Seventh Circuit Stumble

Considering the existing circuit split, the Wellness International decision would be interesting, but not extraordinary, had the Seventh Circuit stopped after deciding the waiver issue. Indeed, the Supreme Court is set to take up this waiver question and will presumably resolve the circuit split in Executive Benefits Insurance Agency v. Arkison (In re Bellingham Insurance Agency, Inc.), 702 F.3d 553 (9th Cir. 2012), cert. granted 133 S. Ct. 2880 (2013). (See article on the left.)

Instead of stopping after deciding the waiver issue, however, the Seventh Circuit addressed a separate question ' not raised or briefed by the parties ' of whether a bankruptcy court is authorized to issue proposed findings of fact and conclusions of law in a “core” proceeding in which the bankruptcy court lacks constitutional authority to enter judgment. Answering this question in the negative, the Seventh Circuit effectively ordered wholesale withdrawal of the reference ' on a mandatory basis ' of all “core” proceedings in which the bankruptcy court cannot constitutionally enter final judgment. Even more remarkably, the Seventh Circuit indicated that such withdrawal of the reference should occur immediately, indicating that bankruptcy courts lack authority even to oversee discovery and other pretrial matters in such proceedings.

The Seventh Circuit's statutory interpretation of Section 157 ' to the extent it remains intact (a petition for rehearing and rehearing en banc was filed just prior to publication of this article) ' may prove highly disruptive throughout the Seventh Circuit until this statutory issue is decided by the Supreme Court in Bellingham or ameliorated through lower court decisions that limit the effect of Wellness International.

Background and Summary of Decision

As virtually every bankruptcy practitioner is now aware, the Supreme Court found in Stern that bankruptcy courts, as non-Article III courts, lack constitutional power to enter final judgment in certain disputes, even if such matters are expressly enumerated as “core” proceedings under 28 U.S.C. ' 157(b). Given that the Constitution vests the judicial power of the United States exclusively in Article III judges, bankruptcy courts may permissibly enter final judgment only in matters that fall within the “public rights” exception to this rule. “Public rights” generally involve rights derived from or closely related to federal statutory schemes and are not premised on common law.

Like Stern itself, the Wellness International decision was the product of more than a decade of litigation that wound its way through various lower courts. The debtor in Wellness International, Mr. Richard Sharif, filed a voluntary Chapter 7 bankruptcy petition in the Northern District of Illinois after Wellness International obtained a judgment against him based on discovery sanctions in a litigation pending in the Northern District of Texas. In Mr. Sharif's bankruptcy case, Wellness International filed a non-dischargeability complaint relating to its Texas judgment, which complaint also included a count asserting that a trust controlled by Mr. Sharif should be deemed his alter ego.

After Mr. Sharif failed to respond to discovery requests in the non-dischargeability action, the bankruptcy court entered default judgment against Mr. Sharif on all counts. Mr. Sharif appealed. While the Supreme Court issued its Stern decision several months before Mr. Sharif filed his opening appeal brief, Mr. Sharif did not raise any Stern-objections in his brief. Mr. Sharif's sister (a beneficiary of the alter ego trust) subsequently filed an appeal brief seeking withdrawal of the reference based on the Stern decision. After the district court determined that Mr. Sharif had waived any right to insist that final judgment be entered by an Article III court, the district court affirmed the bankruptcy court's judgment.

On appeal from the district court, the Seventh Circuit reversed. As an initial matter, the Seventh Circuit found that the non-dischargeability counts of the complaint constituted “core” proceedings in which the bankruptcy court could properly enter judgment. As to the alter ego claim, the Seventh Circuit found it unnecessary to determine whether the claim was actually a statutorily “core” proceeding.

Instead, the court found the fact that Mr. Sharif had waived the right to assert the alter ego claim was “non-core,” and the Seventh Circuit simply assumed the alter ego claim was a “core” proceeding under 28 U.S.C. ' 157(b) for the purpose of its constitutional analysis. After finding that the alter ego claim did not fall within the “public rights” exception, the Seventh Circuit concluded that the bankruptcy court lacked judicial power under Stern to enter final judgment on the alter ego claim.

The Seventh Circuit rejected the district court's finding that Mr. Sharif had waived his right to demand entry of final judgment by an Article III court. In doing so, the Seventh Circuit expressly rejected the reasoning in the Ninth Circuit's decision in Bellingham (which held that Stern-based objections are waivable) and determined that the right to demand entry of judgment by an Article III court is not waivable because it implicates critical structural protections of Article III of the Constitution. Relying on the Supreme Court's decision in Commodity Futures Trading Commission v. Schor, 478 U.S.833 (1986), the Seventh Circuit thus sided with the Sixth Circuit's decision in Waldman v. Stone, 698 F.3d 910 (6th Cir. 2013), cert. denied 133 S. Ct. 1604 (2013), and found that Sharif did not and could not waive his right to demand entry of final judgment by an Article III court.

Finally, rather than adopting Mr. Sharif's request that the district court be required to treat the bankruptcy court's judgment as proposed findings of fact and conclusions of law (and notwithstanding the Seventh Circuit's prior finding that Mr. Sharif waived the right to assert the alter ego claim was “non-core”), the Seventh Circuit ordered the district court on remand to first determine whether the alter-ego claim was “core” or “non-core.”
Noting that Section 157(c)(1) authorizes the bankruptcy court to issue proposed findings and conclusions in connection with a “non-core” proceeding, but that Section 157 contains no parallel provision authorizing the bankruptcy court to issue proposed findings and conclusions in a “core” proceeding, the Seventh Circuit instructed the district court to withdraw the reference immediately to conduct fresh discovery proceedings (thereby disregarding the bankruptcy court's default judgment) if the district court finds the alter ego claim to be “core.”

Only if the district court finds the alter-ego claim to be “non-core” could the district court treat the bankruptcy court's judgment as proposed findings and conclusions. This peculiar instruction for the district court to make a core/non-core determination on remand (after the Seventh Circuit treated the claim as “core” for purposes of its opinion) could arguably render Wellness International to be dicta to the extent the district court finds the alter ego claim to be “non-core.”

The absence of express authority in Section 157 to issue proposed findings and conclusions in a “core” proceeding, as identified by the Seventh Circuit, is the consequence of the Supreme Court's ruling in Stern that bankruptcy courts cannot issue final judgments in “core” proceedings that fall outside of the “public rights” exception. But should Congress's silence as to whether bankruptcy courts can issue proposed findings and conclusions in “core” proceedings be interpreted to preclude such practice? The Supreme Court is set to take up this statutory gap issue in Bellingham. To the extent the Supreme Court adopts the Seventh Circuit's interpretation of Section 157, bankruptcy practitioners should be prepared for significant disruptions.

The 'Gap' in Section 157

The finding that bankruptcy courts cannot issue proposed findings and conclusions in “private rights” proceedings that are statutorily “core” creates significant practical difficulties by precluding district courts from utilizing the expertise of bankruptcy courts on specialized core bankruptcy issues. Moreover, prohibiting the bankruptcy courts from overseeing pretrial matters in these “core” proceedings (which is common practice in many jurisdictions) may significantly increase the district courts' workload. The Seventh Circuit's interpretation of Section 157 also leads to the counterintuitive result that bankruptcy courts have greater authority over “non-core,” state law disputes (where bankruptcy courts remain authorized to handle pretrial matters and issue proposed findings and conclusions) than in “private rights” disputes designated by Congress as “core” proceedings (which now must be withdrawn immediately from the bankruptcy courts even though these matters frequently involve traditional bankruptcy concepts, such as fraudulent transfers).

Notwithstanding the Seventh Circuit's limited interpretation in Wellness International, Section 157 likely provides sufficient authority to permit bankruptcy courts to issue proposed findings and conclusions in “core” proceedings even if bankruptcy courts cannot enter judgment. Section 157(a) authorizes the district court to refer to the bankruptcy court “any or all proceedings arising under title 11 or arising in or related to a case under title 11.” The Seventh Circuit's conclusion that bankruptcy courts cannot preside over any aspect of certain “core” proceedings is inconsistent with the unqualified referral authorization in Section 157(a), which contemplates withdrawal of the reference only upon “cause shown.” 28 U.S.C. ' 157(d).

Indeed, many jurisdictions have amended their standing orders of reference to expressly authorize bankruptcy courts to issue proposed findings and conclusions in a “core” proceeding in which the bankruptcy court cannot enter final judgment. Whether accomplished through modification of the district's standing order of referral or handled on an ad hoc basis through orders of referral in specific proceedings, referral of a “core” proceeding to the bankruptcy court with the instruction to oversee pretrial matters and issue proposed findings and conclusions appears to be consistent with Section 157.

Of course, concluding that referral of a “core” proceeding (or a “non-core” proceeding, for that matter) to the bankruptcy court for pretrial matters and proposed findings and conclusions is consistent with Section 157 does not resolve the question of whether such referral is constitutional absent consent, particularly where litigants in a referred matter may have no access to an Article III judge until after issuance of proposed findings and conclusions. Indeed, the Wellness International court expressed concerns about whether Section 157(c)(2), which authorizes parties to consent to judgment by a bankruptcy court in a “non-core” dispute, properly authorizes bankruptcy courts to exercise Article III judicial power.

A subsequent panel of the Seventh Circuit, however, has already answered that question, finding that consent is sufficient to permit the bankruptcy court to enter final judgment. See Peterson v. Somers Dublin Ltd., 2013 U.S. App. LEXIS 18650, Nos. 12-2463 (7th Cir. Sept. 6, 2013). Nevertheless, all eyes will be on the Supreme Court in Bellingham to see how these statutory and constitutional issues are resolved.

Dion W. Hayes,' a member of this newsletter's Board of Editors, and Aaron G. McCollough are attorneys in the Restructuring & Insolvency Group of McGuireWoods LLP. The views expressed in this article are those of the authors and do not necessarily represent the views of McGuireWoods LLP or its clients.'

As fallout from the Supreme Court's decision in Stern v. Marshall , 131 S. Ct. 2594 (2011) continues to disrupt bankruptcy litigation throughout the country, the Seventh Circuit recently provided a new (and rather unfortunate) contribution to the body of post- Stern authority from the Court of Appeals level. The Seventh Circuit's new decision is notable not so much for its constitutional analysis (which is important, but merely adds to an existing circuit split that will likely be resolved by the Supreme Court next term), but for its statutory analysis of 28 U.S.C. ' 157, which could prove highly disruptive.

Wellness International

In Wellness International Network, Ltd. v. Sharif (In re Sharif), 2013 U.S. App. LEXIS 17553, No. 12-1349 (7th Cir. Aug. 21, 2013), the Seventh Circuit addressed the thorny issue of whether a litigant ' through conduct and failure to object ' may be found to have waived the right to object to entry of final judgment by a bankruptcy court in a matter in which the bankruptcy court would otherwise lack constitutional authority to enter judgment. The Sixth and Ninth Circuit Courts of Appeals have previously weighed in on this same waiver question, with those two circuits reaching opposite conclusions. In Wellness International, the Seventh Circuit sided with the Sixth Circuit, finding that a litigant cannot waive the constitutional right to have disputes that involve “private rights” (as described in Stern) decided by an Article III judge.

Considering the existing circuit split, the Wellness International decision would be interesting, but not extraordinary, had the Seventh Circuit stopped after deciding the waiver issue. Indeed, the Supreme Court is set to take up this waiver question and will presumably resolve the circuit split in Executive Benefits Insurance Agency v. Arkison (In re Bellingham Insurance Agency, Inc.), 702 F.3d 553 (9th Cir. 2012), cert. granted 133 S. Ct. 2880 (2013). (See article on the left.)

Instead of stopping after deciding the waiver issue, however, the Seventh Circuit addressed a separate question ' not raised or briefed by the parties ' of whether a bankruptcy court is authorized to issue proposed findings of fact and conclusions of law in a “core” proceeding in which the bankruptcy court lacks constitutional authority to enter judgment. Answering this question in the negative, the Seventh Circuit effectively ordered wholesale withdrawal of the reference ' on a mandatory basis ' of all “core” proceedings in which the bankruptcy court cannot constitutionally enter final judgment. Even more remarkably, the Seventh Circuit indicated that such withdrawal of the reference should occur immediately, indicating that bankruptcy courts lack authority even to oversee discovery and other pretrial matters in such proceedings.

The Seventh Circuit's statutory interpretation of Section 157 ' to the extent it remains intact (a petition for rehearing and rehearing en banc was filed just prior to publication of this article) ' may prove highly disruptive throughout the Seventh Circuit until this statutory issue is decided by the Supreme Court in Bellingham or ameliorated through lower court decisions that limit the effect of Wellness International.

Background and Summary of Decision

As virtually every bankruptcy practitioner is now aware, the Supreme Court found in Stern that bankruptcy courts, as non-Article III courts, lack constitutional power to enter final judgment in certain disputes, even if such matters are expressly enumerated as “core” proceedings under 28 U.S.C. ' 157(b). Given that the Constitution vests the judicial power of the United States exclusively in Article III judges, bankruptcy courts may permissibly enter final judgment only in matters that fall within the “public rights” exception to this rule. “Public rights” generally involve rights derived from or closely related to federal statutory schemes and are not premised on common law.

Like Stern itself, the Wellness International decision was the product of more than a decade of litigation that wound its way through various lower courts. The debtor in Wellness International, Mr. Richard Sharif, filed a voluntary Chapter 7 bankruptcy petition in the Northern District of Illinois after Wellness International obtained a judgment against him based on discovery sanctions in a litigation pending in the Northern District of Texas. In Mr. Sharif's bankruptcy case, Wellness International filed a non-dischargeability complaint relating to its Texas judgment, which complaint also included a count asserting that a trust controlled by Mr. Sharif should be deemed his alter ego.

After Mr. Sharif failed to respond to discovery requests in the non-dischargeability action, the bankruptcy court entered default judgment against Mr. Sharif on all counts. Mr. Sharif appealed. While the Supreme Court issued its Stern decision several months before Mr. Sharif filed his opening appeal brief, Mr. Sharif did not raise any Stern-objections in his brief. Mr. Sharif's sister (a beneficiary of the alter ego trust) subsequently filed an appeal brief seeking withdrawal of the reference based on the Stern decision. After the district court determined that Mr. Sharif had waived any right to insist that final judgment be entered by an Article III court, the district court affirmed the bankruptcy court's judgment.

On appeal from the district court, the Seventh Circuit reversed. As an initial matter, the Seventh Circuit found that the non-dischargeability counts of the complaint constituted “core” proceedings in which the bankruptcy court could properly enter judgment. As to the alter ego claim, the Seventh Circuit found it unnecessary to determine whether the claim was actually a statutorily “core” proceeding.

Instead, the court found the fact that Mr. Sharif had waived the right to assert the alter ego claim was “non-core,” and the Seventh Circuit simply assumed the alter ego claim was a “core” proceeding under 28 U.S.C. ' 157(b) for the purpose of its constitutional analysis. After finding that the alter ego claim did not fall within the “public rights” exception, the Seventh Circuit concluded that the bankruptcy court lacked judicial power under Stern to enter final judgment on the alter ego claim.

The Seventh Circuit rejected the district court's finding that Mr. Sharif had waived his right to demand entry of final judgment by an Article III court. In doing so, the Seventh Circuit expressly rejected the reasoning in the Ninth Circuit's decision in Bellingham (which held that Stern-based objections are waivable) and determined that the right to demand entry of judgment by an Article III court is not waivable because it implicates critical structural protections of Article III of the Constitution. Relying on the Supreme Court's decision in Commodity Futures Trading Commission v. Schor , 478 U.S.833 (1986), the Seventh Circuit thus sided with the Sixth Circuit's decision in Waldman v. Stone , 698 F.3d 910 (6th Cir. 2013), cert. denied 133 S. Ct. 1604 (2013), and found that Sharif did not and could not waive his right to demand entry of final judgment by an Article III court.

Finally, rather than adopting Mr. Sharif's request that the district court be required to treat the bankruptcy court's judgment as proposed findings of fact and conclusions of law (and notwithstanding the Seventh Circuit's prior finding that Mr. Sharif waived the right to assert the alter ego claim was “non-core”), the Seventh Circuit ordered the district court on remand to first determine whether the alter-ego claim was “core” or “non-core.”
Noting that Section 157(c)(1) authorizes the bankruptcy court to issue proposed findings and conclusions in connection with a “non-core” proceeding, but that Section 157 contains no parallel provision authorizing the bankruptcy court to issue proposed findings and conclusions in a “core” proceeding, the Seventh Circuit instructed the district court to withdraw the reference immediately to conduct fresh discovery proceedings (thereby disregarding the bankruptcy court's default judgment) if the district court finds the alter ego claim to be “core.”

Only if the district court finds the alter-ego claim to be “non-core” could the district court treat the bankruptcy court's judgment as proposed findings and conclusions. This peculiar instruction for the district court to make a core/non-core determination on remand (after the Seventh Circuit treated the claim as “core” for purposes of its opinion) could arguably render Wellness International to be dicta to the extent the district court finds the alter ego claim to be “non-core.”

The absence of express authority in Section 157 to issue proposed findings and conclusions in a “core” proceeding, as identified by the Seventh Circuit, is the consequence of the Supreme Court's ruling in Stern that bankruptcy courts cannot issue final judgments in “core” proceedings that fall outside of the “public rights” exception. But should Congress's silence as to whether bankruptcy courts can issue proposed findings and conclusions in “core” proceedings be interpreted to preclude such practice? The Supreme Court is set to take up this statutory gap issue in Bellingham. To the extent the Supreme Court adopts the Seventh Circuit's interpretation of Section 157, bankruptcy practitioners should be prepared for significant disruptions.

The 'Gap' in Section 157

The finding that bankruptcy courts cannot issue proposed findings and conclusions in “private rights” proceedings that are statutorily “core” creates significant practical difficulties by precluding district courts from utilizing the expertise of bankruptcy courts on specialized core bankruptcy issues. Moreover, prohibiting the bankruptcy courts from overseeing pretrial matters in these “core” proceedings (which is common practice in many jurisdictions) may significantly increase the district courts' workload. The Seventh Circuit's interpretation of Section 157 also leads to the counterintuitive result that bankruptcy courts have greater authority over “non-core,” state law disputes (where bankruptcy courts remain authorized to handle pretrial matters and issue proposed findings and conclusions) than in “private rights” disputes designated by Congress as “core” proceedings (which now must be withdrawn immediately from the bankruptcy courts even though these matters frequently involve traditional bankruptcy concepts, such as fraudulent transfers).

Notwithstanding the Seventh Circuit's limited interpretation in Wellness International, Section 157 likely provides sufficient authority to permit bankruptcy courts to issue proposed findings and conclusions in “core” proceedings even if bankruptcy courts cannot enter judgment. Section 157(a) authorizes the district court to refer to the bankruptcy court “any or all proceedings arising under title 11 or arising in or related to a case under title 11.” The Seventh Circuit's conclusion that bankruptcy courts cannot preside over any aspect of certain “core” proceedings is inconsistent with the unqualified referral authorization in Section 157(a), which contemplates withdrawal of the reference only upon “cause shown.” 28 U.S.C. ' 157(d).

Indeed, many jurisdictions have amended their standing orders of reference to expressly authorize bankruptcy courts to issue proposed findings and conclusions in a “core” proceeding in which the bankruptcy court cannot enter final judgment. Whether accomplished through modification of the district's standing order of referral or handled on an ad hoc basis through orders of referral in specific proceedings, referral of a “core” proceeding to the bankruptcy court with the instruction to oversee pretrial matters and issue proposed findings and conclusions appears to be consistent with Section 157.

Of course, concluding that referral of a “core” proceeding (or a “non-core” proceeding, for that matter) to the bankruptcy court for pretrial matters and proposed findings and conclusions is consistent with Section 157 does not resolve the question of whether such referral is constitutional absent consent, particularly where litigants in a referred matter may have no access to an Article III judge until after issuance of proposed findings and conclusions. Indeed, the Wellness International court expressed concerns about whether Section 157(c)(2), which authorizes parties to consent to judgment by a bankruptcy court in a “non-core” dispute, properly authorizes bankruptcy courts to exercise Article III judicial power.

A subsequent panel of the Seventh Circuit, however, has already answered that question, finding that consent is sufficient to permit the bankruptcy court to enter final judgment. See Peterson v. Somers Dublin Ltd., 2013 U.S. App. LEXIS 18650, Nos. 12-2463 (7th Cir. Sept. 6, 2013). Nevertheless, all eyes will be on the Supreme Court in Bellingham to see how these statutory and constitutional issues are resolved.

Dion W. Hayes,' a member of this newsletter's Board of Editors, and Aaron G. McCollough are attorneys in the Restructuring & Insolvency Group of McGuireWoods LLP. The views expressed in this article are those of the authors and do not necessarily represent the views of McGuireWoods LLP or its clients.'