07/21/2011 – Defendants’ Motion to Dismiss Adversary Proceeding filed in the Kimball Hill, Inc. Adversary Proceedings by Wisenbaker Builder Services, Inc. et al before Judge Sonderby in the Northern District of Illinois (Eastern) Filed by King & Spalding LLP (Houston, TX) Attorneys Henry J. Kaim, Edward L. Ripley, and Eric M. English; and Swanson, Martin & Bell, LLP (Chicago, IL) Attorney Darren B. Watts . Registered users click here to see a copy of this brief.

This is the second motion to dismiss by defendants Wisenbaker Builder Services, Inc. and Wisenbaker Builder Services, Ltd. (the “Defendants”) before U.S. Bankrutpcy Judge Susan Pierson Sonderby in the Northern District of Illinois. The first (“Wisenbaker I”) was notable both for its unsuccessful Fed. R. Civ. P. 12(b)(1) challenge to the standing of the litigation trust and for its successful Fed. R. Civ. P. 12(b)(6) challenge to the adequacy of the complaint. (See a discussion of Judge Sonderbby’s opinion KHI Liquidation Trust v. Wisenbaker Builder Services, Inc. et al (In Re Kimball Hill, Inc.), AP No. 10-00824 (Bankr. N.D. Ill. June 2, 2011) Defendants move to dismiss Plaintiff’s Second Amended Complaint on grounds of the Bankruptcy Court’s lack of subject matter jurisdiction is based on the United States Supreme Court’s recent decision in Stern v. Marshall, ___ U.S. , 131 S. Ct. 2594 (2011). Should the Bankruptcy Court hold that it has jurisdiction, Defendants request that the preference count of the Liquidation Trust’s Second Amended Complaint be dismissed with prejudice pursuant to rule 41(b) since “the Liquidation Trust Failed to comply with the terms of the Judge Sonderby’s Memorandum Opinion [in Wisenbaker I].”

Defendants challenge the bankruptcy court’s jurisdiction over both (1) a Bankruptcy Code Section 547 preference claim and (2) a fraudulent conveyance claim relying on both Bankruptcy Code Section 548 and the Illinois Uniform Fraudulent Transfer Act. The state law claim was made pursuant to Bankruptcy Code Section 544.

Defendants’ argument is deja vu the early 1980s when the last crisis of bankruptcy court jurisdiction arose. It hinges on the failure of either Defendant to have any pending proof of claim at the time the adversary proceeding was filed. The Defendants had filed proofs of claim in the bankruptcy cases of some of the debtors, but “these claims were either paid or resolved by prior Court Order [and] at the time this Adversary was filed… .” The Defendants primary arguments are contained in the following paragraphs.

A. This Adversary Proceeding Should Be Dismissed Pursuant to the Supreme Court’s Recent Decision in Stern v. Marshall

6.  The Supreme Court’s recent analysis of the jurisdictional limitations of the bankruptcy courts in Stern v. Marshall compels the conclusion that this Court lacks subject matter jurisdiction to resolve the Liquidation Trust’s preference and fraudulent transfer claims. See Stern v. Marshall, 131 S. Ct. 2594 (2011). Accordingly, as set forth below, this Court should dismiss this entire adversary proceeding with prejudice.

i. The Stern v. Marshall Decision

7. The primary issue in Stern was whether the bankruptcy court had the constitutional authority to render a final judgment on a debtor’s counterclaim for tortious interference against a creditor under 28 U.S.C. § 157(b)(2)(C).1 Id. at 2601. The Supreme Court held that bankruptcy courts “lack[] the constitutional authority to enter a final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim.” Id. at 2620.

8.  In so ruling, the Supreme Court first expounded upon the limited role of Article I bankruptcy courts in relation to Article III courts. The judicial power of the United States is vested in courts established under Article III of the Constitution. Id. at 2608. Article III and the safeguards within it are central to the Constitution’s separation of the legislative, executive, and judicial powers. Id. at 2609. Among other things, this separation of powers generally inhibits Congress’s ability to withdraw “any matter which, from its nature, is the subject of a suit at the common law, or in equity, or in admiralty” from the purview of Article III courts. Id. (quoting Murray’s Lessee v. Hoboken Land & Improvement Co., 59 U.S. 272 (1856)).

9.  Stern went on to explain, however, that the Supreme Court has recognized an exception to Article III’s general prohibition against “legislative” tribunals. Id. at 2610. Under the “public rights” doctrine, Congress may establish non-Article III courts to resolve matters “in connection with the performance of the constitutional functions of the executive or legislative departments . . . that historically could have been determined exclusively by those branches.” Id. (quoting Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50, 67-68 (1982) (plurality)). This “public rights” exception is limited “to cases in which the claim at issue derives from a federal regulatory scheme, or in which resolution of the claim by an expert government agency is deemed essential to a limited regulatory objective within the agency’s authority.” Id. at 2613. Further, in order to qualify as a “public right,” the right at issue must be “integrally related to particular federal government action.” Id. (citations omitted).

10.  Stern then summarized the Supreme Court’s prior decision in Granfinanciera, which held that the “public rights” doctrine does not encompass a bankruptcy trustee’s fraudulent transfer action against a non-creditor to the bankruptcy case:

[In Granfinanciera,] [w]e reasoned that fraudulent conveyance suits were “quintessentially suits at common law that more nearly resemble state law contract claims brought by a bankrupt corporation to augment the bankruptcy estate than they do creditors’ hierarchically ordered claims to a pro rata share of the bankruptcy res.” . . . As a consequence, we concluded that fraudulent conveyance actions were “more accurately characterized as a private rather than a public right as we have used those terms in our Article III decisions.”

Id. at 2614 (quoting Granfinanciera, S.A. v. Nordberg, 492 U.S. at 54-56) (emphasis added).

11. In Stern, the Supreme Court applied the “public rights” doctrine and Granfinanciera to the debtor’s tortious interference counterclaim. Stern found that the debtor’s “counterclaim—like the fraudulent conveyance claim at issue in Granfinanciera—does not fall within any of the varied formulations of the public rights exception in this Court’s cases” and, therefore, the “public rights” exception did not apply. Id.

12. As in Granfinanciera, the key distinction in Stern was that the debtor’s claim (i) functioned only to augment the estate and (ii) was independent of the claims allowance process. See id. at 2616. In the words of the Supreme Court, the creditor’s “claim for defamation in no way affects the nature of [the debtor's] counterclaim for tortious interference as one at common law that simply attempts to augment the bankruptcy estate—the very type of claim that we held in Northern Pipeline and Granfinanciera must be decided by an Article III court.” Id. (emphasis added). In fact, at the very least, Stern implies that the outcome would have been different if the nature of the debtor’s counterclaim was such that it would have necessarily been fully resolved through the process of ruling on the creditor’s proof of claim. Id. at 2620 (“The Bankruptcy Court below lacked the constitutional authority to enter a final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim.”) (emphasis added).

13.  According to Stern, the basis for this distinction is found in the Supreme Court’s decisions in Katchen and Langenkamp. See id. at 2616-19 (citing Katchen v. Landy, 382 U.S. 323 (1966); Langenkamp v. Culp, 498 U.S. 42 (1990) (per curiam)). In Katchen, the Supreme Court found that the bankruptcy court had jurisdiction to resolve a debtor’s preference action against a creditor—who had previously filed a proof of claim—because “it was not possible for the [bankruptcy] referee to rule on the creditor’s proof of claim without first resolving the voidable preference issue.” Id. at 2616 (citing Katchen, 382 U.S. at 329-330, 332-334, and n. 9). Katchen rejected the creditor’s theory that the preference action should be resolved through a “plenary suit” in an Article III court, finding that “[t]he plenary proceeding the creditor sought could be brought into the bankruptcy court because the same issue arose as part of the process of allowance and disallowance of claims.’” Id. (quoting Katchen, 382 U.S. at 336) (emphasis added).

13.  Likewise, in Langenkamp, the Supreme Court determined that “a preferential transfer claim can be heard in bankruptcy when the allegedly favored creditor has filed a claim, because then the ensuing preference action by the trustee become[s] integral to the restructuring of the debtor-creditor relationship.’” Id. at 2617 (quoting Langenkamp, 498 U.S. at 44) (emphasis added). Langenkamp cautioned, however, that if the creditor had “not filed a proof of claim, the trustee’s preference action [would] notbecome part of the claims-allowance process’ subject to resolution by the bankruptcy court.” Id. (quoting Langenkamp, 498 U.S. at 45). In the present proceeding, neither of the Defendants filed any proof of claim against the alleged transferor debtor, KHH Texas. Furthermore, neither Defendant has any pending proof of claim or claim allowance matter in these cases.2 Accordingly, this dispute does not involve the claim allowance process.

15.  In sum, Stern held that the bankruptcy court lacked constitutional jurisdiction even though the bankruptcy court was statutorily authorized by § 157(b)(2)(C) to render a final judgment on the debtor’s tortious interference counterclaim, a statutorily defined “core” matter. Id. at 2608, 2620. The counterclaim fell outside of the scope of the “public rights” doctrine because (i) its purpose was solely to augment the bankruptcy estate and (ii) it would not necessarily be resolved through the claims allowance process. Id. at 2614-2620.

ii. Stern Compels the Dismissal of this Adversary Proceeding

16. Although Stern’s specific focus was upon the bankruptcy court ‘s jurisdiction to resolve a tortious interference counterclaim, the decision’s language requires bankruptcy courts to consider whether they have constitutional jurisdiction to issue final judgments in all pending core proceedings under 28 U.S.C. § 157(b)(2). 3 See also Warth v. Seldin, 422 U.S. 490, 498 (1975)  (The requirements of Article III of the Constitution relative to the Court’s subject matter jurisdiction are “the threshold question in every federal case, determining the power of the court to entertain the suit”). Like the counterclaim in Stern, the Liquidation Trust’s preference and fraudulent transfer claims are defined as “core” under 28 U.S.C. § 157(b)(2). However, Stern held this definition is not controlling. Stern’s analysis is, therefore, fundamental to the resolution of the jurisdictional question in this case.

iii. The Court Lacks Jurisdiction Over the Fraudulent Transfer Claim

17. Granfinanciera and Stern establish that the Court lacks jurisdiction over the Liquidation Trust’s fraudulent transfer claim. In Granfinanciera, the Supreme Court determined that a trustee’s fraudulent transfer lawsuit against a non-creditor falls outside the scope of the “public rights” exception because such suits “more nearly resemble state law contract claims . . . to augment the bankruptcy estate than they do creditors’ hierarchically ordered claims to a pro rata share of the bankruptcy res.” Granfinanciera, 492 U.S. at 54-56. Stern demonstrates that such private rights lawsuits—involving merely the augmentation of the estate and not the claims allowance process—must be resolved by Article III courts.

18. The Liquidation Trust ‘s fraudulent transfer claim falls squarely within the framework established by Granfinanciera and Stern. The Defendants never filed a proof of claim against the alleged transferor debtor. The Defendants have no pending claims or allowance matters in the Debtors’ cases and thus, the Liquidation Trust’s fraudulent transfer claim is unrelated to the claims allowance process. Therefore, under Granfinanciera and Stern, the Liquidation Trust’s fraudulent transfer claim constitutes a private rights action merely seeking to augment the bankruptcy estate. This Court lacks subject matter jurisdiction to resolve it.

iv. The Court Lacks Jurisdiction Over the Preference Claim

19.  Stern, Langenkamp, and Katchen establish that this Court lacks jurisdiction to resolve the Liquidation Trust’s preference action. Langenkamp and Katchen hold that a bankruptcy court is authorized to resolve a preference claim when the claim is inextricably linked to the resolution of a creditor’s proof of claim. This authority is founded upon the bankruptcy court’s role in overseeing and adjudicating disputes concerning the claims allowance process. However, when the defendant in a preference lawsuit has “not filed a proof of claim, the trustee’s preference action [would] notbecome part of the claims-allowance process’ subject to resolution by the bankruptcy court.” Stern, 131 S. Ct. at 2617 (quoting Langenkamp, 498 U.S. at 45) (emphasis original).  A preference action that is unrelated to the claims allowance process functions solely to augment the bankruptcy estate. The holding in Stern requires that such claims, which only involve private rights, must be adjudicated by Article III courts.4

20. The Defendants in this case have not filed a proof of claim against the alleged transferor debtor’s estate. The preference cause of action does not involve the claim allowance process. Instead, the Liquidation Trust’s preference action seeks only to augment the bankruptcy estate. Accordingly, this Court lacks subject matter jurisdiction to resolve the Liquidation Trust’s preference action.

v. Dismissal is Proper Since the Court Also Lacks Authority to Issue Proposed Findings to the District Court

21.  Finally, because the Court lacks jurisdiction to resolve the Liquidation Trust’s preference and fraudulent transfer claims, the proper remedy is dismissal. The Court would be in error to retain jurisdiction over this Adversary for the purpose of submitting proposed findings of fact and conclusions of law to the district court since, under 28 U.S.C. § 157(c)(1), bankruptcy courts are only authorized to submit proposed findings of fact and conclusions of law in non-core5 , “related to” proceedings. There is no equivalent statutory authorization for a bankruptcy court to submit proposed findings of fact and conclusions of law in core proceedings. See 28 U.S.C. § 157(b)(1).

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