Resolving a split among the circuits regarding the constitutionality of 11 U.S.C. §106(a), the Supreme Court held, in a 5-4 decision, that lawsuits to avoid preferential transfers brought in federal bankruptcy court against states or state agencies are not barred by the doctrine of sovereign immunity established by the Eleventh Amendment. Central Virginia Community College v. Katz, 126 S.Ct. 990 (2006). The decision retreated from statements contained in Seminole Tribe of Florida v. Florida, 517 U.S. 44 (1996), in which the Supreme Court indicated that the sovereign-immunity defense would apply in bankruptcy-related proceedings. The decision constitutes the second decision by the Supreme Court limiting, in the bankruptcy arena, the application of the broad sovereign-immunity doctrine articulated in Seminole Tribe. In 2004, the Supreme Court held that sovereign immunity did not bar an individual debtor's action in federal bankruptcy court seeking a hardship discharge of student loan debt. Tennessee Student Assistance Corp. v. Hood, 541 U.S. 440 (2004).

Tortured History

States' sovereign immunity from suit in federal court began shortly after ratification of the Constitution when the Supreme Court, in Chisholm v. Georgia, 2 U.S. (2 Dall.) 419 (1793), permitted a suit by a citizen of the state of South Carolina against the state of Georgia to proceed in federal court based on diversity of citizenship. The Eleventh Amendment, which provides that "the judicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by citizens of another state, or by citizens or subjects of any foreign state," was enacted in response to the Chisholm decision. Young, Gordon, Comment: Seminole Tribe v. Florida, 56 Md. L. Rev. 1411, 1413 (1997).

The presupposition underlying the Eleventh Amendment is that the states retain certain attributes of sovereignty and that it would violate the sovereignty retained by the states for the federal courts to exercise jurisdiction over them without their consent. Hans v. Louisiana, 134 U.S. 1, 15 (1890). Sovereign immunity under the Eleventh Amendment is not limited to suits based on diversity of citizenship, but also bars suits against a state by its own citizens (Edelman v. Jordan, 514 U.S. 651, 662-663 (1974)) and suits invoking federal question jurisdiction under Article 3 of the Constitution. Idaho v. Coeur d'Alene Tribe of Idaho, 517 U.S. 44 (1997).

The seminal modern case addressing sovereign immunity is Seminole Tribe of Florida v. Florida, 517 U.S. 44 (1996). In Seminole Tribe, the Supreme Court addressed a challenge by the state of Florida to certain provisions of the Indian Gaming Regulatory Act, which Congress had passed pursuant to the Indian Commerce Clause of Article 1 of the Constitution. Seminole Tribe, 517 U.S. at 47. The state of Florida contended that the Indian Gaming Regulatory Act's provisions authorizing a tribe to bring suit in federal court in order to compel performance of the statutory duty imposed upon states to negotiate in good faith with the tribes regarding gaming activities violated the Eleventh Amendment. Id.

Reasoning that the Eleventh Amendment restricts the judicial power under Article III and that Article I cannot be used to circumvent the constitutional limitations placed on the jurisdiction of the federal courts, the Supreme Court enunciated a two-part test to determine whether specific legislation validly abrogates state sovereign immunity. First, a court must determine whether there is an unequivocal expression of congressional intent to overturn constitutionally guaranteed immunity. If the congressional intent is clear, courts then must determine whether Congress acted pursuant to a valid grant of power to it by the states in the Constitution itself. Seminole Tribe, 517 U.S. 44, 72-73. The Supreme Court determined that the provision of the Indian Gaming Regulatory Act permitting tribes to sue states in federal court violated this test, stating that "even when the Constitution vests complete lawmaking authority over a particular area, the Eleventh Amendment prevents congressional authorization of suits by private parties against unconsenting states." Seminole Tribe, 517 U.S. 44, 72-73.

This decision expressly overruled the Supreme Court's decision in Pennsylvania v. Union Gas Co., 491 U.S. 1 (1989), in which the Supreme Court held that Congress could enact legislation pursuant to its powers under Article I of the Constitution, specifically the Interstate Commerce Clause of the Constitution, abrogating the sovereign immunity of the states. After Seminole Tribe, the Supreme Court reaffirmed its holding that Congress may not abrogate sovereign immunity under the Eleventh Amendment based on powers enumerated in Article I of the Constitution. See Board of Trustees of Univ. of Alabama v. Garrett, 531 U.S. 356, 362 (2001).

Relevant to bankruptcy practitioners, the majority in Seminole Tribe addressed, in a footnote, Justice Stevens' assertion in his dissenting opinion that the majority opinion prohibits "federal jurisdiction over suits to enforce the bankruptcy, copyright and antitrust laws against the states." Seminole Tribe, 517 U.S. at 73 n. 16. The majority dismissed this conclusion as "exaggerated both in its substance and its significance," noting that "although 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." Id.

The Circuits Split

In the wake of the Seminole Tribe decision, the majority of circuit courts, relying, in part, on the language contained in footnote 16 of the Seminole Tribe decision, concluded that §106(a) was unconstitutional and did not abrogate state sovereign immunity. For example, the Fourth Circuit, in two separate cases, concluded that §106(a) of the Code, as applied in the case before it, was unconstitutional. Maryland v. Schlossberg (In re Creative Goldsmiths of Washington D.C.), 119 F.3d 1140, 1147 (4th Cir. 1997); In re NVR LP, 189 F.3d 442 (4th Cir. 1999) (despite federal court ruling that debtor was exempt from Maryland and Pennsylvania transfer and recording taxes, Fourth Circuit permitted Maryland and Pennsylvania to retain transfer and recording taxes paid by debtor).

Likewise, in Sacred Heart Hosp. v. Department of Public Welfare (In re Sacred Heart Hosp.), 133 F.3d 237, 243 (3d Cir. 1998), the Third Circuit concluded that certain Pennsylvania agencies were immune from suit in federal court by the debtor hospital under the Eleventh Amendment notwithstanding the purported abrogation of sovereign immunity in §106(a). Relying on Seminole Tribe, the Third Circuit reasoned that there simply was "no principled basis to distinguish the Bankruptcy Clause from other Article 1 clauses." In Mitchell v. Franchise Tax Bd. (In re Mitchell), 209 F.3d 1111, 1121 (9th Cir. 2000), the Ninth Circuit affirmed the dismissal of an adversary proceeding brought by chapter 7 debtors seeking a determination of the dischargeability of tax debt on the basis that the suit was barred by the Eleventh Amendment.

In contrast, the Sixth Circuit concluded that Congress could enact legislation under the Bankruptcy Clause abrogating the immunity of the states from suit in adversary proceedings in bankruptcy courts. Hood v. Tennessee Student Assistance Corp. (In re Hood), 319 F.3d 755, 764-768 (6th Cir. 2003). Hood involved an adversary proceeding brought by a chapter 7 debtor against the Tennessee Student Assistance Corp. (TSAC) seeking a hardship discharge from student loan debt pursuant to §523(a)(8) of the Code. TSAC moved to dismiss the adversary proceeding on the basis of sovereign immunity. The Sixth Circuit concluded that the suit was not barred by sovereign immunity because it was not an instance in which a private party could drag a state into court against its will but involved an adjudication of interests claimed in a res, in which the TSAC could assert an interest or decline to do so. Id. at 768.

The Supreme Court granted certiorari to resolve the split among the circuits regarding Congress' power to abrogate state sovereign immunity under the Bankruptcy Clause, but ultimately determined the Hood case on different grounds. Specifically, the Supreme Court held that sovereign immunity was not implicated in the determination of whether the debtor was entitled to a hardship discharge because that determination fell within the exercise of the bankruptcy court's in rem jurisdiction. "A bankruptcy court's in rem jurisdiction permits it to 'determin[e] all claims that anyone, whether named in the action or not, has to the property or thing in question.'" Hood, 541 U.S. at 448.

Adding to the confusion regarding the application of sovereign immunity were holdings that, just as a creditor could waive its Seventh Amendment right to a jury trial by filing a proof of claim pursuant to the Supreme Court's holding in Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989), a state could waive any sovereign immunity to which it may otherwise be entitled under the Eleventh Amendment by merely filing a proof of claim in a bankruptcy case. See, e.g., In re Barrett Refining Corp., 221 B.R. 795, 809-810 (Bankr. W.D. Okla. 1998); In re Stoecker, 202 B.R. 429, 448 (Bankr. N.D. Ill. 1996). Reliance for this result was placed in part on the Supreme Court's holding in New York v. Irving Trust Co., 288 U.S. 329, 333 (1933).

Katz Presents the Issue Squarely

In Katz, Bernard Katz (the trustee), the liquidating supervisor for the bankruptcy estate of Wallace Bookstores Inc., filed complaints against four Virginia state colleges that alleged that the state colleges received preferential transfers during the 90-day period before Wallace commenced its chapter 11 case. Wallace had operated a chain of college bookstores. Only one of the four institutions sued by the trustee, Virginia Military Institute, had filed a proof of claim in Wallace's bankruptcy case. In the adversary proceedings, Katz sought to avoid the transfers and entry of money judgments against the state colleges pursuant to §§547 and 550 of the Code. The state colleges filed motions to dismiss the lawsuits on the grounds that the claims were barred by the doctrine of sovereign immunity under the Eleventh Amendment. Central Virginia Community College v. Katz, 126 S.Ct. 990, 994-995 (2006).

The Supreme Court primarily relied on the history surrounding the adoption of the Constitution's Bankruptcy Clause in reaching the conclusion that the lawsuits were not barred by the doctrine of sovereign immunity. The Court noted the statements in the majority and dissenting opinions in Seminole Tribe that indicated that the holding therein would apply to the Bankruptcy Clause, but dismissed those statements as dicta. In reaching its conclusion that the lawsuits were not barred by the Eleventh Amendment, the Supreme Court emphasized that the "critical features" of every bankruptcy proceeding are the exercise of exclusive jurisdiction over the debtor's property, the equitable distribution of the debtor's property and the discharge of the debtor's indebtedness. Id. at 996-997.

The Court further reasoned that one of the principal reasons the Bankruptcy Clause was included in the Constitution was to resolve the inconsistency among debt laws in the states (noting that the only consistency was the use of imprisonment for debt by every state) and the perceived inequity of debtors discharged in one state as a result of turning over all of their assets for liquidation being imprisoned in another state for the same debts. The Supreme Court also noted that the federal habeas corpus power was applied to prisoners held in state prison after being discharged of their debts by another state for approximately 67 years before the federal habeas corpus power became applicable to all prisoners. Id. at 1003.

After examining the historical context in which the Bankruptcy Clause was adopted, the Supreme Court concluded that the Bankruptcy Clause was intended not only to grant Congress power to enact a uniform federal bankruptcy law, but also as a consent by the states to waive state sovereign immunity in the bankruptcy arena, including in actions to avoid preferential transfers. Id. at 1002. Accordingly, the state college defendants were not protected by sovereign immunity under the Eleventh Amendment from suits to avoid preferential transfers.

In dissent, Justice Thomas (joined by Chief Justice Roberts and Justices Scalia and Kennedy) argued that the grant of authority to enact a uniform federal bankruptcy law and the use of habeas corpus to remove debtors from state prisons did not mean that the states consented to being sued for the entry of money judgments in federal court. Justice Thomas noted that for most of the Nineteenth Century, no national bankruptcy law existed. He argued that this fact refuted the majority's view that a national bankruptcy law was of such importance to the framers that the states intended to consent to the jurisdiction of federal courts in the bankruptcy arena through the Bankruptcy Clause. Katz, 126 S.Ct. at 1009-1010 (Thomas, J., dissenting). The dissent further argued that the framers' concern with discharge orders entered by one state binding other states implicated no more than the application of the full faith and credit provisions of the Constitution and had nothing to do with state sovereign immunity. Finally, the dissent noted that in Hood, the Supreme Court distinguished avoidance actions against states from discharge proceedings and emphasized that the majority's decision fell outside any possible in rem exception to sovereign immunity. Id. at 1013.