of Beanie Babies.  And an oral agreement between friends to sell the soft, cuddly plush toys to customers and share the profits.  What could go wrong?
It was 1998, near the tail-end of the Beanie craze.  Timothy Frazin believed he had a deal with Lamajak, Inc., which owned a chain of gift shops, to receive millions of dollars in Lamajak’s profits made selling Beanies in exchange for providing access to his customer list and other services.  Lamajak, however, claimed there was no such deal.
Bankruptcy, Litigation and More Litigation
Frazin subsequently filed a chapter 13 petition and retained the law firm of Griffith & Nixon as special counsel to litigate his claims against Lamajak in state court.  After a two week jury trial, the jury awarded Frazin a total judgment of $6.3 million.  Lamajak appealed.  Frazin then retained the law firm of Haynes & Boone to litigate the appeal.  On appeal, the state Court of Appeals reduced Frazin’s judgment to approximately $3.4 million.  Lamajak initiated the process to seek review of the judgment by the state Supreme Court but, while that was pending, the parties agreed to settle for $3.2 million.
Griffith & Nixon and Haynes & Boone (collectively, the Attorneys) later filed applications with the bankruptcy court seeking approval of their fees under their respective contingency fee arrangements.  Frazin, dissatisfied with the reduced state court judgment, objected to the Attorneys’ fee applications and asserted state-law counterclaims against the Attorneys for negligence, violations of the Texas Deceptive Trade Practices Act (“DTPA”), and breach of fiduciary duty.
The case was tried before the bankruptcy court, which ruled against Frazin on the merits of the malpractice and DTPA claims.  While the bankruptcy court determined that Frazin had shown a breach of fiduciary duty, he failed to prove damages.  As a result, the court ruled against him on that claim as well.  It concluded that the Attorneys’ breaches were not serious enough to warrant fee forfeiture.  Lastly, the bankruptcy court overruled Frazin’s objections to the fee applications and awarded the Attorneys the original fee amounts requested.
The district court affirmed the bankruptcy court’s judgment in all respects, noting that the bankruptcy court’s factual findings were “amply supported by the record” and that the bankruptcy court’s legal conclusions – which the district court reviewed de novo – were proper.  Frazin appealed to the Fifth Circuit, arguing among other things that Stern precluded the bankruptcy court from entering a final judgment on his state law counterclaims.  The Fifth Circuit heard oral argument on June 6, 2012 and, after a lengthy period of time, issued its opinion on October 1, 2013.
The Fifth Circuit’s Ruling
In a majority opinion issued by a split panel, the Fifth Circuit held that Stern “unequivocally” overruled existing circuit precedent, Blackburn-Bliss Trust v. Hudson Shipbuilders, Inc. (In re Hudson Shipbuilders, Inc.), that held that bankruptcy courts have the authority to enter final judgments in all proceedings defined as “core” by 28 U.S.C. § 157(b).  All that was left then for the Fifth Circuit to decide was whether Frazin’s state-law claims fell within the scope of Stern.  In other words, were any of Frazin’s state-law counterclaims claims that would have necessarily been resolved in the claims-allowance process?  If so, then the bankruptcy court would have constitutional authority to issue a final judgment on those claims.
According to the Fifth Circuit, the answer was yes for the majority of the claims.  It concluded that the bankruptcy court had constitutional authority to enter a final judgment on Frazin’s state-law counterclaims for malpractice and breach of fiduciary duty, but not the DTPA claims.
In reviewing the malpractice claims, the Fifth Circuit discussed prior authority that recognized the “interconnectedness of fee applications and malpractice claims.”  The Court noted that the award of professional fees arises from a “common nucleus of operative fact” as the determination of malpractice claims.  In fact, the court stated, the award of fees was “inseparably related” to the enforcement of the appropriate standards of conduct.  According to the Fifth Circuit, in awarding the Attorneys’ fees, the bankruptcy court implicitly determined that the benefit and value of the Attorneys’ services were sufficient to approve payment under §§ 330(a)(3) and (a)(4)(B) of the Bankruptcy Code, which permitted bankruptcy courts to award reasonable compensation to professionals based on a consideration of the “benefit and necessity” of the services rendered, as well as the nature, extent and value of such services.
Likewise, the court concluded that “because the sole purpose of Frazin’s breach of fiduciary duty action was to defeat the Attorneys’ fee applications in bankruptcy court, the bankruptcy court necessarily had to resolve every aspect of his breach of fiduciary duty claim to rule on the Attorneys’ fee applications.”  In the Fifth Circuit’s view, these types of claims were exactly the kind the Supreme Court in Stern envisioned the bankruptcy court having the power upon which to render a final judgment.
The court distinguished, however, the DTPA claims from the malpractice and breach of fiduciary claims.  It drew a fine line, delineating what the bankruptcy court did and did not have authority to do when reviewing those claims.  According to the Fifth Circuit, the bankruptcy court had constitutional authority to make factual determinations regarding the DTPA claims, but it did not have constitutional authority to enter a final judgment on those claims.  The court stated, “In the present case, although the bankruptcy court necessarily had to resolve most, if not all, of Frazin’s factual allegations that supported his DTPA claims in the course of addressing claims that were otherwise within the court’s jurisdiction, the bankruptcy court was not required to resolve the legal effect flowing from those factual allegations in the context of a DTPA claim.”  (emphasis added).  The Fifth Circuit observed that the bankruptcy court’s factual findings spanned twenty-six pages of its memorandum opinion, and that the court had examined the evidence presented at trial in “minute detail.”  The Fifth Circuit viewed these factual resolutions as “part and parcel” of the bankruptcy court’s adjudication of the fee applications and, therefore, concluded that they must survive reversal.  The court, therefore, remanded the case to the district court.
Significantly, the Fifth Circuit addressed in a footnote the issue of whether a party can consent to a bankruptcy court’s authority to issue a final judgment.  In the footnote, the court stated:

The Attorneys argue that Frazin consented to the jurisdiction of the bankruptcy court and waived any objection to the contrary by filing his claims there and failing to object.  However, when “separation of powers] [sic] is implicated in a given case, the parties cannot by consent cure the constitutional difficulty …. When these Article III limitations are at issue, notions of consent and waiver cannot be dispositive because the limitations serve institutional interests that the parties cannot be expected to protect.”  C.F.T.C. v. Schor, 478 U.S. 833, 850-51 (1986).  As discussed above, Stern makes clear that the practice of bankruptcy courts entering final judgments in certain state-law counterclaims “compromise[s] the integrity of the system of separated powers and the role of the Judiciary in that system.”  131 S.Ct. at 2620.  Thus, structural concerns cannot be ameliorated by Frazin’s consent or waiver.

The Fifth Circuit’s view here is consistent with that taken by the Sixth Circuit in Waldman v. Stone and Seventh Circuit in Wellness Int’l Network v. Sharif and contrary to the one taken by the Ninth Circuit in In re Bellingham Ins. Agency, Inc.  While it’s exciting that the Fifth Circuit has finally weighed in on this issue, it’s not entirely clear why the court chose to address such a significant and controversial issue (which was expressly raised by the Attorneys in their brief) in a footnote, as opposed to the body of its opinion.  It is possible that with the Supreme Court about to review the Ninth Circuit’s decision in Bellingham, the Fifth Circuit saw the footnote as an opportunity to telegraph to the Supreme Court its view on consent while also hedging its bets.  In the event the Supreme Court sides with the Ninth Circuit, relegating the consent issue to a footnote would allow the Fifth Circuit to avoid having its decision overturned.
Also interesting is the scope of the Fifth Circuit’s holding overruling Hudson.  While the Fifth Circuit appeared to overrule Hudson’s application as to only one type of core proceeding (namely, state-law counterclaims that are not necessarily resolved in the claims-allowance process), elsewhere it suggested that the implications of its holding are much broader.  In another meaningful footnote, the Fifth Circuit stated that Stern’s holding may extend to other core proceedings and that the “task of interpreting the scope of Stern” had only just begun.
Lastly, the Fifth Circuit’s resolution of the DTPA claims is worth highlighting.  The Fifth Circuit’s ruling appears to permit bankruptcy courts, in circumstances where the factual issues underlying a claim are also necessarily resolved in the claims allowance process, to make factual determinations regarding claims that they would otherwise not have constitutional authority to adjudicate on a final basis– effectively affording such claims the same level of appellate review as claims over which the bankruptcy court did have constitutional authority to finally adjudicate.  Although few courts have expressly ruled on the appropriate treatment of factual findings made by a bankruptcy court in the course of simultaneously hearing issues over which they have the constitutional authority to enter a final order and those over which they do not, the Fifth Circuit’s approach departs substantially from approaches suggested by other courts, which include permitting the bankruptcy court to issue only reports and recommendations (which would be subject to de novo review only) or requiring the district court to withdraw the reference.
It’s unclear why in Frazin the Fifth Circuit remanded the case down to the district court for further proceedings given that the district court had already given deference to the bankruptcy court’s factual findings and reviewed its legal conclusions de novo in deciding the appeal.  Perhaps that is why the very short dissent stated that “no harm is done, at least in this case, and the district court will no doubt simply dismiss whatever has been remanded,” although the dissenting judge “would hold that a bankruptcy court does not lose jurisdiction in deciding the administration of the estate when that has some collateral effect not easily avoided.”  Thus, even within the Fifth Circuit, judges cannot reach consensus over the true meaning of Stern.
It remains to be seen whether other courts will adopt the Fifth Circuit’s approach.  And we continue to watch SCOTUS…
(p.s.:  The score is now 3 to 1, at the Court of Appeals level, in favor of Article III adjudication as a non-waiveable structural right.)