Zazzali v. Swenson (In re DBSI, Inc.)

463 B.R. 709

56 Bankr.Ct.Dec. 16

In re DBSI, INC., et al., Debtors.James R. Zazzali, as Trustee of the DBSI Estate Litigation Trust created by operation of the Second Amended Joint Chapter 11 Plan of Liquidation, Plaintiff,

v.Douglas L. Swenson, et al., Defendants.

Bankruptcy No. 08–12687(PJW).

Adversary No. 10–54649(PJW).

United States Bankruptcy Court, D. Delaware.

Jan. 27, 2012.

West Codenotes

Prior Version Recognized as Unconstitutional

28 U.S.C.A. § 1471

Brian D. Nicholas, Deputy Attorney General, State of Idaho, Boise, ID, for the Movant States.

F. Mark Bromley, Assistant Attorney General, Wisconsin Department of Justice, Madison, WI, for the State of Wisconsin.Natasha M. Songonuga, Gibbons P.C., Wilmington, DE, Brian J. McMahon, Michael F. Quinn, Gibbons P.C., Newark, NJ, to James R. Zazzali, Trustee for the DBSI Estate Litigation Trust.

MEMORANDUM OPINION

PETER J. WALSH, Bankruptcy Judge.

This opinion is with respect to the motion to dismiss (the “Motion”) (Doc. # 103) the Third through Sixth Causes of Action in James R. Zazzali's (“Trustee”) Second Amended Complaint (the “Complaint”) (Doc. # 33). The Motion is filed by numerous states named by Trustee in the Complaint (the “Movant States”),¹ pursuant to Federal Rule of Civil Procedure 12(b)(6). ² Counts Three through Six seek to recover allegedly fraudulent transfers from the Movant States under § 544(b)(1) of the Bankruptcy Code, 11 U.S.C. §§ 101 et seq., incorporating applicable provisions of Idaho law. The principal question presented here is whether the Movant States sovereign immunity was abrogated for suits under § 544(b)(1) and relevant state laws. For the reasons discussed below, I find that it was abrogated and I will deny the Motion.

Background

DBSI, Inc. and certain of its affiliates filed bankruptcy petitions under chapter 11 of the Bankruptcy Code on November 6, 2008. A plan of liquidation was confirmed on October 26, 2010, resulting in the appointment of Trustee to administer the DBSI Estate Liquidation Trust (Doc. # 5924). As that confirmation order sets forth in greater detail, DBSI, Inc. and its affiliates were operated as a single enterprise under the control of a small group of insiders. ( Id. ¶ 27.) Trustee commenced this adversary proceeding to recover allegedly fraudulent transfers made to insiders and to recover transfers made on behalf of the insiders to the Movant States.³ Trustee seeks to recover transfers made in the two years prior to the petition date pursuant to § 548, and in the four years prior to the petition date under § 544(b)(1). The Motion does not address § 548, but challenges Trustee's right to seek recovery under § 544(b)(1), incorporating Idaho's fraudulent transfer statutes, Idaho Code Ann. §§ 55–906, 55–913, 55–914, 55–916, and 55–917 (the “State Laws”).⁴

The Movant States seek to dismiss Counts Three through Six under Federal Rule of Civil Procedure 12(b)(6). The Movant States concede that “[w]ith the exception of the sovereign immunity objections raised herein, the claim ... otherwise satisfies the requirements for such a claim,” at least for the purpose of the Motion. (Doc. # 103, at 4). Thus, the Motion squarely turns on the scope of the Movant States' sovereign immunity.

The Movant States argue that they did not waive sovereign immunity with respect to the relevant State Laws. They argue that for Trustee to assert claims under the State Laws, § 544(b)(1) requires the existence of an actual unsecured creditor who could successfully assert claims under the State Laws against the Movant States. Because the Movant States did not waive their sovereign immunity, they argue, no actual unsecured creditor could successfully assert claims under the State Laws against them. Therefore, the Movant States conclude that § 544(b)(1) cannot be satisfied and Counts Three through Six should be dismissed.

Trustee argues that the Movant States cannot use sovereign immunity as a defense against the State Laws. Trustee argues that in Cent. Va. Cmty. Coll. v. Katz, 546 U.S. 356, 126 S.Ct. 990, 163 L.Ed.2d 945 (2006), the Supreme Court held that the states subordinated their sovereign immunity rights to Congress's properly exercised Article I Bankruptcy powers. Congress, Trustee argues, properly exercised its Article I power in enacting 11 U.S.C. § 106(a)(1), ⁵ which expressly provides that sovereign immunity is abrogated as to “governmental units,” including the Movant States, with respect to § 544. This constitutional subordination, Trustee argues, applies to § 544(b)(1) and State Laws referenced through § 544(b)(1).⁶ Additionally, Trustee argues that he has rights greater than those possessed by the unsecured creditor upon whom a § 544(b)(1) claim is based. Therefore, Trustee concludes that sovereign immunity is no defense for the Movant States and that the Motion should be denied.

Standard of Review

In considering a motion to dismiss, I must accept all factual allegations as true, construe the complaint in the light most favorable to the non-movant, and determine whether, under any reasonable reading of the complaint, the non-movant may be entitled to relief. Rea v. Federated Investors, 627 F.3d 937, 940 (3d Cir.2010).

Discussion

The central question presented in the Motion is whether the Movant States sovereign immunity was abrogated for fraudulent transfer actions brought under § 544(b)(1) and the State Laws.

I find that the state sovereign immunity issue presented here is controlled by the Supreme Court's opinion in Katz, 546 U.S. at 356, 126 S.Ct. 990. As I view it, pursuant to Katz, I must determine (1) whether those who crafted the Bankruptcy Clause intended to give Congress the power to authorize courts to avoid fraudulent transfers and recover the relevant property, and (2) whether there is a relevant law on the subject of bankruptcy that Congress applied to the Movant States and other creditors in the same way. See Katz, 546 U.S. at 372, 379, 126 S.Ct. 990 (“[T]hose who crafted the Bankruptcy Clause would have understood it to give Congress the power to authorize courts to avoid preferential transfers and to recover the transferred property.... 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 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 [Constitutional] Convention, not by statute.”). I answer both of Katz's questions affirmatively. Therefore, I conclude that the Movant States cannot invoke sovereign immunity with respect to Trustee's Counts Three through Six.

No state sovereign immunity protection exists in proceedings pursuant to laws on the subject of bankruptcies, where such laws are properly labeled. ⁷ The Supreme Court held in Katz that this was an inescapable conclusion, based on the fact that states surrendered their relevant sovereign immunity in the plan of the convention. See Katz, 546 U.S. at 377, 126 S.Ct. 990 (“The ineluctable conclusion, then, is that States agreed in the plan of the Convention not to assert any sovereign immunity defense they might have had in proceedings brought pursuant to ‘Laws on the subject of Bankruptcies.’ ”).

One of the many reasons the states surrendered this immunity was to prevent assertions of sovereign immunity from frustrating equitable distributions of the res of the bankruptcy estate among a debtor's creditors. See Katz, 546 U.S. at 363–64, 126 S.Ct. 990. Another was to promote the debtor's “fresh start.” Id. These aims, and the desire for uniform application of the bankruptcy laws, would be jeopardized if the states were able to draw resources from the res or retain estate property when other creditors were unable to do so. See id. at 362–64, 126 S.Ct. 990 (discussing the importance of uniformity and noting that “states ... are bound by a bankruptcy court's discharge order no less than are other creditors.”) (citation and internal quotation marks omitted). Katz also described other historical problems that led to the states' surrender of sovereign immunity. See id. at 364–66, 375–77, 126 S.Ct. 990.

As Katz held, Congress “has the power to enact bankruptcy laws the purpose and effect of which are to ensure uniformity in treatment of state and private creditors.” Id. at 377 n. 13., 126 S.Ct. 990 With this power, Congress is authorized to treat state sovereigns the same way under the bankruptcy laws as it treats non-sovereign creditors. Id. at 379, 126 S.Ct. 990 (“Congress may, at its option, either treat [s]tates in the same way as other creditors insofar as concerns ‘Laws on the subject of Bankruptcies' or exempt them from 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.”). This power clearly includes, and is in fact, the ability to subordinate state sovereignty with respect to proceedings in the area of bankruptcy laws. Id. at 377, 126 S.Ct. 990 (“The power to enact bankruptcy legislation was understood to carry with it the power to subordinate state sovereignty, albeit within a limited [bankruptcy] sphere.”).

Moreover, contrary to the Movant States' contention, Katz held that the Eleventh Amendment did not secure sovereign immunity protection for unprotected areas exposed by the states' surrender in the plan of the convention. See Katz, 546 U.S. at 375, 126 S.Ct. 990 (“This history strongly supports the view that the Bankruptcy Clause of Article I, the source of Congress's authority to effect this intrusion upon state sovereignty, simply did not contravene the norms this [Supreme] Court has understood the Eleventh Amendment to exemplify.”).⁸

The Movant States direct my attention to Katz's discussion of in rem jurisdiction and matters ancillary to in rem jurisdiction, arguing that I should be concerned with K...