Third Circuit Publishes Significant Opinion on Bankruptcy Jurisdiction, Holds That When a Court Possesses "Arising In" Jurisdiction, "Close Nexus" Test Does Not Apply
In re Seven Fields Dev. Corp., 505 F.3d 237 (3d Cir. 2007) (Circuit Judge Morton I. Greenberg)
Creditors of the debtor, Seven Fields Development Corporation, brought an action against an accounting firm employed by the debtor for alleged misconduct occurring during the debtor’s Chapter 11 case, but prior to plan confirmation. The United States Court of Appeals for the Third Circuit found the claims arose in bankruptcy, and the action therefore was a core proceeding. Because the Bankruptcy Court possessed “arising in” jurisdiction, there was no need for the Bankruptcy Court to determine whether the action had a “close nexus” to the bankruptcy case. In dicta, the Third Circuit also decided that when a federal court exercises “related to” jurisdiction, the Court is required to determine whether there is a “close nexus” between the claims asserted and the bankruptcy cases, such determination to be made as of the time that the claims are brought.
This opinion arises out of a bankruptcy case filed in 1986. A group of corporations engaged in real estate development in Seven Fields, Pennsylvania sold investment shares to raise capital. The debtors promised their investors an annual return on their investments. As the debtors became unable to make their payments to the investors, they filed Chapter 11 petitions in the United States Bankruptcy Court for the Western District of Pennsylvania. The Court approved the appointment of Arthur Young & Company (a predecessor of Ernst & Young) to serve as accountants. Young determined that the debtors were insolvent, and that the vast majority of their debt was owed to the investors. The Court approved a plan of reorganization that merged the debtors into a single successor entity, Seven Fields Development Corporation. The plan provided for payment in full to secured and trade creditor claims. The investor class of unsecured creditors received common stock in Seven Fields at a par value equal to 5% of their allowed claims, with the remaining 95% classified as unsecured nondischargable debt. Under the plan, the purpose of Seven Fields was to manage the real estate and seek to achieve maximum returns for the investors. After confirmation of the plan, Seven Fields liquidated its real estate holdings, but did not realize sufficient proceeds to the investors in full. The bankruptcy case later closed.
In 2004, the shareholders filed a complaint against Ernst & Young in the Court of Common Pleas of Butler County, Pennsylvania alleging professional negligence, fraud and deceit and negligent misrepresentation. The complaint alleged that, based upon Young’s advice, a plan was approved and implemented that caused the investors to suffer losses.
Ernst & Young filed a notice of removal of the Butler County action with the clerk of the Bankruptcy Court, removing the case to the United States Bankruptcy Court for the Western District of Pennsylvania. Ernst & Young also filed a motion to dismiss. The shareholders then moved to remand the case back to the state court, or in the alternative, to abstain from exercising jurisdiction.
The Bankruptcy Court, sua sponte, reopened the bankruptcy case and dismissed the case on various substantive grounds. The shareholders appealed, challenging the Bankruptcy Court’s jurisdiction.
The Bankruptcy Court held that it had jurisdiction, under 28 U.S.C. § 1334(b), over the shareholders’ claims because they arose in the bankruptcy case. The claims asserted professional malpractice by a professional approved by and subject to the supervision of the Bankruptcy Court. The Bankruptcy Court further held that it did not need to apply the “close nexus” test set forth in the Third Circuit’s Resorts International case because, in this case, Young was a court-appointed professional providing services during the bankruptcy case, whereas the professionals in Resorts provided post-confirmation services to a litigation trust, not to the debtor. The district court affirmed the Bankruptcy Court’s decision.
On appeal to the Third Circuit, the shareholders argued that the Bankruptcy Court erred by finding that the close nexus test did not apply, based on the Court’s determination that the state law claims arose during the bankruptcy case. The shareholders argued that what mattered was not when the actions occurred, but when the state law claims were asserted. They asserted that the close nexus test applies whenever a state lawsuit is removed to federal court on the basis of a bankruptcy case that was already closed when the state law action was filed. The appellants also contended that the Bankruptcy Court erred when it found that the state law action was a core proceeding under 28 U.S.C. § 157(b).
The Third Circuit affirmed, holding that the “close nexus” test applies only to determine whether a federal court has jurisdiction over a non-core “related-to” proceeding under 28 U.S.C. § 1334(c)(2). It does not apply where the federal court possesses “arising in” jurisdiction. The relevant inquiry is not into when the state law action was commenced, but instead when the underlying events took place.
The Third Circuit also affirmed the finding that the Bankruptcy Court possessed “arising in” jurisdiction. The investors alleged that their claims against Ernst & Young arose out of the work conducted during the course of the bankruptcy case. Moreover, the investors’ allegations implicated the integrity of the entire bankruptcy process. The investors alleged that Young’s work led the Bankruptcy Court to the conclusion that the debtors were insolvent, and the resulting formation of Seven Fields to achieve the goal of full payment of claims. This was a significant factor in bringing about confirmation of the plan. The Third Circuit concluded, therefore, that a malpractice action against an accountant for misconduct during the bankruptcy case, on which the judge relied in confirming a plan and approving fees, is a core proceeding, “arising in” the bankruptcy and subject to bankruptcy jurisdiction.
The Court then went on to address a question that it did not need to resolve, but that was the subject of division in the courts within the Third Circuit. That question was, “in analyzing a court’s “related-to” jurisdiction, is pre-confirmation conduct alleged in a complaint that is filed post-confirmation evaluated under the Pacor test or the Resorts “close nexus” test? The Bankruptcy Courts in Delaware in New Jersey have reached inconsistent results on this question, with at least one opinion in each court holding that the proper inquiry is into when the conduct occurred or the cause of action arose, and another set of decisions in each court stating that when the cause of action was filed is the starting point. The Third Circuit concluded that, under Resorts, the “close nexus” test is applicable to “related to” jurisdiction over any claim filed post-confirmation regardless of when the underlying conduct occurred.
