Bankruptcy court can be an effective forum to deal with aggressive actions by state or state agencies given the recent decision to waive sovereign immunity

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The Eleventh Amendment preserves the right of states to assert immunity from prosecution in federal courts. However, the sovereign immunity enjoyed by states is not absolute. The exceptions to this immunity generally fall into three categories: a state may expressly consent to bring an action in a federal court by voluntarily invoking the jurisdiction of the federal courts; Congress can revoke state immunity from prosecution by unequivocally expressing its intention to do so under valid constitutional authority; and, in ratifying the Constitution of the United States, states have consented to certain waivers of their sovereign immunity. Section 106 of the Bankruptcy Code sets out a list of bankruptcy actions that are not subject to the defense state assertion of sovereign immunity. Up to Central Virginia Community College c. Katz, 546 US 356, 378 (2006), questions relating to sovereign state immunity in bankruptcy cases were generally dealt with under the second statutory repeal exception. In Katz, the Supreme Court determined that the third exception to sovereign immunity could include the bankruptcy clause in Article I of the United States Constitution and held that the waiver extended to the property of the debtor and to the actual jurisdiction of the bankruptcy court.

The recent decision of Davis v. State of California (In re Venoco), 998 F.3d 98 (3d Cir. 2021) extends the third exception based on Katz a claim for damages against a public body in adversarial proceedings initiated by a litigation trust established under a reorganization plan. The rationale for Venoco provides an analytical framework to assess the extent of such a waiver. In an era of increasing involvement and regulation of various government agencies in companies eligible for bankruptcy relief, the Venoco The decision is an important development in assessing the extent to which a troubled company can respond to the action of a government unit in bankruptcy proceedings.

context

Venoco LLC and its affiliated debtors operated a drilling rig off the coast of Santa Barbara, California, processing and refining oil and gas at a nearby facility. Venoco owned the processing facility. It did not own the drilling rig, but leased it to the State of California, acting through its Land Commission. A pipeline rupture in 2015 led Venoco to seek Chapter 11 relief, reorganization and emergence in 2016. Its struggles, however, continued and Venoco again filed for Chapter 11 bankruptcy in 2017. The day Venoco filed for bankruptcy again. started her second business, she abandoned her leases and drilling rig operations. The Land Commission took over, decommissioning platforms and plugging abandoned wells. Initially, there was an agreement to pay Venoco to continue operating the drilling rig and processing facility, which was later supplanted by a third-party contractor taking over Venoco’s operations. At this point, the Land Commission and Venoco reached an agreement whereby the Commission would compensate Venoco for the use of the treatment facility still owned by Venoco. During the Chapter 11 case, the Lands Commission asserted its rights as a creditor of Venoco, filing a claim for reimbursement of the costs of plugging and dismantling as well as the costs of operating the platform. and the processing facility. After negotiations to sell the treatment facility to the Land Commission failed, the Commission stopped payments to Venoco under the agreement, but continued to use the treatment facility, arguing that the protection of the The environment and public safety by relying on its police powers justified this action. As part of the Chapter 11 plan, the assets of Venoco, including the processing facility, were transferred to a liquidation trust. The trustee then filed adversarial proceedings against the State of California and its Land Commission to recover the value of the processing facility which, according to the trustee, had in fact been taken by the government defendants, arguing a demand for conviction. reverse.

State defendants have filed motions to dismiss, arguing, among other things, that the sovereign immunity provisions of the Eleventh Amendment preclude the action of the liquidator. The bankruptcy court rejected this argument. On appeal, the defendants raised a further argument of sovereign immunity under state law. District court upheld bankruptcy court ruling on Eleventh Amendment immunity and dismissed state law immunity argument for failing to raise it in lower court . The State appealed against this decision to the third circuit.

The analytical framework: function rather than form

The Court of Appeal considered cases involving the waiver of sovereign immunity in bankruptcy cases under the second exception to sovereign immunity — the express repeal by Congress. He then focused on a Supreme Court case in which the lower court had determined that the Bankruptcy Code validly repealed state sovereign immunity by providing for a release of student debt guaranteed by a public body. Rather than relying on statutory repeal, the Supreme Court instead asserted on the basis of its conclusion that when “the bankruptcy court’s jurisdiction over the res is unchallenged … the exercise of its jurisdiction in rem to discharge a debt does not affect the sovereignty of the State ”. Tennessee Student Assistance v. Hood, 541 US 440, 448 (2004). The Court of Appeal then turned to Katz, summarizing its decision as excluding a “defense of sovereign immunity in a proceeding which strengthens the in rem jurisdiction of a bankruptcy court, regardless of the technical classification of that proceeding”.

Certainly Katz did not define the range of procedures that strengthen the in rem jurisdiction of a bankruptcy court, but the Court of Appeal observed that Katz identified the three critical functions of bankruptcy as: “[1] the exercise of exclusive jurisdiction over all the debtor’s assets, [2] the equitable distribution of such assets among the debtor’s creditors, and [3] the ultimate discharge which gives the debtor a “new start” by freeing him from all responsibility for old debts. In this context, the central question is whether a procedure advances one or the other of these three functions.

In this case, the court determined that adversarial proceedings favor the exercise of jurisdiction over debtors’ property and their property by seeking to rule on rights in the processing facility, noting that although adversarial proceedings do not or not clearly in rem in form, its function is to decide the rights to the property of Venoco. The court also found that the adversarial procedure favors the second function, facilitating a fair distribution of the assets of the estate. By invoking sovereign immunity, the state is making free use of Venoco’s property while seeking to collect its claim against Venoco. The position of the State allows it to improve its status vis-à-vis other creditors by the sole fact of their status of State which can invoke sovereign immunity. The Court of Appeal held that the analysis did not focus on the impact on sovereign immunity, but on ensuring that sovereign immunity would not interfere with the bankruptcy court’s jurisdiction over property. inheritance and its orderly administration. The Court of Appeal relied heavily on what it identified as the underlying guiding principle Katz; that is, the bankruptcy clause has a unique history and is “sui generis … among the authorizations of Article I, the result being that federal courts could impose state sovereignty in bankruptcy proceedings ”.

The Court of Appeal then rejected the temporal distinction raised by the state. The argument that the trustee was not the debtor, nor the assets of the bankruptcy because the lawsuit was brought by a trust created by a Chapter 11 plan was unconvincing because the bankruptcy court retained significant control and oversight over the trust which existed primarily to facilitate the “equitable distribution” of the debtor’s property among its creditors.

Conclusion

This case brings together a series of decisions from the Supreme Court and other circuit appellate courts grappling with the extent of the waiver of sovereign immunity in bankruptcy. the Venoco Justification requires consideration of whether the assertion of sovereign immunity will interfere with one or more of the three essential functions of bankruptcy. Government action can have a significant impact on the ownership and operations of a business to the detriment of its stakeholders. It can also affect investors’ willingness to save a struggling business. Venoco represents the proposition that assertions of sovereign immunity can now be considered in the context of bankruptcy. The bankruptcy forum is not a bilateral adversity, but rather a collective and multilateral proceeding aimed at maximizing value for the benefit of all stakeholders, encouraging rescue and investment.

Increasing government involvement and presence in business circles will likely result in increased attention to the interplay of bankruptcy defenses and sovereign state immunity, as well as position and interest. economics of investors and lenders. Courts tend to recognize the unique story of bankruptcy and focus on its essential functions as an effective counterweight to the assertion of sovereign immunity. If this trend continues, investors will have a forum to make their voices heard and make their case for a fair distribution of a debtor’s assets as well as to gain assurance that the release of the debtor will protect their investment from harm. other state actions.

Corinne Boule is a partner of Jones Day.

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