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March 27, 2014 Articles

Compelling Arbitration in an Adversary Proceeding

More and more bankruptcy and district courts have compelled arbitration against debtors or their trustees.

By Gregory W. Werkheiser and Christopher M. Hayes

Although debtors and bankruptcy trustees typically favor litigating claims against third parties in the friendly confines of a bankruptcy court, those initiating adversary proceedings against counterparties to a contract that contains an arbitration provision may find themselves litigating in a somewhat less friendly venue: in a conference room in the local offices of an arbitration association. Debtors and bankruptcy trustees, who stand in the shoes of the debtor, are often subject to arbitration provisions contained in the debtor’s pre-petition contracts when they assert claims arising from those agreements. In such a case, the Federal Arbitration Act generally requires bankruptcy judges to compel a debtor or trustee to comply with the debtor’s agreement to arbitrate certain disputes between the parties, unless arbitration would conflict with a fundamental purpose of the Bankruptcy Code. As explained below, conflicts between the Bankruptcy Code and arbitration are not easily identified, and more and more bankruptcy and district courts have compelled arbitration against debtors or their trustees. See, e.g., In re Great Spa Mfg. Co., 2009 WL 1457740 (Bankr. E.D. Tenn. 2009); In re Tirex, Inc., 395 B.R. 182 (Bankr. S.D. Fla. 2008); In re Shores of Panama, Inc., 387 B.R. 864 (N.D. Fla. 2008); In re Wire Comm Wireless, Inc., 2008 WL 4279407 (E.D. Cal. 2008); In re Piedmont Engineers of Carolinas, P.C., 2008 WL 2902182 (Bankr. M.D.N.C. 2008); Brownstone Inv. Grp., LLC v. Levey, 514 F. Supp. 2d 536 (S.D.N.Y. 2007); In re Martin, 387 B.R. 307 (Bankr. S.D. Ga. 2007); In re Friedman’s, Inc., 372 B.R. 530 (Bankr. S.D. Ga. 2007); Pac. Emp’rs Ins. Co. v. Moglia, 365 B.R. 863 (N.D. Ill. 2007); In re Cooley, 362 B.R. 514 (Bankr. N.D. Ala. 2007); In re Fries, 2007 WL 1073868 (Bankr. D. Md. 2007); In re Dixon, 2007 WL 703612 (Bankr. M.D. Ala. 2007); In re Arellano, 2007 WL 1746246 (Bankr. D. N.M. 2007); In re Dawsey, 2007 WL 1140358 (Bankr. M.D. Ala. 2007); In re Rozell, 357 B.R. 638 (Bankr. N.D. Ala. 2006); In re White, 2006 WL 3694858 (Bankr. N.D. Ala. 2006); In re Merrill, 343 B.R. 1 (Bankr. D. Me. 2006).

The Federal Arbitration Act
The Federal Arbitration Act provides that an agreement to settle by arbitration any claim arising from such agreement “shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” 9 U.S.C. § 2. The act has established a liberal federal policy favoring arbitration agreements (see Moses H. Cone Memorial Hospital v. Mercury Construction Corp., 460 U.S. 1, 24 (1983)), and courts are required to enforce rigorously agreements to arbitrate. See Dean Witter Reynolds, Inc. v. Byrd, 470 U.S. 213, 221 (1985). Under 9 U.S.C. § 4, a party to an arbitration agreement may move for an order compelling arbitration, and the burden is placed on any party opposing arbitration—including a debtor or bankruptcy trustee—to show that Congress intended to preclude an arbitration under the circumstances. See Shearson/American Express, Inc. v. McMahon, 482 U.S. 220, 227 (1987).

Hays v. Merrill Lynch
In 1989, the Third Circuit considered whether a bankruptcy trustee was bound by a pre-petition contract between the debtor and a securities brokerage firm that contained an arbitration provision. Hays & Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 885 F.2d 1149 (3d Cir. 1989). In holding that the trustee was obligated to arbitrate claims arising from the contract, the court cited the long-recognized principle that a trustee is generally bound by the debtor’s nonexecutory contracts. Id. at 1153–54. The Third Circuit noted that there was no reason to make an exception for arbitration agreements, especially in the face of the strong federal policy favoring arbitration. Id. at 1153. The court therefore held that “the trustee-plaintiff stands in the shoes of the debtor for the purposes of the arbitration clause and that the trustee-plaintiff is bound by the clause to the same extent as would the debtor.” Id.

The Third Circuit, however, distinguished between debtor-derived claims and Bankruptcy Code-derived creditor claims under section 544. The latter, according to the Third Circuit, are creditor claims that the Bankruptcy Code authorizes a bankruptcy trustee to assert on their behalf, and because creditors were not parties to an agreement to arbitrate, the Third Circuit reasoned that the trustee was not bound to arbitrate their claims. Id. at 1155. Notably, though, no circuit court decision concerning the compelling of an arbitration against a bankruptcy trustee outside the Third Circuit has since made a distinction between “debtor-derived” and “creditor-based” claims. Thus, given the decisions discussed below, it is not clear that the Third Circuit’s distinction regarding creditor claims has continued vitality, especially outside the Third Circuit.

In re Mintze
The Third Circuit had an opportunity to address the issue of the ability to compel arbitration against a debtor again in 2006. Mintze v. Am. Gen. Fin. Servs., Inc. (In re Mintze), 434 F.3d 222 (3d Cir. 2006). Reiterating its earlier holding in Hays, the Third Circuit held that a bankruptcy court lacked authority and discretion to deny enforcement of an arbitration provision where the debtor failed to establish that Congress intended to preclude judicial remedies for its claims. Id. at 226. It is important to note that the Third Circuit reached this conclusion even though the debtor’s claim was a “core” proceeding under section 157 of the Bankruptcy Code, specifically noting that its decision in Hays applied equally to core and non-core proceedings. Id. at 229, 231. To prevent an arbitration, the debtor must establish that Congress intended to preclude a waiver of judicial remedies. Id. See also Rozell v. Citifinancial Auto Corp. (In re Rozell), No. 06-80123-JAC-13, 2006 WL 3531284, at *4 (Bankr. N.D. Ala. Dec. 7, 2006) (“Under McMahon, the inherent conflict standard must still be satisfied before a bankruptcy court has discretion to deny arbitration.”). The Third Circuit held that a rescission claim that would affect the order of priority and amount of distribution to other creditors did not create a conflict between the Bankruptcy Code and an arbitration. Id. at 232.

MBNA v. Hill
The Second Circuit also took up this issue in 2006, similarly concluding that a bankruptcy court did not have discretion to refuse to stay an adversary proceeding under the facts at issue pending an arbitration. MBNA Am. Bank, N.A. v. Hill, 436 F.3d 104 (2d Cir. 2006). The
debtor asserted that a creditor violated the automatic stay by automatically withdrawing a monthly payment from her bank account even though the creditor had notice of her bankruptcy filing. Id. at 105. The Second Circuit noted that even as to core proceedings (such as an alleged violation of the automatic stay), a bankruptcy court does not have discretion to override an arbitration agreement unless it finds that the proceedings are based on provisions of the Bankruptcy Code that “inherently conflict” with the Arbitration Act or that arbitration of the claim would “necessarily jeopardize” the objectives of the Bankruptcy Code. Id. at 108. Because the debtor’s debts had already been discharged, the Second Circuit concluded, among other reasons, that an arbitration would not “seriously” jeopardize the objectives of the Bankruptcy Code, and therefore ordered the debtor to arbitration. Id. at 109.

In re Electric Machinery Enterprises, Inc.
The Eleventh Circuit followed suit in 2007 in Whiting-Turner Contracting Co. v. Electric Machinery Enterprises, Inc. (In re Electric Machinery Enterprises, Inc.), 479 F.3d 791 (11th Cir. 2007). In re Electric Machinery involved an adversary proceeding filed by a debtor subcontractor against a general contractor, alleging that the general contractor owed it funds collected by the general contractor in a settlement with its customer. Id. at 794. Prior to the adversary proceeding, the general contractor and the subcontractor entered into a tolling agreement containing an arbitration provision regarding their dispute. Id. The bankruptcy court, in holding that the funds were being held by the general contractor in a “constructive trust” on behalf of the subcontractor, denied a motion to compel on the grounds that the dispute involved a core proceeding. Id. at 795.

In evaluating whether an inherent conflict existed between an arbitration and the underlying purposes of the Bankruptcy Code, the Eleventh Circuit noted that other courts distinguished between core and non-core proceedings (including Hays, which, as noted above, had also distinguished between “debtor-derived” and “creditor-based” claims). Id. at 796. The Eleventh Circuit stated that, in general, bankruptcy courts do not have discretion to decline to enforce an arbitration agreement relating to a non-core proceeding. Id. Furthermore, even if a core proceeding was involved, the bankruptcy court was obligated to determine whether enforcing a valid arbitration agreement would inherently conflict with the underlying purposes of the Bankruptcy Code. Id. Although the Eleventh Circuit determined that the proceeding at issue was non-core, it stated that even if the proceeding were core, the debtor had not sustained its burden to demonstrate that Congress intended to preclude an arbitration. Id. at 798. Therefore, it held that the bankruptcy court erred in denying the motion to compel arbitration. Id. at 799.

Conflicts Between an Arbitration and the Bankruptcy Code
As these cases suggest, courts have not readily found that an arbitration conflicts with general bankruptcy policy, especially with respect to non-core proceedings. There are, however, exceptions where an arbitration has been found to conflict with the Bankruptcy Code.

In In re U.S. Lines, Inc., the Second Circuit held that a bankruptcy court did not abuse its discretion in refusing to refer an adversary proceeding to arbitration. 197 F.3d 631 (2d Cir. 1999). In that case, a reorganization trust (as successor in interest to the debtor) filed an adversary proceeding against four insurance companies seeking a declaratory judgment that the companies were liable to the trust under pre-petition insurance policies issued to the debtor. Id. at 635. The Second Circuit found that the action involved a core proceeding because the insurance agreements included a pay-first provision that required the debtor to pay the claims of its injured workers before the insurance companies became liable to indemnify the debtor. Id. at 635. Thus, if the reorganization trust were to pay claims from assets available for other creditors first and then fail to recover under the policies (the subject of the adversary proceeding), an inequitable distribution among creditors would result. Id. at 639. Therefore, the Second Circuit concluded that the proceeding was core because it directly affected the bankruptcy court’s core administrative function of asset allocation among creditors, and that the bankruptcy court had discretion to reject an arbitration. Id. at 639, 641.

Similarly, the Fifth Circuit affirmed a bankruptcy court’s refusal to compel arbitration in In re Gandy, 299 F.3d 489 (5th Cir. 2002). Among other claims, the debtor primarily sought to recover alleged fraudulent transfers from the debtor’s partners in a limited partnership. Id. at 493. The Fifth Circuit noted that the bankruptcy court retained significant discretion to refuse to refer a proceeding to arbitration where the proceeding involves claims derived entirely from federal rights conferred by the Bankruptcy Code. Id. at 495, 497 (citing In re Nat’l Gypsum, 118 F.3d 1056, 1067 (5th Cir. 1997) (“The heart of Debtor’s complaint concerns the avoidance of fraudulent transfers and implicates non-bankruptcy contractual and tort issues ‘in only the most peripheral manner.’”). The Fifth Circuit further pointed out that resolution of the debtor’s claims appeared to represent nearly the entirety of the debtor’s bankruptcy estate and was therefore central to the purposes and policies of the Bankruptcy Code. Id. at 498.

Finally, in In re White Mountain Mining Co., the Fourth Circuit affirmed a bankruptcy court’s rejection of an international arbitration in London where investors in the debtor were disputing whether millions of dollars in advances made by one of the investors to the debtor were debt or equity. 403 F.3d 164 (4th Cir. 2005). The bankruptcy court concluded that a conflict existed with allowing an arbitration to proceed because it would interfere with the debtor’s efforts to reorganize by making it difficult for the debtor to obtain additional financing, undermine creditor confidence in the debtor’s ability to reorganize, impose additional costs on the estate, and divert attention and time of the debtor’s management. Id. at 170.

A party who is sued by a debtor or bankruptcy trustee on claims arising from or related to a pre-petition contract that contains an arbitration clause should give serious consideration to moving to compel arbitration of the dispute and seeking a stay of the adversary proceeding pending in bankruptcy court. In many recent cases, the debtor has not been able to identify a conflict sufficient to preclude application of the Federal Arbitration Act, although debtors may have a greater chance of avoiding arbitration in core bankruptcy matters.

Keywords: bankruptcy and insolvency litigation, adversary proceedings, arbitration, Federal Arbitration Act, core, non-core

Gregory W. Werkheiser and Christopher M. Hayes – March 27, 2014