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Article: Southern District Decision Confirms Breadth of Bankruptcy Court Jurisdiction

Business Litigation Reports

The Southern District of New York in the recent Ames decision engaged in a detailed analysis of the contours of bankruptcy-court jurisdiction and found it broadly included a wide array of state law claims (notwithstanding the “reverse-preemption” provisions of federal insurance statutes). Report and Recommendation on Ames’ Motion to Confirm Exclusive Jurisdiction, Ames Dep’t Stores, Inc. v. Lumbermens Mut. Cas. Co. (In re Ames Dep’t Stores, Inc.), Case No. 01-42217 (REG), Adversary No. 06-01890, 2015 Bankr. LEXIS 4106 (Bankr. S.D.N.Y. Dec. 7, 2015) (“Ames”). Specifically, the state-law claims in Ames implicated the McCarran-Ferguson Act’s reverse preemption provisions, which typically elevate state law regulating the insurance business over federal law. Bankruptcy Courts are units of United States District Courts, which have “original and exclusive jurisdiction of all cases under title 11 [i.e., the Bankruptcy Code]” and “original but not exclusive jurisdiction of all civil proceedings arising under title 11, or arising in or related to cases under title 11.” 28 U.S.C. § 1334(a), (b). The defendant in Ames challenged the District Court’s jurisdiction concerning a host of claims the Ames estate brought under state law and the Bankruptcy Code. Notably, these claims included “issues of particular importance to the bankruptcy system—most significantly, serious allegations of interference with the Debtors’ property, of two separate types, each of which is subject to the Court’s in rem jurisdiction and the protection of the Bankruptcy Code’s automatic stay.” Ames at 1. The detail and scope of the Ames decision make it one of the most significant recent pronouncements on bankruptcy court jurisdiction and ensure it will be cited frequently in the jurisdictional challenges that have become routine practice in bankruptcy litigation.

Challenged Transactions
Lumbermens Mutual Casualty Company (“Lumbermens”) provided a $14.35 million bond surety (the “Bond”) to backstop Ames’ payment obligations to its workers’ compensation insurer, Travelers Indemnity Company (“Travelers”) under a bond agreement (the “Bond Agreement”) that required Lumbermens to pay Travelers following its demand with respect to Ames’ workers’ compensation policies. In turn, Ames reimbursed Lumbermens, on an unsecured basis, for any payments it made to Travelers.

After Ames filed for bankruptcy (and invoked the automatic stay under section 362 of the Bankruptcy Code), Lumbermens and Travelers entered into a letter agreement (the “Letter Agreement”) beyond the confines of the Bankruptcy Court pursuant to which (i) Lumbermens deposited $8 million into a trust account (the “Trust Monies”); (ii) Travelers agreed to draw on two letters of credit (the “Letters of Credit”) Ames obtained in the bankruptcy cases for Traveler’s benefit—before satisfying Ames’ obligations from the Trust Monies; and (iii) Travelers agreed not to make a demand on Lumbermens for any remaining amounts owed under the Bond until after it exhausted both the Letters of Credit and the Trust Monies.

Neither Lumbermens nor Travelers sought bankruptcy court approval of the Letter Agreement or relief from the automatic stay, a significant omission because the Letter Agreement authorized Travelers to draw on Letters of Credit that Ames had collateralized with its own cash. Ames ultimately brought various claims against Lumbermens in the Bankruptcy Court, including (i) breach of the Bond Agreement, (ii) violation of the automatic stay and contempt pursuant to sections 105 and 362(a) of the Bankruptcy Code (“Automatic Stay and Contempt Claims”); (iii) declaratory judgment directing that the $8 million in Trust Monies be released to Ames, (iv) declaratory judgment that Ames’ obligations to Travelers should have been satisfied from the amounts available under the Bond prior to a draw on the Letters of Credit pursuant to section 1107 and 105 of the Bankruptcy Code (“Marshalling Claim”), and (v) equitable subordination of Lumbermens’ claims pursuant to sections 510(c) and 105(a) of the Bankruptcy Code (“Equitable Subordination Claim”). Subsequently, Lumbermens, as a result of financial difficulties, commenced a rehabilitation proceeding under Illinois state law in the Circuit Court of Cook County, Illinois.

After Lumbermens moved to withdraw the reference, the United States District Court directed the Bankruptcy Court to provide a report and recommendation on the ability of a federal court to exercise jurisdiction over the claims Ames asserted in its adversary proceeding. Lumbermens argued the dispute belonged before the Illinois state court supervising its insolvency proceeding.

Bankruptcy Court’s Jurisdiction Analysis
The Bankruptcy Court first determined that it could exercise jurisdiction over each of Ames’ claims under the “arising in,” “arising under,” or “related to” prongs of 28 U.S.C. § 1334. With respect to the state law claims (e.g., breach of contract and unjust enrichment), the Bankruptcy Court found that it could exercise “related to” jurisdiction over those claims and that the breach of contract claim was a “core” matter because the issues raised by those claims overlapped with issues raised in the proof of claim Lumbermens filed against the Ames estate. The Bankruptcy Court found it has exclusive jurisdiction over the Automatic Stay and Contempt, Marshalling, and Equitable Subordination Claims because they pertained to property of Ames’ bankruptcy estate, e.g., the “bundle” of Ames’ rights under the Bond Agreement and to excess cash collateral. Similarly, with respect to the Equitable Subordination Claim, the Bankruptcy Court noted the “claims allowance process is another classic in rem function, appropriately handled by no court other than a bankruptcy court.” Ames at 31.

McCarran-Ferguson Act
Intertwined with the issue of jurisdiction was whether the McCarran-Ferguson Act, which “reverse preempts” federal law, applying state law concerning the regulation of the insurance business over federal law—suggested the Illinois court should decide the claims in the Ames proceeding. 15 U.S.C. §§ 1011-1015 (1994). Noting “[m]any courts, including the Second Circuit, have taken a narrow reading of McCarran- Ferguson,” the Bankruptcy Court concluded the McCarran-Ferguson Act did not apply when “the Bankruptcy Code and relevant federal jurisdiction provisions do not specifically relate to the business of insurance.” Ames at 33-34. While the Illinois Code regulates insurance because it enables the state court overseeing the rehabilitation to issue injunctions against actions against the insurer and to establish claim priority and a procedure for claim allowance, the Bankruptcy Court concluded nonetheless that “application of the Bankruptcy Code would not ‘impair, invalidate, or supersede’ the relevant jurisdictional provision (or any other provision) of Illinois insurance law.” Ames at 38. It also noted the “property in question is not subject to the in rem jurisdiction of the Illinois court, and insurance law has nothing to do with the controversy” because the Trust Monies were no more property of the Lumbermens estate than they were property of the Ames estate. Ames at 39. Similarly, the Bankruptcy Court noted the Illinois statute did not provide that the state court was an exclusive forum and concluded that “[a]bsent a legitimate policy concern and substantive conflict with a federal court’s exercise of jurisdiction, McCarran-Ferguson cannot de facto deprive such federal court of its otherwise valid jurisdiction.” Ames at 41.

Given the depth of the Court’s analysis and the extent to which it confirmed the breadth of bankruptcy-court jurisdiction, Ames is sure to be cited with frequency in jurisdictional challenges that are routine features of bankruptcy litigation.