In litigation, the first question is where should the claim be adjudicated. In bankruptcy matters, additional complexity is involved given that bankruptcy court jurisdiction is governed by a separate federal statute. In addition to needing to examine what matters can be heard by the bankruptcy court during the pendency of the bankruptcy case, courts also are asked to review what claims related to a Chapter 11 bankruptcy case can be heard by the bankruptcy court after the plan of reorganization is confirmed and becomes effective. In these situations, courts have held that the bankruptcy court's jurisdiction narrows after the Chapter 11 plan becomes effective.

The issue was recently considered by the U.S. District Court for the District of Colorado in Centrix Financial Liquidating Trust v. Sutton, (In re Centrix), Case No. 18-cv-02769-RBJ. The court ruled that, unlike a Chapter 11 reorganization case where the debtor emerges from Chapter 11 as an operating business, a bankruptcy court's jurisdiction does not narrow if the matter involves a liquidating trust whose only purpose is the administration of the bankruptcy estate.

The Claims at Issue

The debtor, Centrix Financial filed a Chapter 11 bankruptcy case in 2006. The Chapter 11 plan was confirmed in 2008. Under the plan, the bankruptcy estate assets were transferred to a trust, and Jeffrey A. Weinman was appointed as trustee and authorized to take any and all necessary actions to use the proceeds of the trust assets, including claims held by the estate, for distribution to creditors. The plan authorized the trustee to bring adversary proceedings based on estate claims. The plan noted that the claims were "likely the key source of any meaningful recovery to unsecured creditors."

The trustee brought claims in the bankruptcy case against Robert Sutton, the former CEO of the company, and his family, alleging that they "used the company as a vehicle to perpetrate a large-scale fraud scheme on the subprime auto-loan industry." Specifically, the trustee alleged that Sutton and his family siphoned off tens of millions of dollars for the benefit of his family and friends. The lawsuit settled for a "proportionally de minimus amount" because Sutton, his wife and their family trust represented via sworn declarations that they had practically no assets.

The trustee and the trust (the plaintiffs) brought a second action in 2018 alleging that the sworn declarations were fraudulent, and the defendants had transferred assets to other entities that were not disclosed to the trustee. The settlement agreement provided that the plaintiffs would receive a $15 million nondischargeable judgment if any of the financial disclosures submitted were materially false. The complaint alleged claims for breach of contract, fraudulent misrepresentation, fraudulent conveyance pursuant to state law, conspiracy to defraud creditors and the trust, aiding and abetting fraud, and fraudulent concealment. The plaintiffs later withdrew the breach of contract claim, but filed an amended complaint asserting additional federal bankruptcy avoidance claims. The plaintiffs alleged the jurisdictional basis for the claims was 28 U.S.C. Section 1331 and 1334(b).

Reorganization and Liquidation

The court began its analysis by noting: "Subject matter jurisdiction defines the court's authority to hear a given type of case." While state courts enjoy general jurisdiction, federal court jurisdiction is limited to the powers authorized by the Constitution and statute. Federal courts assume a matter lies outside of their jurisdiction unless the party asserting federal jurisdiction can establish that jurisdiction is proper.

In this case, the trustee alleged that the district court had jurisdiction under 28 U.S.C. Sections 1131 and 1334(b). Section 1331 grants federal courts the power to hear cases "arising under" or "arising in" a bankruptcy case. Because the court ultimately concluded that it had jurisdiction under Section 1334(b), it did not decide whether it had jurisdiction under Section 1331.

Section 1334(b) expressly grants federal district courts the power to hear a cause of action "related to" a bankruptcy case. Federal court jurisdiction under Section 1334(b) is broad, but not limitless. The opinion quotes opinions from the U.S. Courts of Appeal for the Tenth and Third Circuits that "The test for determining whether a civil proceeding is related in bankruptcy is whether the outcome of that proceeding could conceivably have any effect on the estate being administered in bankruptcy, such as altering the debtor's rights, liabilities, options or freedom of action in any way, thereby impacting on the handling and administration of the bankruptcy estate." The U.S. Supreme Court has stated that "causes of action owned by the debtor which become property of the estate are proceedings related to the bankruptcy."

The court noted that literal application of the rules stated above would strip the bankruptcy court of all post-confirmation jurisdiction because after the plan is confirmed the debtor's estate ceases to exist. Instead, most courts have ruled that bankruptcy jurisdiction remains, but "narrows" after confirmation. The court quoted the Third Circuits' rule that post-confirmation jurisdiction is proper when there is a "close nexus to the bankruptcy plan or proceeding … matters that affect the interpretation, implementation, consummation, execution or administration of the confirmed plan will typically have the requisite close nexus." Further, the opinion notes the rule is flexible and courts should make the determination on a case-by-case basis.

The court then reviewed the case law and concluded that "the overwhelming majority" of cases that have adopted the "close nexus" test involved a Chapter 11 reorganization plan and narrowed jurisdiction for a reorganized debtor operating in the marketplace after bankruptcy. In contrast, in cases where a liquidating plan was involved, most courts did not narrow post-confirmation jurisdiction. Those courts have reasoned that a liquidation's sole purpose is to implement an order of the bankruptcy court, and as such, any post-effective date litigation relates directly to the bankruptcy proceeding. As one court reasoned, when a debtor or trustee commences litigation designed to marshal the debtor's assets for the benefit of its creditors pursuant to a liquidating plan, "the compass of related to jurisdiction persists undiminished after plan confirmation." In this case, the court agreed with these decisions and ruled that post-confirmation jurisdiction does not narrow in a liquidation context.

The court then reasoned that the claims in the case before it were sufficiently related to the Centrix bankruptcy for four reasons. First, the Centrix plan authorized and required the trustee to take actions reasonably necessary to carry out the liquidating plan's primary purpose of reducing the debtors' assets to cash and making distributions to creditors. The lawsuit was the plaintiffs' attempt to execute the plan, which alone would satisfy the "close nexus" test. Second, the specific claims authorized under the plan were claims against the Suttons and the Supreme Court had ruled that estate claims are related to the bankruptcy. Third, the trust was a liquidating trust whose sole purpose was to implement and execute the plan, litigation involving a liquidating debtor relates more directly to a bankruptcy. Finally, the court reasoned that its decision did not clash with those courts who have narrowed post-confirmation jurisdiction in nonliquidating contexts.

Bankruptcy Court Hears Liquidation Trust Litigation

A successful Chapter 11 case is one in which a plan is confirmed by the court and becomes effective. It is well-established that a company can liquidate through Chapter 11 proceedings. As such, a debtor in Chapter 11 can either liquidate its business or reorganize its affairs and emerge from Chapter 11 as an operating company, utilizing the "fresh start" discharge provisions of the Bankruptcy Code. When the debtor liquidates then post-confirmation activity is usually carried out by a liquidating trust. The court in this case articulated why the scope of bankruptcy court jurisdiction is different in each scenario.

Andrew C. Kassner is the chairman and chief executive officer of Drinker Biddle & Reath, a national law firm with more than 635 lawyers in 12 offices. He chaired the corporate restructuring group for almost 20 years. He can be reached at [email protected] or 215-988-2554.

Joseph N. Argentina Jr. is an associate in the firm's corporate restructuring practice group in the Philadelphia and Wilmington, Delaware, offices. He can be reached at [email protected] or 215-988-2541.