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Chapter 9's Cabinet of Constitutional Curiosities: Ongoing Constitutional Violations

posted by Melissa Jacoby

Just a handful of modern big-city bankruptcies have revealed foundational questions about chapter 9's fit within federal courts and constitutional jurisprudence. Given that chapter 9 no longer is simply an adjustment of bond debt, bankrupt cities restructure a wide range of claims in their plans, including those arising from long-lingering disputes; to this point, a Ninth Circuit panel just heard oral argument on a dispute from Stockton's exercise of its eminent domain power twelve years before Stockton filed its chapter 9 petition, only to put the case on hold pending rehearing en banc of a chapter 11 equitable mootness dispute. But my commentary today focuses on the impact of events and decisions during a bankruptcy case. If cases no longer must be prepackaged, a city's decisionmakers have a longer period of automatic stay protection during which to act in ways that might generate controversy, causes of action, or both.

Recall, for example, Detroit's headline-making residential water shutoff policies and practices. The bankruptcy court used informal control to coax the city into increasing protections for low-income residents. In response to an adversary proceeding requesting more formal intervention, the bankruptcy court held it did not have the power to enter an order enjoining the policy or directing changes. But Judge Rhodes' analysis included a significant caveat: in a follow-up written ruling, Judge Rhodes held that section 904 of the Bankruptcy Code does not shield a municipal debtor from injunctions of ongoing constitutional violations:

The Court concludes that § 904 does not protect the City from the bankruptcy court's jurisdiction over the plaintiffs' constitutional claims because the City does not have the "governmental power" to violate the due process and equal protection mandates of the Constitution [citations omitted]. The City must comply with those constitutional mandates [citation omitted]. Accordingly, the Court concludes that those claims, unlike the plaintiffs' other claims, do survive the City's § 904 challenge.

Lyda v. City of Detroit, 2014 WL 6474081 at *5 (Bankr. E.D. Mich., Nov. 19, 2014). That holding did not get the Lyda plaintiffs far because, according to the court, the allegations failed to state a constitutional claim on which relief could be granted. The adversary proceeding was dismissed. Judge Rhodes' decision rightly signaled, though, that a municipal bankruptcy petition is not a license to engage in constitutional violations without consequence. The district court had affirmed the ruling. Lyda v. City of Detroit, 2015 WL 5461463 (E.D. Mich. Sept. 16, 2015).

Last week, the Sixth Circuit reversed the portion of the bankruptcy court's decision on the relationship between section 904 and alleged ongoing constitutional harms. The reversal did not change the outcome for the parties, but generates a troubling question: can municipal bankruptcy allow a city to continue to violate constitutional rights with no redress? Surely the answer must be "no"?

The Sixth Circuit panel states:

The pivotal issue in this case is one of statutory construction... namely, whether and to what extent plaintiffs' complaint survives 11 U.S.C. § 904. While the bankruptcy court determined that § 904 foreclosed recovery only on plaintiffs' state-law claims, defendants argued below that the provision's effect is broader, prohibiting the court from awarding any of the relief requested, whether plaintiffs alleged their injuries as state-law or constitutional harms. We agree.

Lyda v. City of Detroit, 15-2236 (6th Cir. Nov. 14, 2016). 

A closer look at the decision suggests the panel is making a more modest holding, albeit one that increases the cost of challenging a bankrupt city's acts: that the court presiding over the bankruptcy is the wrong forum to address ongoing constitutional harms:

Municipal governments indisputably do not have "governmental power" to violate citizens' constitutional rights. But it does not follow that the bankruptcy court has judicial power to enjoin such violations.

Id. at 14. And, on page 16, the court says, "[p]laintiffs' constitutional rights are inviolable; but the remedies available to them in the chapter 9 setting are not." A footnote following this sentence suggests that plaintiffs should seek to lift the automatic stay and take their complaints to a different federal court. Presumably this path also avoids the conflict between the details of the requested remedy and the proscriptions of section 904.

One could read Lyda as discomfort with bankruptcy judges presiding over constitutional disputes. But the written decision relies in part on sources that predate Congress giving bankruptcy judges the authority to preside over municipal cases. For example, the Sixth Circuit discusses the well-known Supreme Court decision Ashton striking down the first bankruptcy law in 1936. District judges, not bankruptcy referees, presided over municipal bankruptcies at that time, and all the way through 1978. Most of section 904 was part of bankruptcy law well before that change in authority. In any event, Title 28 and recent Supreme Court jurisprudence already offer routes to get a matter arising in a bankruptcy case to a district judge.

Whatever one's view of the analysis or the water shutoff, lawyers should not wait until an emergency to devise strategies to address Lyda. Here's the question for advocates: would you recommend that plaintiffs seeking redress from an alleged ongoing violation operate on multiple tracks, namely filing an adversary proceeding in the bankruptcy case, seeking to withdraw the reference from the bankruptcy judge to a district court, and filing a motion to lift the automatic stay to file the action in a separate district court? Would you aim to be less specific about the requested remedy than the plaintiffs in Lyda? And request damages too?




Professor Jacoby,

You are alluding to my favorite bankruptcy topic - expedited non-plan 363 sales enjoining successor liability when you wrote:

One could read Lyda as discomfort with bankruptcy judges presiding over constitutional disputes. ... In any event, Title 28 and recent Supreme Court jurisprudence already offer routes to get a matter arising in a bankruptcy case to a district judge.

My reading of Northern Pipeline, Granfinanciera, and the Stern Trilogy tells me that bankruptcy creditors enjoy jury trial rights in an Article 3 Court when litigating common law claims like successor liability and injunctions thereof when the Plaintiff is another third party - such as the buyer at a 363 sale.

But no bankruptcy, district, or circuit court on appeal is going to prohibit a 363 sale with a successor liability injunction and the US Supreme Court is not going to hear an appeal challenging such a sale.

Yes, I know, that leaves it for Congress to adopt 363 reform - which is even more unlikely.

So evidently the only way to avoid having your claim enjoined (discharged) by a corporate debtor who does not confirm a plan is to insist on security protecting every pre-petition transaction or don’t go into business, or file bankruptcy yourself before the debtor enjoins your claim.

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