Is Arbitration Binding After Bankruptcy Filing?
Courts Apply Same Standards, Reach Different Results

by R. Timothy Bryan, Brent R. McIlwain

Nov 1, 2007

(TMA Global)

Arbitration clauses have become increasingly common in commercial contracts. Stated reasons for including such clauses in these contracts include increased certainty, decreased cost compared to typical litigation, more expedited resolution, and in some instances the desire for industry-specific experts to adjudge a particular dispute. Whether those attributes are perceived or a reality, the fact is many of those same characteristics are used to describe the bankruptcy process and the ability of a bankruptcy judge to dispose of almost any issue quickly and efficiently.

Interestingly, a review of the recent cases regarding the enforcement of arbitration clauses in bankruptcy revealed a few consistent themes. First, each court pays great respect to the Federal Arbitration Act (FAA). 9 U.S.C. Section 1 et. seq. Second, most Bankruptcy Courts determine that arbitration clauses should not be enforced, only to be overturned in many instances by appellate courts. Third, despite the similarities of the standards applied in the various circuits, the results are quite different.

This article reviews the general standards for determining whether arbitration should be enforced, discusses recent opinions that have applied those standards in disparate manner, and highlights a recent case in which even rejecting a contract could not prevent enforcement of an arbitration clause.

Virtually every written opinion regarding the enforceability of arbitration clauses in bankruptcy begins with a discussion of the FAA, which “establishes a ‘federal policy favoring arbitration agreements,’ and mandates the enforcement of contractual arbitration provisions.” MBNA America Bank, N.A. v. Hill , 436 F.3d 104, 107 (2nd Cir. 2006) (internal citations omitted). That policy can be overridden if a party can establish “congressional intent to create an exception to the FAA’s mandate.” Mintze v. American General Finance, Inc ., 434 F.3d 222, 229 (3rd Cir. 2006).

The standard for whether congressional intent exists is found in a Supreme Court case, Shearson/American Express, Inc. v. McMahon, 482 U.S. 220, 225-227 (1987). The McMahon case provides that the congressional intent to create an exception to the FAA will be found either in (i) the text of a statute, (ii) legislative history, or (iii) “an inherent conflict between arbitration and the statute’s underlying purposes.” Id at 227. In other words, the Supreme Court has held that if another federal statute either explicitly or implicitly demonstrates that Congress intended to create an exception to the FAA, arbitration agreements need not be honored.

The next query in a bankruptcy matter typically is whether the matter to be decided in arbitration or through bankruptcy is “core” or “non-core.” While a complete discussion of the nuances between core and non-core matters is beyond the scope of this article, for these purposes it is sufficient to describe core matters as those that are unique to bankruptcy, while non-core matters are those that can arise outside of the bankruptcy framework.

Almost uniformly courts have held that a Bankruptcy Court must compel arbitration under circumstances in which a matter is non-core and the parties are subject to a valid arbitration agreement. See The Whiting-Turner Contracting Co. v. Electric Machinery Ent., Inc., 479 F.3d 791 (11th Cir. 2007). That is because a court has some difficulty in finding that matters that arise outside of the bankruptcy context can meet the strictures of the test laid down in McMahon .

The converse is not true, of course, in that courts have not uniformly held that core matters are exempted from valid arbitration agreements. Instead, the analysis typically proceeds as follows. If a matter is determined to be non-core, the matter will be subject to a valid arbitration agreement. If a matter is determined to be core, a court proceeds to apply the McMahon test to determine whether the matter should proceed in bankruptcy or be sent to arbitration. See The Whiting-Turner , 479 F.3d at 796; Arellano v. Montoya , 2007 Bankr. LEXIS 2055, *9 (Bankr. NM June 14, 2007).

Although this may sound simple enough, the application of these standards has led to distinctly different results.

Arbitration Enforced

One of the more surprising recent cases ordering enforcement of an arbitration agreement is MBNA America Bank, N.A. v. Hill out of the 2d U.S. Circuit Court of Appeals. The MBNA case revolved around whether a debtor’s claim for a violation of the automatic stay should be subject to a valid arbitration agreement.

The debtor in MBNA had authorized a credit card company to withdraw funds from her bank account on a monthly basis to pay credit card charges. MBNA , 436 F.3d at 106. The debtor later filed bankruptcy, and despite receiving notice of the filing, the credit card company continued to withdraw funds from the debtor’s bank account. As a result, the debtor filed a complaint against the credit card company alleging willful violation of the automatic stay. Interestingly, the debtor styled her claim as a class action. The credit card company requested dismissal of the adversary proceeding in the Bankruptcy Court, citing an agreement to arbitrate contained in an amendment to the debtor’s credit card agreement.

That court found that the claim for willful violation of the automatic stay was a core proceeding, and then held that the Bankruptcy Court was the most appropriate forum for adjudication of the claim. The District Court affirmed the decision, and the credit card company appealed.

The 2d Circuit agreed with the lower court rulings holding that the claim was a core matter; however, the court reversed the lower court’s ruling that the Bankruptcy Court was the most appropriate forum. In so doing, the appellate court, applying the McMahon factors, determined that allowing a core matter such as violation of the automatic stay to be determined in arbitration did not conflict with the purpose or objectives of the Bankruptcy Code.

The court relied on three factors in reaching the decision. First, the debtor had received a discharge and was no longer in need of stay protection. Second, the fact that the complaint was styled as a class action demonstrated to the court that the claims were not tied to the debtor’s bankruptcy. Finally, and most surprising, the court held that an arbitrator was just as capable as a bankruptcy judge to address issues related to the automatic stay.

Had the MBNA case dealt with a different core matter, such as claim adjudication, the result might not have been surprising, as few could argue that an arbitrator could, in most instances, adjudicate such an issue just as well as a Bankruptcy Court. Allowing an arbitrator to decide a claim for willful violation of the automatic stay, however, seems to go beyond a simple respect for arbitration agreements.

Had the debtor not attempted to bring a class action, one would imagine that the court would have ruled otherwise. However, other decisions by other courts certainly do not support that conclusion. See Mintze v. American General Financial Services, Inc., 434 F3d 222 (3rd Cir. 2006) (holding that arbitration must be order with respect to rescission claim when Congressional intent to the contrary is not established); The Whiting-Turner Contracting, Co. v. Electric Machinery Ent., Inc., 479 F.3d 791 (11th Cir. 2007) (determination of the res of a constructive trust was not core, and even if core, arbitrating the claim would not inherently conflict with the purposes of the Bankruptcy Code); Arellano v Montoya, 2007 Bankr . LEXIS 2055 (Bankr. NM June 14, 2007) (claims for breach of contract, fraud, and other torts were found to be non-core, and despite provision in unconfirmed plan that attempted to reject arbitration agreements, the court ordered arbitration).

Arbitration Not Enforced

The 4th U.S. Circuit Court of Appeals addressed the issue of the enforceability of an arbitration agreement against a bankrupt debtor in Phillips v. Congelton L.L.C., 403 F.3d 164 (4th Cir. 2005). Applying essentially the same factors as the 2d Circuit, the 4th Circuit reached a different result.

In Phillips , a dispute arose over the sale of assets and certain advances made by a former owner, Phillips, to the debtor pre-petition. The underlying sale documents required that disputes to be submitted to arbitration in London, in accordance with the “Commercial Arbitration Rules then in effect of the International Arbitration Association.” Id at 166. A dispute arose, and one of owners of the debtor and a party to the agreements, Congelton, made a demand for arbitration in accordance with the agreements. Prior to the commencement of arbitration, Phillips filed an involuntary bankruptcy petition against the debtor in the United States.

Thereafter, Phillips filed an adversary proceeding seeking a determination of the amount of his claim against the debtor and seeking a determination that he was no longer required to advance funds to the debtor. Congelton requested that the Bankruptcy Court dismiss the adversary proceeding and force Phillips to submit the claims to arbitration, in accordance with the agreements of the parties. The court denied Congelton’s request, citing the fact that the adversary proceeding involved a core matter that was critical to the debtor’s ability to formulate a plan. The District Court affirmed the Bankruptcy Court, and Congelton appealed to the 4th Circuit.

The 4th Circuit determined that the matters in dispute were core. Then, the court proceeded to apply the McMahon test to determine whether the matter should be sent to arbitration. The court’s application of that test focused on whether there was an inherent conflict between arbitration and bankruptcy with respect to the issues in dispute. The court held that there was an inherent conflict because the adversary proceeding dealt with claims against the estate, the resolution of which would determine whether the debtor could reorganize.

In reaching the decision, the 4th Circuit stated that “[a]rbitration is inconsistent with centralized decision making because permitting an arbitrator to decide a core issue would make debtor-creditor rights ‘contingent upon an arbitrator’s ruling’ rather than the ruling of the bankruptcy judge assigned to hear the debtor’s case.” Id at 169.

The 4th Circuit’s approach would give comfort to most bankruptcy practitioners, because most core issues have a direct impact on a debtor’s reorganization and interrelate to many other issues decided by the Bankruptcy Court. In addition, the 4th Circuit, while paying deference to the FAA, seems to recognize that an arbitrator may not be in the best position to decide issues that are unique to bankruptcy.

Agreement Survives Rejection

If simply filing a bankruptcy petition is not sufficient to extricate a party from such an agreement, are there any events in a bankruptcy that might change the enforceability of the arbitration agreement? One recent case demonstrates the strength of arbitration agreements, even in the face of rejection of the underlying contract.

A U.S. District Court in Delaware recently held that rejection of a contract containing a valid arbitration agreement does not relieve the parties of the obligation to submit to arbitration. Selby’s Market, Inc. v. PCT ( In re Fleming Companies, Inc.), 2007 U.S. Dist. LEXIS 18739 (D. Del. March 16, 2007). In that case, after rejecting an agreement with a third-party supplier, the debtor filed for arbitration with the American Arbitration Association, in accordance with the provisions of the underlying supply agreement. The debtor sought payment from the supplier for an alleged breach of the supply agreement between the two of them.

Thereafter, a plan was confirmed and a post-confirmation trustee (PCT) was appointed. The PCT sought to compel arbitration, even though the underlying agreement had been rejected by the debtor. The seller argued that because the underlying agreement had been rejected, the PCT could no longer reap the benefits of the arbitration clause contained within that agreement.

The Bankruptcy Court disagreed, holding that the arbitration clause survived rejection of the contract, because a rejection is not a termination of the underlying contract. In a short opinion, the District Court affirmed the bankruptcy court’s ruling, reasoning that a rejection of a contract only rejects provisions of a contract that are executory (remaining unperformed) and is not meant to alter substantive rights of a party. Id at *7. Accordingly, the court held that the arbitration provision survived rejection of the underlying contract.

It would be interesting to see if the same result would have been reached had the party seeking arbitration been the creditor, rather than the debtor. The Fleming case only highlights further how deferential courts have become to arbitration agreements in commercial contracts.

 

R. Timothy Bryan
Patton Boggs LLP
tbryan@pattonboggs.com

Bryan is a director of TMA International and a past president of TMA’s Chesapeake Chapter. He can be reached at (703) 744-8030.

Brent R. McIlwain
Associate
Patton Boggs LLP
bmcilwain@pattonboggs.com
McIlwain can be reached at (214) 758-3581.

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