In a scholarly opinion, Chief Bankruptcy Judge Christopher S. Sontchi of Delaware explained when there is or is not a waiver of sovereign immunity allowing a debtor to sue a state or local government in bankruptcy court for a tax refund. The opinion could be applied in other contexts when a state or local government raises a sovereign immunity defense.
Judge Sontchi’s intricate dissection of the law features the triumvirate of Supreme Court opinions where the justices quickly backtracked in two later cases after having insinuated earlier in dicta that the waiver of sovereign immunity in Section 106(a) is unconstitutional. Were it not for the two later Supreme Court decisions coupled with astute analysis like Judge Sontchi’s, bankruptcy courts might lack the power to adjudicate the amount of a state’s claim against a debtor or to discharge a state tax claim.
The Facts in Judge Sontchi’s Case
In his 66-page opinion on July 25, Judge Sontchi carefully laid out the factual and procedural history of the claims for real estate tax refunds made by a trust created under a confirmed chapter 11 plan. He also minutely described the procedures a debtor must follow under California state law, as a predicate for seeking a refund in state court or bankruptcy court.
For the sake of understanding his conclusions, however, the essential facts are simple: Before bankruptcy, the debtor paid several years of real estate taxes on its electric generating plant. Also before bankruptcy, the debtor initiated proceedings before the California State Board of Equalization, or SBE, claiming refunds because the assessments were allegedly too high.
After confirmation, the creditors’ trust in substance filed suit against the SBE and the county, asking Judge Sontchi to value the property, reduce the assessments, and direct the county to pay refunds based on lower assessments. The SBE made the equivalent of a motion to dismiss, contending that sovereign immunity left the bankruptcy court without jurisdiction to lower the assessments.
Judge Sontchi agreed and dismissed the proceedings against the SBE seeking to lower the assessments.
The Statutory Waiver of Sovereign Immunity
The creditors’ trust sued under Section 505(a), which provides that bankruptcy courts, under certain circumstances, “may determine the amount or legality of any tax, . . . whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction.”
The Third Circuit, according to Judge Sontchi, has held that Section 505(a) is a jurisdictional statute that was enacted “to clarify the bankruptcy court’s jurisdiction over tax claims.”
The Third Circuit also held that a sovereign immunity defense is jurisdictional in nature. Thus, the Bankruptcy Code may confer jurisdiction through Section 505(a), but the court will have no jurisdiction if the government has a sovereign immunity defense. The state’s sovereign immunity (or lack of it) therefore comes to the fore.
Facially, however, Section 106(a)(1) by its terms abrogates sovereign immunity with respect to claims under Section 505. Judge Sontchi therefore analyzed whether Section 106(a)(1) withstood constitutional scrutiny to waive sovereign immunity for the trust’s suit under Section 505.
Governing Supreme Court Authority
In the Supreme Court’s seminal decision on sovereign immunity, Seminole Tribe of Florida v. Florida, 517 U.S. 44 (1996), the majority in the 5/4 decision used a footnote to describe a dissenter as interpreting the majority opinion to prohibit federal jurisdiction to enforce bankruptcy laws against the states. The majority said that the dissent’s conclusion was “exaggerated.” Id. at 72.
Two years later, the Third Circuit nonetheless applied Seminole Tribe to hold that Section 106(a) is “unconstitutional to the extent that it purports to abrogate state sovereign immunity in federal court.” Sacred Heart Hospital v. Dept. of Public Welfare (In re Sacred Heart Hospital), 133 F.3d 237, 245 (3d Cir. 1998). According to Judge Sontchi, most but not all circuits agree.
In bankruptcy cases, the Supreme Court later began to backtrack, else discharge, fresh start and reorganization might become unattainable for some debtors.
In Tennessee Student Assistance Corp. v. Hood, 541 U.S. 440 (2004), the high court was asked to decide whether Section 106(a) was unconstitutional.
The high court ducked the larger issue in Hood by holding that the dischargeability of a student loan was not a suit against the state in terms of Eleventh Amendment sovereign immunity. Rather, the Court said, discharge was an in rem proceeding where “the bankruptcy court’s jurisdiction over the res is unquestioned.” Id. at 448. The Court went on to say that “the exercise of its in rem jurisdiction to discharge a debt does not infringe state sovereignty.” Id.
Ducking the larger question again two years later, the Supreme Court held in Central Valley Community College v. Katz, 546 U.S. 356 (2006), that the power to avoid and recover a preference operates “free and clear of the State’s claim of sovereign immunity,” since the preference power has been a “core aspect” of bankruptcy “since at least the 18th century.” Id. at 373.
In Katz, Judge Sontchi said that the Supreme Court “refused to abide by the dicta” in Seminole Tribe.
Waiver by Consent
Although the Supreme Court twice undermined Seminole Tribe in the bankruptcy arena, Judge Sontchi said he remained bound by the Third Circuit’s opinion in Sacred Heart and could not rely on Section 106(a) to override the SBE’s claim of sovereign immunity.
The creditors’ trust nonetheless argued several theories of waiver. Judge Sontchi held that the SBE had not waived sovereign immunity by having previously participated in preliminary stages of litigation in bankruptcy court over the refund claim. The state, he said, had neither filed a claim nor “joined any causes of action” that would constitute waiver.
The trust, however, gained more (but not enough) traction with the waiver of sovereign immunity by consent arising from the states’ ratification of the U.S. Constitution and the Bankruptcy Clause. Still, Judge Sontchi said, every law labeled “bankruptcy” may not impinge on sovereign immunity.
Cobbling together the notion of consent by ratification of the Constitution with Katz and Hood, Judge Sontchi said that sovereign immunity will not bar “proceedings that effectuate the in rem jurisdiction of bankruptcy courts.” He proceed to analyze whether the tax refund claims invoked the court’s in remjurisdiction.
“[M]erely because the estate may have a claim for a tax refund is not enough to invoke the in rem jurisdiction of the bankruptcy court,” Judge Sontchi said. Essentially, he concluded that assessing the value of the plant would not invoke in rem jurisdiction over estate property when the claim for a refund pertained to taxes already paid, because ruling on the value of the plant would “not actually affect rights in the Facility.”
On the other hand, Judge Sontchi said there would be in rem jurisdiction to value the property had the refund claim pertained to post-petition payments or if the state were lodging a claim for unpaid taxes.
The case at hand, according to Judge Sontchi, “is nothing more than a state law claim for a sum of money. To disallow a sovereign immunity defense in this situation would . . . allow a wholesale suit for money damages.”
Judge Sontchi capped off his decision by finding no ancillary jurisdiction to sidestep sovereign immunity.
In substance, Judge Sontchi held that sovereign immunity left the court without jurisdiction to determine the proper assessment with respect to taxes that already had been paid, but there would be jurisdiction if the taxes had not been paid because the state would be seeking to collect taxes from estate property.
The trust was not left without a remedy, however, because the trust could utilize the California courts to contest the assessments. Once the assessments were determined, Judge Sontchi’s opinion indicates there would be no sovereign immunity bar to proceedings seeking the payment of tax refunds.