Breach of Pre-petition Contract Claims May Be Subject to “Core” Jurisdiction
A creditor that brings a breach of contract claim against its debtor for an alleged breach that occurred prior to the debtor’s filing for bankruptcy may expect the proceeding to be litigated before a state court. However, this is not always the case. Recently, the United States Bankruptcy Court for the Southern District of New York, in In re Charter Communications, held that an adversary proceeding by a group of creditors for an alleged pre-petition breach of contract was one over which the bankruptcy court could exercise its “core” jurisdiction.[i] Specifically, the court found that an adversary proceeding involving a claim for breach of contract that allegedly occurred prior to the debtor’s filing for bankruptcy may still be subject to the bankruptcy court’s jurisdiction if the proceeding is found to be sufficiently related to the core functions of the bankruptcy process.
The court held that creditors, expecting to litigate their pre-petition breach of contract claims in state or federal court before a jury, may nevertheless find their claims being decided by a bankruptcy judge despite not having filed a proof of claim after the debtor filed for bankruptcy. Filing a proof of claim is an indication of the creditor voluntarily subjecting itself to the bankruptcy court’s jurisdiction.[ii] When a creditor has not filed a proof of claim, but is nevertheless involuntarily subjected to the bankruptcy court’s jurisdiction, the consequential impact on the creditor’s choice of forum might result in a less favorable outcome than the creditor would have received in state or federal court.
Part I of this memorandum discusses information relevant to the issue presented, including pertinent statutory provisions and case precedent. Part II discusses the particular controversy arising in In re Charter Communications and the Bankruptcy Court’s holding in the case. Finally, Part III concludes with a discussion of the holding’s relevance in the larger context of bankruptcy and its potential effect on future cases.
I. “Core” Jurisdiction under Section
The distinction between “core” and “non-core” matters originates in the Supreme Court’s plurality opinion in Northern Pipeline Constr. Co. v. Marathon Pipeline Co.[iii] In Marathon, a chapter 11 debtor brought an action for a pre-petition breach of contract in bankruptcy court. The defendant creditor had not filed a proof of claim and contested the bankruptcy court’s jurisdiction over the matter.[iv] The creditor challenged the constitutionality of the Bankruptcy Reform Act of 1978 (the “Act”), which expanded bankruptcy court jurisdiction, and moved to dismiss the action for lack of jurisdiction.[v] In considering the constitutionality of bankruptcy court jurisdiction provided by the Act, the Supreme Court held that a bankruptcy judge did not have the constitutional authority to decide a pre-petition contract dispute and that the broad grant of jurisdiction to bankruptcy judges under the Act violated Article III of the Constitution.[vi] The Court focused on the distinction between public rights, rights that arise “between the government and others,”[vii] and private rights, rights that arise from “the liability of one individual to another under the law as defined,”[viii] and concluded that only public rights may be decided in bankruptcy court.[ix] The Court explained that “the restructuring of debtor-creditor relations” was a core bankruptcy function, but that “the adjudication of state-created private rights, such as the right to recover contract damages,” was not.[x]
In response to the Supreme Court’s decision in Marathon, Congress enacted the Bankruptcy Amendments and Federal Judgeship Act of 1984, which later codified the core/non-core distinction in 11 U.S.C. § 157.[xi] This section states that “[b]ankruptcy judges may hear and determine all cases under title 11 and all core proceedings arising under title 11 . . . and may enter appropriate orders and judgments”[xii] regarding these matters. Subsection (b)(2) of section 157 provides a nonexclusive list of matters that constitute “core proceedings.” These include administration of the estate, the allowance or disallowance of claims against the estate for the purposes of chapter 11 plan confirmation, confirmation of plans, and other proceedings affecting the adjustment of the debtor-creditor relationship.[xiii]
A determination of whether a proceeding is “core” is made by the bankruptcy judge upon his own motion or on timely motion of a party.[xiv] Bankruptcy judges are provided with the guideline that “[a] determination that a proceeding is not a core proceeding shall not be made solely on the basis that its resolution may be affected by State law.”[xv] Therefore, the mere fact that a proceeding involves a breach of contract claim, which is “historically tried in a court of law,”[xvi] does not necessarily preclude the bankruptcy judge from determining that the proceeding is “core” and thus within the bankruptcy court’s jurisdiction.
Courts have consistently applied a broad interpretation of the term “core proceeding” and have construed the Marathon holding narrowly.[xvii] This interpretation is supported both by the legislative history of section 157[xviii] and the precise language of subsection (b)(3). Consequently, in determining whether a cause of action for breach of contract is within the bankruptcy court’s core jurisdiction, courts will consider “(1) whether the contract is antecedent to the reorganization petition; and (2) the degree to which the proceeding is independent of the reorganization.”[xix] Regarding the second consideration, courts will primarily focus on the nature of the proceeding and its relation to the bankruptcy process.[xx]
II. In re Charter Communications: Breach of Pre-Petition Contract Claim Does Not Fall Outside Bankruptcy Court’s Jurisdiction
A. The Facts
In In re Charter Communications, creditor JPMorgan alleged that the debtor had committed non-curable nonmonetary pre-petition defaults under a pre-petition contract (“the Credit Agreement”). The Credit Agreement was executed among Charter, as Borrower; the lenders party thereto; and JPMorgan as Administrative Agent for the lenders.[xxi] The Credit Agreement between the parties created a secured term and revolving facility from which Charter would be able to continuously draw down to a specified limit, provided Charter was not in default.[xxii] Under the Credit Agreement, whenever Charter drew down on the revolving facility, Charter covenanted that it would be able to pay its debts as they became due. JPMorgan alleged that Charter breached the agreement by making allegedly false representations that “no Default or Event of Default” had occurred when Charter sought to borrow an additional $750 million.[xxiii] In addition, one of the provisions of the Credit Agreement provided that Charter would be in default if it was unable to pay its debts as they became due.[xxiv] Although Charter asserted that it had made all of its interest payments on time as required so as not to have been in default, JPMorgan argued that the agreement’s language that debts be paid “as they become due” should be read as Charter’s ability to pay “as they would become due.”[xxv] Under this interpretation, JPMorgan alleged that Charter was in default when it made the request to borrow additional funds since at least one of its Designated Holding Companies, as defined by the Credit Agreement, was insolvent and, thus, would not be able to pay its debt when it would become due at some point in the future.[xxvi] Charter argued against this forward-looking interpretation by asserting that JPMorgan was creating an extra-contractual obligation under the Credit Agreement.[xxvii]
JPMorgan filed an adversary proceeding in bankruptcy court, claiming that the alleged default under the Credit Agreement should be deemed “non-core,” since it involved a breach of contract that occurred prior to Charter’s filing for chapter 11 and thus was not properly before the bankruptcy court.[xxviii] JPMorgan did not file a proof of claim before commencing the adversary proceeding.[xxix] Charter argued that, despite not filing a proof of claim within the bankruptcy proceeding, JPMorgan had nevertheless consented to the court’s jurisdiction by voluntarily electing to involve itself in the bankruptcy proceeding.[xxx]
B. The Bankruptcy Court’s Holding
The United States Bankruptcy Court for the Southern District of New York held that JPMorgan’s adversary proceeding for an alleged pre-petition breach of contract was within the court’s “core” jurisdiction.[xxxi] In deciding whether the claims fell within its jurisdiction, the court was guided by 28 U.S.C. § 157, but focused more on “the close interconnection between the adversary proceeding [at issue] and the bankruptcy process.”[xxxii]
The bankruptcy court noted that an evaluation of the matter’s independence from the debtor’s reorganization “hinges on the ‘nature of the proceeding.’”[xxxiii] In its analysis of whether the nature of the proceeding was core, the bankruptcy court applied the two-prong test provided by the Second Circuit in In re U.S. Lines,[xxxiv] which held that: “Proceedings can be core by virtue of their nature if either (1) the type of proceeding is unique to or uniquely affected by the bankruptcy proceedings, . . . or (2) the proceedings directly affect a core bankruptcy function.”[xxxv]
Applying the first prong of this test, the court noted that no monetary default had ever occurred and that, under the terms of the Credit Agreement, the debt had been accelerated by virtue of Charter’s filing for bankruptcy.[xxxvi] Although the alleged defaults occurred prior to Charter’s filing for bankruptcy, JPMorgan never sought to exercise its rights under the Credit Agreement, accelerate the debt, or take any other action until Charter publicly disclosed its intent to file for chapter 11 protection.[xxxvii] Accordingly, the court reasoned that there was no other purpose for JPMorgan to have initiated the litigation “other than the bankruptcy objective of attempting to prevent reinstatement, and that [that] objective [wa]s meaningful only in relation to the plan process.”[xxxviii] Therefore, because the purpose of the litigation in the adversary proceeding was “indisputably connected to and ‘uniquely affected’ by the bankruptcy proceeding,” the matter was deemed to satisfy the first prong of the In re U.S. Lines test.[xxxix]
Applying the second prong of this test, the court determined that the nature of JPMorgan’s proceeding was directly related to the court’s core bankruptcy functions, namely “confirmation of plans,”[xl] since JPMorgan’s claim would ultimately determine whether the Credit Agreement could be reinstated due to the non-curable nature of the alleged breach,[xli] and since Charter’s plan of reorganization relied on the Credit Agreement’s reinstatement in order to provide the loans it required.[xlii] Although the claim asserted by JPMorgan related to a pre-petition breach of a pre-petition agreement, “a factor which ‘weighs against finding core status,’”[xliii] the court found the dispute to be core since the dispute might result in a judgment of default under the Credit Agreement which would then render confirmation of Charter’s reorganization plan impossible.[xliv] Therefore, because the nature of plaintiff JPMorgan’s proceeding directly affected the confirmation of debtor Charter’s chapter 11 bankruptcy plan – a core administrative function of the bankruptcy court – the matter was deemed to satisfy the second prong of the In re U.S. Lines test.[xlv]
The court determined that JPMorgan’s failure to file a proof of claim was irrelevant to the determination of a proceeding as within the bankruptcy court’s core jurisdiction.[xlvi] Although filing a proof of claim has the potential to cause a creditor to “lose its right to a jury trial even with regard to traditional legal claims,”[xlvii] the lack of filing, and presumed lack of consent to jurisdiction it creates, need not be considered once a sufficient relationship has been established between the claim and the core proceedings.
C. Distinguishing In re Orion Pictures Corp.
The bankruptcy court held that exercising core jurisdiction over JPMorgan’s proceeding was appropriate notwithstanding the holding in In re Orion Pictures Corp.,[xlviii] in which the Second Circuit found a pre-petition breach of contract claim to be non-core.[xlix] In In re Orion Pictures Corp., Showtime and Orion had entered into an agreement, which was essentially an output contract under which Showtime would license all films distributed by Orion.[l] After Orion had filed for reorganization under chapter 11, Showtime refused to license films it would otherwise be obligated to accept under the agreement.[li] Subsequently, Orion filed an adversary proceeding in bankruptcy court against Showtime seeking specific performance of the agreement, which would entitle Orion to $77 million.[lii] The Second Circuit indicated that the only relationship between the adversary proceeding and the bankruptcy process was that Orion’s claim simply sought to augment the size of the debtor’s estate and, therefore, held the proceeding to be non-core.[liii] In contrast, the bankruptcy court noted that JPMorgan’s proceeding would directly affect confirmation of the reorganization plan.[liv] This is because JPMorgan’s claim carried the potential of invalidating the Credit Agreement, which was a critical element of Charter’s reorganization plan.[lv]
The bankruptcy court also noted that the Second Circuit had limited the applicability of In re Orion Pictures Corp. in two of its subsequent decisions: In re Best Prods. Co.[lvi] and In re U.S. Lines.[lvii] In In re Best Prods. Co., two groups of creditors provided financing to Best Products.[lviii] One of these groups, the Bank Group, had a subordination agreement that expressly stated that the financing provided by the other group, RTC, was subordinate to the Bank Group’s senior indebtedness.[lix] Among other provisions, Best Products’ plan of reorganization called for the enforcement of the subordination agreement, which RTC challenged.[lx] In its discussion, the Second Circuit explained that its decision in In re Orion Pictures Corp. did not narrow the scope of the provisions of section 157(b)(2), but rather that the subsection did not encompass “[a]ny [breach of] contract action that the debtor would pursue . . . [and that] would be expected to inure to the benefit of the debtor estate.”[lxi] In other words, the holding in In re Orion Pictures Corp. merely illustrated that not every breach of contract claim is subject to bankruptcy court jurisdiction. The Court further acknowledged that the proceeding in In re Best Prods. Co. did not simply seek to affect the size of the estate, as had been the case in In re Orion Pictures Corp., but rather “involve[d] the priority rights of creditors who have filed claims against the estate.”[lxii] Analogously, the Second Circuit distinguished the facts of In re U.S. Lines from those of In re Orion Pictures Corp. by indicating that the pre-petition contract dispute at issue would have a “much more direct impact on the core administrative functions of the bankruptcy court.”[lxiii]
The bankruptcy court further indicated that the most notable distinction was that, unlike in In re Orion Pictures Corp., JPMorgan’s adversary proceeding had been brought by a creditor, not a debtor.[lxiv] As such, JPMorgan was not an “unwilling party that ha[d] been ‘involuntarily subjected’ to the [c]ourt’s jurisdiction,”[lxv] but rather a willing party that had strategically elected to file its complaint with the bankruptcy court.[lxvi] However, since a determination of the matter as core can readily be established from the nature of JPMorgan’s proceeding, the court noted that it was unnecessary to consider whether JPMorgan’s voluntary activities amounted to a consent to the bankruptcy court’s jurisdiction.[lxvii]
After In re Charter Commc’ns, a creditor with a state law claim may be involuntarily subjected to the equitable powers of federal bankruptcy judges. The fact that the litigation involves a pre-petition contract with alleged pre-petition defaults is but one of many factors considered in determining appropriate jurisdiction, and, thus, is not determinative in and of itself. Most importantly, the analysis requires an examination of the relationship between the adversary proceeding and the bankruptcy process. Consequently, a creditor that brings a state law claim for breach of pre-petition contract can find itself under the jurisdiction of the bankruptcy court if the court cannot confirm the plan without addressing the claimed pre-petition defaults. Therefore, a claimed pre-petition breach of contract that must be resolved in order for the court to rule on final confirmation of a plan cannot as a legal and practical matter be decided in another forum.