Arbitration Agreements in Bankruptcy - ABA YLD 101 Practice Series


By Johnathan C. Bolton

Arbitration agreements are common provisions in commercial contracts. When a counterparty breaches its contract with your client and then files for bankruptcy relief, will you be able to enforce the arbitration clause or must you litigate the breach of contract action in the bankruptcy court?.

There is a split of authority regarding whether and when a bankruptcy court has the discretion to deny the right to arbitration to a creditor ( i.e., when does the contractual right to arbitrate override the bankruptcy court's jurisdiction). First, the Circuit Courts are split on the substantive point of what constitutes a "bankruptcy issue"; sufficient to trump the FAA's mandate in favor of arbitration. Second, the Circuit Courts are split on the procedural issue of what standard of review is applicable on appeal of a bankruptcy court's decision to deny arbitration. This article will discuss what you need to know about the enforceability of arbitration agreements in the context of a bankruptcy case and where the circuit courts diverge on this issue.

Federal Courts typically Favor Arbitration of Disputes.
The Federal Arbitration Act (the "FAA";) provides that arbitration agreements "shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract."; Gandy v. Gandy ( In re Gandy), 299 F.3d 489, 494 (5th Cir. 2002) (quoting 9 U.S.C. § 2) (emphasis added). Federal courts recognize that federal policy favors the enforcement of bargained-for arbitration agreements. See Moses H. Cone Mem'l Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24 (1983). Indeed, the judicial trend has been toward promoting and enforcing arbitration where the parties to a contract have evidenced their intent to resort to arbitration for the resolution of disputes between them. Thus, the party attempting to overcome an arbitration provision not only has the procedural burden of trying to convince the bankruptcy court that it should not send a dispute to arbitration, it also must overcome the tide of recent federal court jurisprudence favoring arbitration. See, e.g., MBNA Am. Bank, N.A. v. Hill, 436 F.3d 104, 108 (2d Cir. 2006).

Arbitration as to "Bankruptcy Issues"; is Generally Disfavored.
The Supreme Court, in the case of Shearson/Am. Express, Inc. v. McMahon, 482 U.S. 220 (1987), held that the party resisting arbitration must establish that "Congress intended to preclude a waiver of judicial remedies for the statutory rights at issue"; and that any such "congressional intent"; is to be deduced from (1) the statute's text, (2) legislative history, or (3) an inherent conflict between arbitration and the underlying purpose of a statute. 227. Few cases have addressed the first and second prong of the McMahon guidelines. The judicial divergence stems from how courts have determined whether there is an inherent conflict between the purposes of the Bankruptcy Code and the arbitration of a particular dispute.

The tension between the FAA and the Bankruptcy Code has been described as follows:

[The Bankruptcy Code and the FAA foster policy] at near polar extremes: bankruptcy policy exerts an inexorable pull towards centralization while arbitration policy advocates a decentralized approach toward dispute resolution.

If a severe conflict [between these policies] is found, then the court can properly conclude that, with respect to the particular Code provision involved, Congress intended to override the Arbitration Act's general policy favoring the enforcement of arbitration agreements.

Hill, 436 F.3d at 108 (emphasis added).

The Substantive Issue: What Constitutes a "Bankruptcy Issue"; Sufficient to Trump Arbitration?
The starting point for the substantive issue analysis is whether the matter to be arbitrated is a "core"; or "non-core"; bankruptcy issue. If a matter is not "core"; and is merely "related to"; the Bankruptcy Code, it is likely that arbitration will be ordered. Older Circuit Court cases seldom questioned the bankruptcy court's discretion to refuse to order arbitration of "core"; matters. However, recent cases have held that, although relevant, the "core v. non-core"; distinction is not dispositive and the bankruptcy court must conduct an analysis of congressional intent, even as to "core"; matters. See, e.g., Hill, 436 F.3d at 109; In re Mintze, 434 F.3d 222, 222 (3d Cir. 2006); Ins. Co. of N. Am. v. NGC Settlement Trust & Asbestos Claims Mgmt. Corp. ( In re Nat'l Gypsum Co.), 118 F.3d 1056, 1067 (5th Cir. 1997).

The Third Circuit - Bankruptcy Court does not have any discretion to deny arbitration Non- Bankruptcy Code-specific causes of action.

The Third Circuit has held that if the complaint does not specifically raise claims under the Bankruptcy Code, there is no "bankruptcy issue"; under McMahon and the dispute must be ordered to arbitration.

In the case of In re Mintze, a Chapter 13 the debtor brought an adversary proceeding seeking the rescission of the mortgage under the Truth in Lending Act and several federal and state consumer protection laws. 434 F.3d at 222. The lender filed a motion to compel arbitration based on an arbitration clause contained in the mortgage agreement. The bankruptcy court determined that Mintze's adversary proceeding was a "core"; matter and denied the arbitration request. The district court affirmed.

The Third Circuit reversed noting that the debtor's rescission claim was based on non-Bankruptcy Code-specific causes of action and stated: "With no bankruptcy issue to be decided by the Bankruptcy Court, we cannot find an inherent conflict between arbitration of [the debtor's claims based on consumer protection laws] and the underlying purposes of the Bankruptcy Code."; Id. Based on this very limited analysis and using a de novo standard of review, the Third Circuit determined that the bankruptcy court did not have discretion to override the "mandatory duty under the Arbitration Act."; Id. at 232.

The Second Circuit - "Core"; issues can be sent to arbitration if the Bankruptcy Case is not an on-going reorganization case and determination of the dispute will not affect on administration of the bankruptcy estate.

In the case of MBNA Am. Bank, N.A. v. Hill, 436 F.3d 104 (2d Cir. 2006), the Second Circuit similarly found that an agreement to arbitrate outweighed any countervailing policy concerns under the Bankruptcy Code where a Chapter 7 debtor filed an adversary proceeding against MBNA America Bank, N.A. ("MBNA";) alleging unjust enrichment and stay violations under Section 362(h) of the Bankruptcy Code. The bankruptcy court denied MBNA's motion to stay or dismiss in favor of arbitration. The district court affirmed in part and reversed in part, finding that arbitration of the alleged automatic stay violation would "seriously jeopardize the objectives of the Bankruptcy Code,"; but holding that the unjust enrichment claim was non-core and arbitrable (Hill agreed to abandon the unjust enrichment claim if arbitration was ordered, therefore, that claim was not a part of the Second Circuit's opinion). Id. at 107.

In Hill, the Second Circuit applied the McMahon test by analyzing the conflict between arbitration and the policies of the Bankruptcy Code and the effect of the core/non-core determination on judicial discretion. Although agreeing that the automatic stay claim was a "core"; proceeding, the Second Circuit held that:

[A]rbitration of [Hill's] claim would not seriously jeopardize the objectives of the Bankruptcy Code because: (1) Hill's estate has now been fully administered and her debts have been discharged, so she no longer requires protection of the automatic stay and resolution of the claim would have no effect on her bankruptcy estate; (2) as a purported class action, Hill's claims lack the direct connection to her own bankruptcy case that would weigh in favor of refusing to compel arbitration; and (3) a stay is not so closely related to an injunction that the bankruptcy court is uniquely able to interpret and enforce its provisions.

Id. at 109. The Second Circuit concluded that, even though Hill was asserting core issues (stay violations) in her adversary proceeding, because Hill's bankruptcy case had been closed and she had received her discharge, distributions of the estate would not be affected by arbitration, and there was no inherent conflict between arbitration of this "core"; issue and the policies of Bankruptcy Code.

The Fifth Circuit - A debtor's claims under Sections 544, 548, and 550 of the Bankruptcy Code are "core"; bankruptcy issues that are not subject to arbitration .

The Fifth Circuit affirmed the denial of arbitration in the Chapter 11 case of In re Gandy, 299 F.3d 489 (5th Cir. 2002). Gandy involved an adversary proceeding brought by the debtor which asserted causes of action under Sections 544, 548, and 550 of the Bankruptcy Code.

The bankruptcy court found that the debtor's claims were core and were not available outside of bankruptcy. Although the appellants argued that the debtor had merely "window-dressed"; state law claims (breach of fiduciary duty, negligence, fraud, constructive trust and breach of contract) and pled them as bankruptcy claims, the Fifth Circuit dismissed that argument, found that the causes of action were derived from the Bankruptcy Code, and addressed the factors under the McMahon test.

The Fifth Circuit relied on the following four facts: (1) the debtor's claims represented very nearly the entirety of the bankruptcy estate; (2) the central bankruptcy purpose of expeditious and equitable distribution of assets of the debtor's estate was "intimately implicate[d];"; (3) a proof of claim was already filed from one of the alleged fraudulent transferees, which invoked the "peculiar powers of the bankruptcy court;"; and (4) claims for substantive consolidation had been asserted, which may be an issue that is "out of reach in arbitration."; Id. at 498-99.

In reaching its decision, the Fifth Circuit, held that it reviewed de novo both the issue of (1) whether a bankruptcy court has discretion to deny a motion to stay a bankruptcy proceeding pending arbitration and (2) the bankruptcy court's determination of whether an adversary proceeding in bankruptcy court is "core"; under 28 U.S.C. § 157(b). Id. at494.

The Fourth Circuit - The issue of characterization of an advance to the debtor as debt versus a capital contribution in a Chapter 11 case is a core matter, not subject to international arbitration.

Running counter to the trend of the cases cited above is the Fourth Circuit's decision in the case of Phillips v. Congelton, L.L.C. ( In re White Mountain Mining Co.), 403 F.3d 164 (4th Cir. 2005) where the matter to be litigated was whether advances made to the debtor were more properly characterized as debt rather than as capital contributions.

The West Virginia bankruptcy court denied a motion to compel arbitration of that matter, holding that the dispute over the nature of the advances was a core issue under 28 U.S.C. § 157(b)(2)(B) and that, under the third McMahon factor, arbitration would have "substantially interfered with the debtor's efforts to reorganize."; Id. at 169. The Phillips court determined that centralized dispute resolution was particularly important in Chapter 11 cases and held that an arbitration proceeding would:

(1) make it very difficult for the debtor to attract additional funding because of the uncertainty as to whether [the owner's] claim was debt or equity, (2) undermine creditor confidence in the debtor's ability to reorganize, (3) undermine the confidence of other parties doing business with the debtor, and (4) impose additional costs on the estate and divert the attention and time of the debtor's management[.]

Id. at 170.

The Phillips decision employed a very practical approach to reviewing the bankruptcy court's discretion. First, the court agreed that the "equity or debt"; issue was a core question, thus the bankruptcy court had the discretion to determine if an inherent conflict between arbitration and the underlying purpose of bankruptcy laws existed. Second, the Fourth Circuit found that arbitration of the matter was inconsistent with Bankruptcy Code's goals of reorganization and centralized dispute resolution - and the Bankruptcy Court's findings of those facts were not clearly erroneous. Implicit in the Fourth Circuit's holding is that a bankruptcy court's decision whether to order the arbitration of a "core"; matter is to be reviewed as a finding of fact under the clear error standard rather than de novo as in Mintze and Hill as discussed below.

The Procedural Issue: What Standard of Review does a District Court use to Review a Bankruptcy Court's Order Regarding Referral to Arbitration?
The Mintze and Hill Courts each appear to apply the McMahon test at the outset of their analysis, not to determine whether the bankruptcy court properly exercised its discretion in applying the McMahon factors but, rather, to determine if the bankruptcy court had any discretion to deny arbitration. Substituting their own analyses, both courts reviewed the facts of the respective cases and determined that there was no conflict between the FAA and the Bankruptcy Code.

On the other hand, after initially determining that the case was a close call involving a core matter, the White Mountain Court recognized that the bankruptcy court had discretion to decide whether to deny or order arbitration and reviewed the bankruptcy court's factual determinations and use of discretion in applying the third McMahon factor for clear error. 403 F.3d at 170. In White Mountain, the Fourth Circuit looked at the core/non-core distinction as a preliminary issue to determine the existence of discretion and then reviewed the bankruptcy court's application of the McMahon test for clear error. The Gandy Court appears to follow this approach as well.

Obviously, the standard of review employed by the appellate court will often determine the outcome of the case on appeal. Reviewing the decision of the bankruptcy court is fairly straightforward if the appellate court has determined that the bankruptcy court had no discretion to decide the issue of arbitrability. In light of the possible uncertainty over what standard of review will apply and whether the bankruptcy or district court's factual determinations will really count, counsel involved in a dispute over the arbitrability of a matter should be sure to make a full record and obtain comprehensive findings from the bankruptcy court to ensure success on appeal.


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About the Author

Johnathan is a senior associate in the Bankruptcy, Reorganization and Creditors' Rights section of Fulbright & Jaworski L.L.P. in Houston, Texas. He is board certified in Business Bankruptcy Law by the Texas Board of Legal Specialization and the American Board of Certification. Johnathan is also the Chairman of the Bankruptcy Committee of the Young Lawyer's Division of the American Bar Association.

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