Third Circuit Decides Bankruptcy Case Addressing Sovereign Immunity

Admin on July 31, 2021 Posted in Bankruptcy News, Blog

Bankruptcy courts have long been overwhelmed with the question of how to apply sovereign immunity. The United States Supreme Court has issued some rulings about sovereign immunity, but has yet to write a definitive ruling about the issue. As a result, no definitive rulebook exists for how lower courts should interpret sovereign immunity issues. One federal circuit court, however, recently considered the issue of sovereign immunity in the Venoco case. 

The Role of Sovereign Immunity in Bankruptcy Cases

State governments can function as the creditors of debtors in bankruptcy. For example, states can end up functioning as tax collectors and lenders to debtors. States also sometimes function as the debtors of debtors. State governments can also function as the transferees of debtor property in every role in which they can be creditors. 

After Congress decided in the late 1970s that a new bankruptcy code should more specifically address a debtors’ assets and liabilities instead of the previous bankruptcy code. This made it more likely that the exercise of sovereign immunity by states would erode the treatment of a debtor’s assets and liabilities. Consequently, Congress established Section 106, which permitted bankruptcy courts to treat states like private parties. Section 106 also attaches waiver consequences to state actions in bankruptcies. Limits exist on the Congressional power to impact the sovereign immunity of a state due to the relationship between state and federal power. 

Section 106 states that bankruptcy courts can issue against a government order or judgment including a money recovery but not a punitive damage award. Section 106 also permits the enforcement of any such judgment or order against any government unit provided it is consistent with nonbankruptcy law. Section 106 also states that a government unit that has filed a proof of claim in a case is considered to have waived sovereign immunity with respect to a claim against a government unit that is the property of the estate. 

The Framework Behind Sovereign Immunity

For many years, bankruptcy courts considered sovereign immunity by analyzing the scope of Section 106, addressing the matter of how sovereign immunity is handled in bankruptcy cases. In one 2004 case, the United States Supreme Court avoided the issue of considering sovereign immunity. The Supreme Court, however, ultimately declined to address the constitutionality of the matter because the court found that sovereign immunity did not apply to the case.

In the 2006 case of Katz, the United States Supreme Court held that in ratifying the Constitution, the states gave up their sovereign immunity when it came to the administrative aspect of the bankruptcy process. This means that states abandoned things like the assertion of jurisdiction, debtor status, and distributions to creditors. The Katz court stopped short of addressing what matters can be tackled in bankruptcy without violating Section 106. 

How Venoco Arose

The debtors in Venoco oversaw drilling operations. Due to environmental concerns, some of these facilities were abandoned. The California Land Commission later exercised control over the drilling facilities in question. Following the confirmation of a Chapter 11 plan, a trustee initiated legal action against the Commission and the State of California for inverse condemnation requesting compensation for the condemnation of the facility. The state of California moved to dismiss the case based on sovereign immunity. The bankruptcy court denied the case, and the district court affirmed this decision. 

The Third Circuit noted in Venoco noted the existence of three categories: 

  • When exclusive jurisdiction is asserted over an estate’s property
  • When assets are fairly divided among creditors, and 
  • When debts are discharged so debtors can pursue new beginnings 

The framework allows courts to evaluate whether a particular issue lies outside the bounds of sovereign immunity. The issue of jurisdiction addresses legal proceedings that impact the property of the party pursuing bankruptcy, whether it be an organization or an individual. 

Applying this framework, courts have determined that states are without sovereign immunity in matters like contract disputes and turnovers. The issue of equitable distribution involves cases that impact on how assets are divided among creditors. Courts have determined that automatic stay violations disrupt this function. For the third category, courts have found states must adhere to the terms of bankruptcy discharges, regardless of whether they are engaged in the case. 

In the Venoco case, the Third Circuit determined two of these three functions were triggered. First, the case concerned assets belonging to an estate in the form of the rigging facility. Even though the trustee pursued  a money judgment for the facility’s value, the judgment’s form is not controlling, and instead, the substance is what is critical. Second, the court found the case also triggered elements of the division of debtor property. The federal court cited earlier documentation in the case where it was articulated that the rigging facility was valuable. The court additionally commented that the state had filed a claim in the case and that the state was allowed to recover on the claim while avoiding scrutiny for its actions involving the estate, the state would better its position and impact equitable distribution.

The court declined to find validity in the state of California’s claim that the court’s exercise of jurisdiction was terminated on the effective date of the debtor’s reorganization plan because the relevant property was no longer the estate’s property. The court determined that the lower court’s jurisdiction was not terminated on the reorganization’s plan effective date because the trust continued to exist and was established to make the division of property among the involved debtors easier. 

The state also attempted to argue that sovereign immunity existed under the California constitution. The federal court also denied this claim because the state had not raised this argument in lower court and therefore waived it. 

The third circuit also determined that the state was not immune from suit. Instead, the issue in question resolved around forum selection rather than sovereign immunity.

Speak with a Knowledgeable California Bankruptcy Attorney

If you or your loved one is navigating the bankruptcy process, you can quickly find yourself overwhelmed with the variety of issues that you must navigate. One of the best things that you can do in such a situation is to obtain the assistance of an experienced bankruptcy lawyer. Contact attorney Melanie Tavare today to schedule a free case evaluation.