April 5, 2023
In Barton v. Barbour, the United States Supreme Court held that before another court could obtain subject matter jurisdiction over a suit against a receiver for acts committed in the receiver’s official capacity, the plaintiff had to obtain permission to sue from the court that appointed the receiver. The United States Court of Appeals for the Fourth Circuit has extended the Barton doctrine to suits against bankruptcy trustees and their attorneys.
So how can it be that a former Chapter 7 debtor could sue its former lawyer, whose engagement by the Chapter 7 trustee had been approved by the bankruptcy court, in state court for malpractice in settling cases with the approval of the bankruptcy court without permission of the bankruptcy court? The answer, according to the Fourth Circuit in Conway v. Smith Development, Inc., is that abstention under 28 U.S.C. §1334(c)(1) may deprive federal courts of jurisdiction to determine if the Barton doctrine applies.
Smith Development, Inc., a luxury home builder, filed a Chapter 11 bankruptcy case. Martin Conway and his firm represented Smith Development. While Smith Development was a Chapter 11 debtor-in-possession, Conway filed on its behalf three adversary proceedings against home buyers who had defaulted under their purchase contracts. Before those adversary proceedings were resolved, Smith Development’s case was converted to a case under Chapter 7.
The Chapter 7 trustee, with bankruptcy court approval, retained Conway as special counsel to prosecute the adversary proceedings on behalf of the bankruptcy estate. The three adversary proceedings were later settled, also with bankruptcy court approval.
Nearly seven years after the Chapter 7 case was closed, Smith Development sued Conway and his firm in state court for malpractice arising from their representation of Smith Development as a Chapter 11 debtor and their representation of the Chapter 7 trustee. Smith Development requested from the bankruptcy court permission under Barton to sue Conway and his firm. The bankruptcy court denied the request.
Smith then amended the complaint in its state court case that the bankruptcy court had declined to give it permission to prosecute to delete the malpractice claim arising out of Conway’s representation of Smith Development as Chapter 11 debtor and to assert only that Conway’s simultaneous representation of it and the Chapter 7 trustee created a conflict of interest which caused the adversary proceeding to be settled for less than what they were actually worth. Conway filed a motion to reopen Smith Development’s bankruptcy case and requested that the bankruptcy court enjoin Smith Development from prosecuting the state court suit.
Smith Development argued that the bankruptcy court did not have jurisdiction to enjoin it from prosecuting the suit against Conway. As a result of that argument, the bankruptcy court did not rule itself, but made a report and recommendation to the United States District Court that it determine that Smith Development’s suit violated Barton and sanction Smith Development for willful violation of the automatic stay.
The District Court rejected the bankruptcy court’s report and recommendation. Instead, it abstained from exercising jurisdiction pursuant to 28 U.S.C. §1334(c)(1). The District Court concluded that: (a) Smith Development’s suit involved purely state law issues; (b) the resolution of Smith Development’s claims would not affect the bankruptcy estate; (c) resolution of factual issues in state court “would bear on whether Barton applied and whether the claims were the bankruptcy estate’s property such that the suit violated the automatic stay;” (d) “comity and respect for the state courts…weighed in favor of abstention;” and (e) the state court was an appropriate forum that could fully adjudicate the state law malpractice claim. Conway appealed the District Court’s decision to the Fourth Circuit.
The Fourth Circuit concluded that it lacked jurisdiction over Conway’s appeal and dismissed it. It noted that 28 U.S.C. §1334(d) provides that a decision to abstain or not to abstain “is not reviewable by appeal or otherwise by the court of appeals.” While the Fourth Circuit acknowledged that some courts have concluded that 28 U.S.C. §1334(d) does not bar an appellate court from reviewing a district court abstention order if the district court itself lacked jurisdiction, the Fourth Circuit said that even if there was such an exception to the prohibition of review in 28 U.S.C. §1334(d), the District Court had jurisdiction to abstain under 28 U.S.C. §1334(c)(1). Finally, the Fourth Circuit brushed aside Conway’s argument that abstention effectively eliminated any opportunity to assert the Barton doctrine by saying that “Congress has expressly limited appellate jurisdiction.”
The bankruptcy court almost certainly made a report and recommendation to the District Court expecting the District Court to accept that report and recommendation and deprive Smith Development of any argument that an injunction of its suit was invalid because it was not entered by court established under Article III of the Constitution of the United States. It surely did not foresee that the District Court might conclude that a determination that claims asserted by a Chapter 7 trustee on behalf the bankruptcy estate had been settled for too little “would not affect the bankruptcy estate” or that the state court suit involved “purely state law issues” and yet might resolve “whether the claims were the bankruptcy estate’s property” or whether Smith Development had violated the automatic stay afforded by federal law in bringing that suit in the first place. Unfortunately for Conway, Congress barred review of what happened by the Fourth Circuit.