States may assert a sovereign immunity defense under the Eleventh Amendment, which generally bars federal court jurisdiction whenever a private citizen attempts to sue a state.

Is sovereign immunity available where a state is sued in an adversary proceeding? In In re Venoco LLC, the United States Court of Appeals for the Third Circuit (the “Third Circuit”) enunciated a standard to this question by ruling: “States cannot assert a defense of sovereign immunity in proceedings that further a bankruptcy court’s in rem jurisdiction no matter the technical classification of that proceeding.” Davis v. Cal. (In re Venoco LLC), Nos. 20-1061, 20-1062, 20-1063, 2021 U.S. App. LEXIS 15359, at *13 (3d Cir. May 24, 2021); In re Venoco LLC, No. 20-1061, 2021 WL 2067331, at *5 (3d Cir. May 24, 2021).

Facts and Procedure

The debtor was in the business of drilling, extracting and refining oil. The debtor leased land from the state of California and the California Land Commission and operated an oil and gas drilling rig. Near this leased property, the debtor also owned land where it processed and refined oil.

After a rupture in its pipelines, the debtor quitclaimed its lease with California and entered into an agreement that allowed California to use, in exchange for money, the land the debtor owned. The debtor and California also entered into negotiations for the sale of this parcel of land. When the parties failed to reach an agreement, California ceased making its rental payments to the debtor for its continued use of the debtor’s land and, instead, invoked its police powers to take the debtor’s land without payment.

Shortly thereafter, the debtor filed for Chapter 11. In the Chapter 11 case, the bankruptcy court authorized the debtor’s liquidating plan, and all of the debtor’s assets were transferred to a liquidating trust upon the plan’s effective date.

Following the occurrence of the plan’s effective date, the liquidating trustee filed an adversary proceeding against California, which included a claim for inverse condemnation. The liquidating trustee sought just compensation for the taking of property the debtor owned. In response, California moved to dismiss the complaint, asserting a sovereign immunity defense.

The bankruptcy court denied California’s motion to dismiss and, on appeal, the district court affirmed. California then appealed to the Third Circuit.

Analysis

States may assert a sovereign immunity defense under the Eleventh Amendment, which generally bars federal court jurisdiction whenever a private citizen attempts to sue a state. In Central Va. Cmty. College v. Katz, 546 U.S. 356, 378 (2006), however, the Supreme Court ruled that the states “agreed… not to assert any sovereign immunity defense they might have had in proceedings brought pursuant to ‘Laws on the subject of Bankruptcies.’” The scope, however, of this consent to suit was unclear. The Court held that the states waived sovereign immunity that “they might otherwise have asserted in proceedings necessary to effectuate the in rem jurisdiction of the bankruptcy courts.” Id. That left one critical question unanswered: What are the metes and bounds of a bankruptcy court’s in rem jurisdiction?

Through In re Venoco, the Third Circuit identified three types of proceedings that advance a bankruptcy court’s in rem jurisdiction and thus deprive a state of the sovereign immunity defense. A proceeding furthers a bankruptcy court’s in rem jurisdiction if it:

1. “[D]ecides and affects interests in the res, the property of the debtor and its estate”;
2. Has an effect “on the equitable distribution of the debtor’s property,” even if the proceeding has no connection to a piece of property from the estate; or
3. Directly relates to the debtor’s bankruptcy discharge.

Application

Under this newly announced standard clarifying the scope of a bankruptcy court’s in rem jurisdiction, the Third Circuit found that California could not assert a sovereign immunity defense in the adversary proceeding because the proceeding sought to determine whether California could use the debtor’s property without payment. While the proceeding was not in rem in form because the trustee sought damages as opposed to equitable relief, the Third Circuit found that the adversary proceeding was in rem in function because it would decide rights concerning the debtor’s property. Accordingly, having found that the adversary proceeding furthered the bankruptcy court’s in rem jurisdiction, the Third Circuit held that California could not assert its sovereign immunity defense.

Practical Implications

In re Venoco proclaimed a broad standard in deciding whether sovereign immunity applies in adversary proceedings. Accordingly, states will likely have a hard time asserting sovereign immunity in adversary proceedings, since such proceedings usually seek one of the three functions identified by the Third Circuit. Thus, moving forward, states litigating adversary proceedings in bankruptcy courts (at least within the Third Circuit) likely cannot avail themselves of a sovereign immunity defense and will have to rely on other defenses to avoid liability.

For More Information

If you have any questions about this Alert, please contact Lawrence J. Kotler, Diane J. Kim, any of the attorneys in our Business Reorganization and Financial Restructuring Practice Group or the attorney in the firm with whom you are regularly in contact.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.