States: Get ready for litigation on bankruptcies

States, under a recent ruling by the Supreme Court, must prepare themselves for bankruptcy litigation.

In Central Virginia Community College, et al. v. Bernard Katz, Liquidating Supervisor for Wallace's Bookstores Inc. , (546 US __ (2006)), the Supreme Court makes a surprising statement: Based on the history of U.S. bankruptcy law, the states may not use the defense of sovereign immunity against proceedings necessary to effectuate the in rem jurisdiction of the bankruptcy courts, including suits by debtors and bankruptcy trustees to enforce discharges and recover preferences.

The Supreme Court previously held in Seminole Tribe of Fla. v Florida (517 US 44 (1996)), that, unless a law was passed under the authority granted by the 14th Amendment or the Interstate Commerce Clause, Congress did not have authority to abrogate the states' sovereign immunity. In Seminole, the Seminole Tribe of Florida sued the state of Florida under the Gaming Act for failure to negotiate in good faith. The Seminole court found that the Seminole Tribe's suit was prohibited, because the Gaming Act was passed under the 11th Amendment, which did not give Congress the power to abrogate sovereign immunity.

The Seminole holding appeared to be broad enough to immunize suits against the states brought according to the Bankruptcy Code, which was not passed following either the 14th Amendment or the Interstate Commerce Clause. This appearance, however, is "erroneous," according to the Central Virginia court.

As background for the Central Virginia decision, the court provides a detailed and thoughtful analysis of the history of U.S. bankruptcy laws. Unlike in England, where a discharge granted both release from prison and from creditors, the early bankruptcy laws in the United States — when they existed — were a patchwork of mismatched relief depending on the colony or state in which a beleaguered debtor found himself. Thus, a debtor could be discharged in one state, and find himself in prison for his debts in another.

It was against this background that Congress enacted the Bankruptcy Clause, Art. 1, §8, cl. 4, which provides that Congress shall have the power to establish "uniform laws on the subject of bankruptcies throughout the United States." Whether or not states choose to participate in a bankruptcy proceeding, they are bound by a bankruptcy court's discharge order, like all other creditors.

In fact, the history of the Bankruptcy Clause indicates that the states agreed not to assert immunity with respect to bankruptcy laws, because the whole point of the Bankruptcy Clause was to prevent the states from exercising separate and wildly competing jurisdiction over bankrupt persons. There is nothing in the background to the adoption of the Bankruptcy Clause, the court notes, that would contradict the plain intent of the Sixth Congress to give bankruptcy legislation the power to subordinate state sovereignty.

Therefore, the court concludes, it was within Congress' power to determine that states should be amenable to proceedings to recover preferential transfers, because that comes under Congress' power to enact "Laws on the subject of bankruptcies." However, Central Virginia is a 5-4 decision, with the chief judge in the minority. The dissent read the same history and came to the conclusion that when ratifying the Bankruptcy Clause, the states were merely giving Congress the power to legislate in the area, and were not surrendering their sovereign immunity in the process.

Central Virginia is a wake-up call to both businesses and the states — more assets may be available to creditors because bankruptcy trustees and debtors in possession can pursue preferences and fraudulent transfer actions against states. As a result, states must beware — the bankruptcy laws apply to you!