Can State Law Now Attack Proof of Claims?

On March 20, 2007, the United States Supreme Court decided the landmark decision of Travelers v. PGE, 127 S. Ct. 1199, 167 L. Ed. 2d 178.  In that case, the longstanding Ninth Circuit Fobian rule was overturned.  The Supreme Court ruled that the Bankruptcy Code does not pre-empt an attorney fees provision arising from state law or an underlying agreement between the parties, in the claims objection process.

Travelers has now provided further guidance to a claim as a creature of state law. The Supreme Court held in Travelers, Id. at 186, “with limited exceptions, any defense to a claim that is available outside of the bankruptcy context is also available in bankruptcy.”

The Supreme Court then cited Raleigh v. Illinois Dep’t of Revenue, 530 U.S. 15, 20, 120 S. Ct. 1951, 147 L. Ed. 2d 13 in stating “That principle requires bankruptcy courts to consult state law in determining the validity of most claims.”

Of most significance is the fact that the Supreme Court ruled that “state law governs the substance of claims.” As such the court quoted Collier P 502.03[2][b], at 502-22 (explaining that § 502(b)(1) is generally understood to “make available to the trustee any defense” available to the debtor “under applicable nonbankruptcy law” — i.e., any defense that the debtor “could have interposed, absent bankruptcy, in a suit on the [same substantive] claim by the creditor”).

In no uncertain terms, the Supreme Court has ruled that claims are a creature of state law and there is “no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.” Id at 186.

So what does this mean? In a nutshell, if a debtor has a counterclaim arising from the underlying claim, she is entitled to assert the counter claim in relation to the objection to claim.

For further analysis of what this means, click here.

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