The Limitations of the Rooker-Feldman Doctrine as a Defense to Avoidance Actions under the Bankruptcy Code

The Rooker-Feldman doctrine is a legal precept invoked by defendants to strip federal district and bankruptcy courts of their subject matter jurisdiction over suits that can be characterized as appeals or reconsideration of state court judgments. This article discusses the nature of the Rooker-Feldman doctrine and its limitations under the Bankruptcy Code when asserted as a defense to the prosecution of avoidance actions.

Under the Bankruptcy Code, avoidance actions consist of the prosecution of preference claims and fraudulent transfers claims. Avoidance actions permit a trustee, a debtor in possession, or the representative of a debtor’s estate to recover assets that were transferred out of the debtor’s estate prior to the commencement of a bankruptcy case for the benefit of the debtor’s creditors. The avoidance powers under the Bankruptcy Code promote the “prime bankruptcy policy of equality of distribution among creditors by ensuring that all creditors of the same class will receive the same pro rata share of the debtor’s estate.” The right to avoid such transfers protects the interests of the debtor’s general body of creditors by maximizing the assets available for distribution to such creditors, thus placing creditors in a more favorable position to recover on their claims against the debtor.

The policy underlying the Rooker-Feldman doctrine is based on the concept that a litigant should not be able to challenge state court orders in federal courts as a means of relitigating matters that already have been considered and decided by a court of competent jurisdiction. The Rooker-Feldman doctrine also applies where a lower federal court is asked to conduct a review of a state court judgment for errors in construing federal law or constitutional claims that are inextricably intertwined with, or impacts the validity of, the state court judgment. The litmus test that a federal court must apply is whether the relief requested in the federal action would effectively reverse the state court decision or void its ruling.

In bankruptcy cases, the Rooker-Feldman doctrine has been applied in cases involving, by way of example, the estimation of a judgment creditor’s claim that arose from a pre-petition state court judgment against a debtor; attacking a state court judgment for lack of procedural due process; dismissing an adversary proceeding challenging a foreclosure judgment; a marital dispute concerning exempt property and discharge in the face of a state court judgment; and a state court’s adjudication of the automatic stay. In these cases, the doctrine was invoked to maintain the separation of federal and state courts and to protect and enforce state court judgments.

However, application of the Rooker-Feldman doctrine is subject to limitations. In Exxon Mobil Corp. v. Saudi Basic Indus. Corp., the Supreme Court recognized that the Rooker-Feldman doctrine is a narrow jurisdictional bar to litigation where the losing party “repairs to federal court to undo the [state court] judgment in its favor.” The Supreme Court cautioned that “Rooker-Feldman does not otherwise override or supplant preclusion doctrine or augment the circumscribed doctrines that allow federal courts to stay or dismiss proceedings in deference to state-court actions.” The Supreme Court noted that, “[i]f a federal plaintiff ‘present[s] some independent claim, albeit one that denies a legal conclusion that a state court has reached in a case to which he was a party . . . , then there is jurisdiction and state law determines whether the defendant prevails under principles of preclusion.” An important factor in Exxon Mobil is that the plaintiff was not seeking to overturn the state court.

A number of courts examining the reach of the Rooker-Feldman doctrine in bankruptcy cases have concluded that it has little or no application in the context of avoidance actions, which are independent claims under the Bankruptcy Code. Recently, the Third Circuit adopted this position in its decision in the Philadelphia Entertainment bankruptcy case in which the court limited the application of the Rooker-Feldman doctrine to an avoidance action under sections 544 and 548 of the Bankruptcy Code.

In Philadelphia Entertainment, the debtor, which owned a gaming business, was awarded a state license to operate slot machines. Prior to the debtor’s commencement of its chapter 11 case, the state gaming authority revoked the gaming license for the debtor’s failure to comply with its past orders and demonstrate financial suitability. The debtor appealed the revocation order to the state court and lost.

After the confirmation of the debtor’s chapter 11 plan, the litigation trustee commenced an adversary proceeding before the bankruptcy court to avoid the revocation of the license as a constructively fraudulent transfer. Specifically, the debtor claimed that the revocation of the license was a transfer for which the debtor received no value from the state. The bankruptcy court invoked the Rooker-Feldman doctrine to dismiss the trustee’s lawsuit, finding that the doctrine divested the court of subject matter to consider the avoidance claim. The district court affirmed, adopting the bankruptcy court’s Rooker-Feldman conclusions.

The Third Circuit reversed the lower courts concluding that the bankruptcy court erred when it held that the Rooker-Feldman doctrine barred its review of the fraudulent transfer claims. The court noted that the doctrine applies when four requirements are met: (1) the federal plaintiff lost in state court, (2) the plaintiff complains of injuries caused by the state court judgment, (3) that judgment issued before the federal suit was filed, and (4) the plaintiff invites the district court to review and reject the state court judgment. The Third Circuit found that the fourth requirement was not met. Relying on Exxon Mobile, the Third Circuit ruled that so long as federal court litigation does not concern “the bona fides of the prior judgment,” the federal court “is not conducting appellate review, regardless of whether compliance with the second judgment would make it impossible to comply with the first judgment.”

The court further noted that the bankruptcy court applied the Rooker–Feldman doctrine too broadly in finding that the fraudulent transfer claims required the federal courts to void the state court order. In particular, the court found that the litigation trustee was not complaining of an injury caused by the state court judgment and thus was not seeking a review and rejection of that judgment. In particular, the trustee’s fraudulent transfer claims did not require the bankruptcy court to conduct an appellate review of the order revoking the gaming license. An important consideration for the Third Circuit was that “a federal court can address the same issue ‘and reach[] a conclusion contrary to a judgment by the first court,’ as long as the federal court does not reconsider the legal conclusion reached by the state court.” In other words, the Rooker-Feldman doctrine should not apply when a federal statute, in this case the avoidance statutes under the Bankruptcy Code, specifically authorizes a lower court to vitiate a state court judgment.

The exception for avoidance actions under the Rooker-Feldman doctrine is important for debtors in possession and trustees in bankruptcy cases because the prosecution of these claims can be highly valuable for creditor recoveries. As noted, one of the key policy objectives of bankruptcy is the maximization of creditor recoveries, which is often achieved through the prosecution of avoidance actions. Although the Rooker-Feldman doctrine operates to protect the integrity of state court judgments attacked in federal courts, the doctrine does not survive this policy objective under the Bankruptcy Code.