Bankruptcy & Restructuring Litigation Update – November 2021

Third Circuit Affirms Dismissal in Reliance on Technical Exception to General Rule That State Sovereign Immunity Does Not Apply in Bankruptcy Cases

In a recent non-precedential decision that relied on the technical distinction between a “property interest” and a “revocable privilege,” the United States Court of Appeals for the Third Circuit upheld the dismissal of claims against the Commonwealth of Pennsylvania arising from its revocation of a slot machine license after the Commonwealth raised state sovereign immunity as a defense.  See Philadelphia Ent. & Dev. Partners LP v. Dep’t of Revenue, 2021 WL 2666690 (3d Cir. June 29, 2021).  Although fraudulent transfers are not typically subject to state sovereign immunity defenses, the Pennsylvania gaming statue at issue explicitly classified the license as “a revocable, non-transferable privilege.”  Therefore, the Court found that the license the Commonwealth revoked was not “property” over which the bankruptcy court had in rem jurisdiction.  

Although the Third Circuit upheld the Bankruptcy Court’s decision to decline to exercise jurisdiction, its decision does not disturb the more general proposition that prevents sovereign immunity from interfering with critical bankruptcy functions, including avoidance actions generally and more particularly estate claims to avoid and recover a government license, provided the debtor retains an interest in the transferred property. 

The Supreme Court’s Katz Decision

The doctrine of sovereign immunity prohibits federal courts from exercising jurisdiction over state government defendants.  In bankruptcy, however, the doctrine has limited reach.  In Central Virginia Community College v. Katz, 546 U.S. 356 (2006), the Supreme Court held that by ratifying the Constitution’s Bankruptcy Clause, which empowers Congress to establish “uniform Laws on the subject of Bankruptcies,” the states waived immunity protection over matters “ancillary to and in furtherance of the court’s in rem jurisdiction.”  Id. at 372.   That waiver is codified in section 106(a) of the Bankruptcy Code.

Despite this broad waiver, however, Katz did not categorically foreclose the defense of sovereign immunity for all bankruptcy matters.  See id. at 378 n.15 (“We do not mean to suggest that every law labeled a ‘bankruptcy’ law could, consistent with the Bankruptcy Clause, properly impinge upon state sovereign immunity.”).  In determining whether sovereign immunity applies in the bankruptcy context, courts generally ask whether the proceeding furthers:  (i) the exercise of jurisdiction over estate property (e.g., avoidance actions); (ii) the equitable distribution of that property to stakeholders (e.g., stay violations); and (iii) the fundamental purpose of bankruptcy (e.g., a debtor’s right to discharge).  See id. at 363-64.  To the extent a claim implicates one of these three critical functions, states do not enjoy immunity from suits.  Id. 364-35. 

Philadelphia Entertainment and Development Partners, L.P. 

In 2006, Philadelphia Entertainment and Development Partners, LP (“PEDP”) made plans to build and operate a casino, paying $50 million to the Commonwealth of Pennsylvania Department of Revenue (the “Commonwealth”) to obtain a slot machine license.  Pennsylvania’s Gaming Control Board revoked the license in 2010 after PEDP failed to satisfy certain deadlines required under the license.  

In 2014, after failing to recover the license in state court, PEDP filed a chapter 11 case and initiated an adversary proceeding against the Commonwealth.  The adversary proceeding sought to recover the value of the license the Commonwealth had revoked as a fraudulent transfer under sections 544 and 548 of the Bankruptcy Code and applicable state law—here, Pennsylvania.  

The bankruptcy court dismissed the adversary proceeding, reasoning that (among other things) the license did not constitute property or an asset of PEDP’s estate, and therefore the suit was barred by the doctrine of sovereign immunity.  The district court affirmed, and PEDP appealed.

To analyze PEDP’s claimed property interest in the gaming license, the Third Circuit turned to state law and, more specifically, the Pennsylvania Horse Racing Development and Gaming Act (the “Gaming Act”), under which the license had issued, and the Pennsylvania Uniform Fraudulent Transfer Act (“PUFTA”).  

The Court first observed that the Gaming Act plainly provides that “[t]he issuance or renewal of a license … shall be a revocable privilege” and the Board can “revoke … any … license … [if] the applicant ... is in violation of any provision of this part.”   The Court also noted that the Gaming Act states that a license issued by the Board “shall not be sold, transferred or assigned,” and that the Gaming Act should not be construed “to create in any person an entitlement to a license.”  Therefore, the Court found that the Gaming Act gave PEDP “a revocable, discretionary, non-transferable privilege to operate a facility with slot machines,” not a recoverable property interest.  

The Court explained that under the PUFTA, the definition of “[p]roperty” included “[a]nything that may be the subject of ownership.”  Ownership, in turn, was defined as “the right to possess a thing.”  Returning to the Gaming Act, however, the Court concluded that the license was not something a licensee could “own,” and therefore found that the adversary proceeding was properly dismissed.  

PEDP urged that the license constituted estate property because commentary in the PUFTA provides that “governmental licenses constitute property even if not transferable.”  The Court rejected this argument, holding that the more specific provisions of the Gaming Act controlled.  The Court concluded that because a license cannot be a licensee’s property under the Gaming Act, the Commonwealth retained its immunity.

Takeaways

The Third Circuit’s decision in Philadelphia Entertainment is narrow and a product of gaming laws unique to Pennsylvania.  The Court’s holding leaves undisturbed longstanding exceptions to sovereign immunity in the bankruptcy context and should have little impact on fraudulent transfer claims against state entities where the debtor retains an interest in the property transferred.  Notably, the debtor in Philadelphia Entertainment did not seek to avoid the $50 million fee paid to the Commonwealth in 2006 (that transfer was time-barred).  Rather, the “fraudulent transfer” was focused on the Commonwealth’s authorized revocation of the license in 2010, which under the statute did not deprive the debtor of any property right. 

Indeed, this decision comes on the heels of another, precedential Third Circuit opinion in which the Court rejected the State of California’s sovereign immunity defense.  In that case, the estate  sought to recover the value of the debtor’s gas and oil processing facility, which had been taken by the California Land Commission through inverse condemnation.  See Davis v. State of California (In re Venoco), 998 F.3d 98 (3d Cir. 2021).  The Third Circuit noted that although the adversary proceeding was not clearly in rem in form, its function was to decide rights to the debtor’s property.  The Davis decision confirms the strength of the general proposition that sovereign immunity is not a bar to fraudulent transfer actions in bankruptcy.