The Bankruptcy Exception to State Sovereign Immunity

On January 23, 2006, the U.S. Supreme Court handed down its decision in Central Virginia Community College v. Katz
[1], holding that a state cannot assert its sovereign immunity as
grounds to block the avoidance of a preferential transfer to a state
agency under § 547(b)
of the Bankruptcy Code [2]. At the heart of the matter was whether
Congress overstepped its constitutional power when it enacted § 106(a) of the Code, which waives state sovereign immunity in bankruptcy.

However fair the outcome may be, the rationale of the Court cannot
be reconciled with its prior decisions addressing Congress's ability to
waive state sovereign immunity under its Article I powers. Indeed the
Court's theory of implied waiver does little to justify why there
should be a "bankruptcy exception" at all. On its face, Katz
may be expected to open the door to broader Congressional abrogation of
state sovereign immunity in the future, but the addition of Justice
Alito to the bench almost certainly promises that Katz will receive a very narrow reading when the issue next reaches the Court.

The Contours of State Sovereign Immunity and Congressional Authority to Abrogate

The principle of sovereign immunity gives each state inherent and
constitutionally protected immunity against suit by its citizens or
citizens of another state, without its consent. [3] Such consent may be
explicit in a state's constitution or statute, or may be imposed by
implication from federal constitution or statute. "When a state submits
itself, without reservation, to the jurisdiction of a court in a
particular case, that jurisdiction may be used to give full effect to
what the state has by its act of submission allowed to be done." [4]
The restriction on a court's exercise of jurisdiction is two-fold: "a
State's constitutional interest in immunity encompasses not merely
whether it may be sued, but where it may be sued." [5] Thus the waiver
of sovereign immunity allowing jurisdiction of federal courts must be
unequivocal.

The Supreme Court's ruling in Seminole Tribe of Florida v. Florida
[6] set out a two-prong test for determining whether an act of Congress
validly abrogates state sovereign immunity: (1) Congress must have
unequivocally expressed its intent to do so, and (2) Congress must have
acted within its constitutional powers. Applying this test, the Court
upheld Florida's assertion of sovereign immunity and rejected the
contention that Congress could lawfully circumvent the restriction that
the Eleventh Amendment placed on the federal court's subject matter
jurisdiction through its Article I powers. [7]

The Bankruptcy Clause [8] give power to Congress to establish
uniform laws on bankruptcy and is likewise in Article I of the
Constitution. The Seminole Tribe opinion pointed out that "[a]lthough
the copyright and bankruptcy laws have existed practically since our
Nation's inception, and the antitrust laws have been in force for over
a century, there is no established tradition in the lower federal
courts of allowing enforcement of those federal statutes against the
States." [9] Although dicta, the Court's statement here is so closely
tied to the logic of its holding that it was followed by six of the
seven U.S. Circuit Courts of Appeal to reach the issue of abrogation in
the bankruptcy context. It is surprising then that after Katz, such a seemingly contradictory case remains good law.

Sidestepping Seminole Tribe: The Bankruptcy Exceptionalism Theory

Katz further carves out a "bankruptcy exception" to the
sovereign immunity trump card played by states and state agencies to
avoid suit in Federal Courts. Functionally, the decision ensures that
when states act as market participants, they are treated equal to other
creditors under the Code.

The Sixth Circuit was the first to distinguish Seminole Tribe as applied to the Bankruptcy Clause. In Tennessee Student Assistance Corp. v. Hood
[10] the United States Supreme Court affirmed the Sixth Circuit's
finding that the assertion of immunity could not be squared with the
uniformity requirement of the Bankruptcy Clause and therefore held that
states must be subject to the finality of discharge. The Court's
rationale in Hood avoided a direct evaluation of Congress's ability to abrogate sovereign immunity through § 106(a) of the Code under the Seminole Tribe test. Instead the Court decided that since bankruptcy courts have in rem jurisdiction over discharge, it is not subject to the Eleventh Amendment protection of sovereign immunity. The in rem
jurisdiction of the bankruptcy courts is not considered to offend
sovereign immunity because it is "premised on the debtor and his
estate, not on the creditors." [11]

Katz arises from the failure of Wallace's Bookstores, Inc., a
campus bookstore operator. While insolvent, Wallace's made payments on
its debts to four state higher-education institutions, including
Virginia Community College. Katz, as liquidating trustee for Wallace's,
initiated adversary proceedings against the schools to avoid those
payments as allegedly preferential transfers under § 547(b)
of the Code. Avoidance generally is a means to invalidate pre-petition
transfers of money or property while a debtor was insolvent, to enhance
the value of the bankruptcy estate for the benefit of all the
creditors. When bankruptcy is imminent, it is contrary to the policy of
'equitable distribution among similarly situated creditors' that one
should be paid in full while the others share in what's left. The
avoidance and recovery provisions of the Code allow the trustee to take
property that the transferee has a lawful claim to, to prevent such
'preferential' treatment. Virginia Community College promptly moved to
dismiss the case in the bankruptcy court for lack of subject matter
jurisdiction, based upon its sovereign immunity as an arm of the state.

The United States Supreme Court had previously heard the question of
whether a trustee can avoid a preferential transfer made to a state
agency in Hoffman v. Conn. Dept. of Income Maintenance. [12] In
that case, the trustee initiated proceedings in the bankruptcy court to
avoid the payment of state taxes, interest, and penalties as
preferential transfers under § 547(b). However, the Supreme Court's reading of § 106
did not convince it that the intent of Congress to abrogate state
sovereign immunity was unequivocally clear. Hoffman lead to revision of
§ 106
in 1994 as follows: "(a) Notwithstanding an assertion of sovereign
immunity, sovereign immunity is abrogated as to a governmental unit to
the extent set forth in this section with respect to [multiple
sections] of this title." In Hood, the Supreme Court had
explicitly distinguished the finality of discharge from an avoidance
proceeding against the state. The stage was set for the next challenge.

In advance of the Katz decision, many commentators anticipated that the Court would "dodge the bullet" of abrogation once again, as it had in Hood. So it was somewhat of a surprise when the Court reached the issue head-on. In evaluating the legality of the new § 106(a),
the Court decided that the "enactment of that provision was not
necessary to authorize the Bankruptcy Court's jurisdiction over these
preference avoidance proceedings." [14] Instead, the Court rested its
holding upon the notion that in ratifying the Constitution, the states
had impliedly waived their inherent sovereign immunity with respect to
the exercise of any power that was granted exclusively to Congress.

"The
bankruptcy exceptionalism theory… posits that the constitutional
requirements of uniformity distinguishes Congress's Bankruptcy Power
from Congress's other Article I powers…" [15]

Justice Stevens, who filed a dissent in Seminole Tribe,
finally had his day. In his opinion, joined by Justices O'Connor,
Ginsburg, Breyer, and Souter, Stevens delved deep into the history of
the Constitutional Convention. Katz holds the state's immunity is subordinated so far as it is necessary for the bankruptcy courts to effectuate their in rem
jurisdiction: "Congress may, at its option, either treat States in the
same way as other creditors insofar as concerns 'Laws on the subject of
Bankruptcies' or exempt them from the operation of such laws. Its power
to do so arises from the Bankruptcy Clause itself; the relevant
'abrogation' is the one effected in the plan of the Convention, not by
statute." [16]  Justice Thomas scratches his head in dissent, wondering
how Katz can possibly be reconciled with Seminole Tribe and even Hoffman: "This conclusion cannot be justified by the text, structure, or history of our Constitution." [17]

In reporting the decision, one media source speculated that "the
ruling overturns the sovereign immunity defense long used by states in
federal bankruptcy cases and might mean that taxpayers' money can be
used to pay creditors in some bankruptcy cases." [18] Not likely. The Katz
decision is likely to be construed very narrowly (if it survives) when
the issue next reaches the high court. The departure of Justice
O'Connor undermines the Katz majority, given that Justice Alito
will almost certainly join Justices Thomas, Scalia, Roberts, and
Kennedy in taking the contrary position. While some limitation and
clarification of the announced doctrine may be warranted, it
nonetheless succeeds in ensuring basic fairness to creditors that is a
hallmark of the bankruptcy scheme.

Sources

[1] 126 S. Ct. 990 (2006).

[2] 11 U.S.C. § 547 (West 2005) [11 U.S.C. § 101 et seq hereinafter the Code].

[3] U.S. Const. amend. XI.

[4] Smith v. Reeves, 178 U.S. 436, 440 (1900).

[5] Pennhurst State School & Hosp. v. Halderman, 465 U.S. 89, 99 (1984).

[6] 517 U.S. 44 (1996).

[7] Id at 73. Seminole Tribe held that notwithstanding the
fact that Congress clearly intended to abrogate state immunity under
the Indian Gaming Regulatory Act (permitting a cause of action for
State's failure to negotiate in good faith), the so-called Indian
Commerce Clause, U.S. Const. art. 1, § 8, cl. 3 did not grant Congress that power.

[8] U.S. Const. art. 1, § 8, cl. 4.

[9] Seminole Tribe, 517 U.S. at 73.

[10] 541 U.S. 440 (2004).

[11] Id. at 447.

[12] 492 U.S. 96 (1989).

[13] 11 U.S.C. § 106(a) (West 2005).

[14] Katz, 126 S. Ct. at 995.

[15] Ralph Brubaker, Abrogation of State Sovereign Immunity
Through Congress's Bankruptcy Power: Considering the Framers' Intent
with Respect to the Attributes of Sovereignty, Uniformity, and
Bankruptcy Exceptionalism
, 23 Bankr. L. Ltr., Mar. 2003, at 4.

[16] Katz, 126 S. Ct. at 1005.

[17] Id. at 1006 (Thomas, J., dissenting).

[18] Jim Jordan, States May be Sued in Bankruptcies, Lexington Herald-Leader, Jan. 31, 2006, available at http://www.kentucky.com/mld/kentucky/business/13752791.htm (last visited Feb. 20, 2006). Wallace's was a Lexington-based company.

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