Arbitration clauses and agreements are common place in many industries such as banking and construction. Disputes arise, however, over the enforceability of an arbitration agreement when one of the parties to the agreement seeks protection under the Bankruptcy Code (11 U.S.C. §§ 101 et seq.). Bankruptcy courts encountering an arbitration agreement must balance the overriding federal policy under the Federal Arbitration Act (the “FAA”) favoring arbitration with the overriding policy under the Bankruptcy Code to administer a debtor’s affairs under the supervision of the bankruptcy court. This article provides an overview of the factors considered by bankruptcy courts in deciding whether to enforce an arbitration clause.
The Bankruptcy Code – A Fresh Start
When a debtor files for bankruptcy protection, a stay of all acts to enforce or collect on an obligation against the debtor automatically arises. This automatic stay is central to the bankruptcy process and serves to protect the principal purposes of the Bankruptcy Code: (1) providing the debtor with a fresh start; (2) protecting the assets of the debtor’s estate (which is automatically created when the debtor files for bankruptcy); and (3) allowing the bankruptcy court to centralize disputes concerning the debtor, its assets, and the estate in one forum. This third purpose protects both debtors and creditors from piecemeal litigation and conflicting judgments. In other words, “[e]ase and centrality of administration are thus foundational characteristics of bankruptcy law.” Moses v. CashCall, Inc., 781 F.3d 63, 72 (4th Cir. 2015).
The FAA – Robustly Followed
On the other hand, the FAA provides, in relevant part, that arbitration agreements “shall be valid, irrevocable, and enforceable, save upon grounds as exist at law or in equity for the revocation of any contract.” 9 U.S.C. § 2. Courts have interpreted the FAA as establishing a “liberal federal policy favoring arbitration agreements.” Moses, 781 F.3d at 71 (internal citations omitted). Consequently, courts have found that unless Congress has clearly expressed an intent to preclude the arbitration of a statutory claim, an agreement to arbitrate will be enforced.
To determine Congress’ intent, the United States Supreme Court promulgated a three-factor test in Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987). First, courts look to the text of the statute at issue. If the statute does not clearly indicate Congress’ intent, then the courts look to the legislative history of the statute. If neither the text of the statute nor the legislative history provides guidance as to Congress’ intent, then the courts turn to the third factor: whether an inherent conflict exists between arbitration and the underlying purposes of the statute at issue.
In the context of the Bankruptcy Code, bankruptcy courts have generally found that neither the text of the Bankruptcy Code nor the legislative history establish a clear Congressional intent to create an exception to the FAA in the Bankruptcy Code. As such, bankruptcy courts focus their examination on the third factor: whether an inherent conflict exists.
Determining Whether An Inherent Conflict Exists: Core Versus Non-Core Issues
In determining whether an inherent conflict exists, bankruptcy courts examine whether the dispute involves a core or non-core bankruptcy matter.
Core matters are generally those matters for which the bankruptcy court has complete statutory authority to issue judgments and orders. Specifically, 28 U.S.C. § 157(b)(2) sets forth a non-exhaustive list of matters that are “core” proceedings. Those matters include:
- Matters concerning the administration of the debtor’s estate;
- Allowance or disallowance of claims against the debtor’s estate;
- Determining property that is exempt from the debtor’s estate;
- The estimation of claims or interests for purposes of confirming a plan under chapters 11, 12, or 13 of the Bankruptcy Code;
- Counterclaims by the debtor’s estate against persons filing claims against the debtor’s estate;
- Orders with respect to the debtor obtaining credit during the pendency of the bankruptcy;
- Orders to turn over property of the estate;
- Proceedings to determine, avoid, or recover preferences (transfers by debtors to creditors within a period before the bankruptcy filing that are determined to be preferential);
- Motions to terminate, annul, or modify the automatic stay;
- Proceedings to determine, avoid, or recover fraudulent transfers;
- Determination as to the dischargeability of particular debts owed to particular creditors;
- Objections to a debtor’s discharge;
- Determination of the validity, extent, or priority of liens;
- Confirmation of plans;
- Orders approving the use or lease of property, including a debtor’s ability to continue to use their cash collateral; and
- Orders approving the sale of property.
Section 157(b)(2) also includes a catch-all: other proceedings affecting the liquidation of the assets of the estate or the adjustment of the debtor-creditor or equity security holder relationship.
Determining whether a matter is core or non-core is only the first step. If the court determines the matter is a core matter, then the court will examine whether it is a substantively or procedurally core matter. “Substantively” core matters are those matters that involve substantive rights that either arise under the Bankruptcy Code or implicate the principal function of the bankruptcy process. Courts have found the following to be substantively core matters:
- A creditor’s (or debtor’s) exercise of the right of setoff;
- Adjudication of disputes regarding whether property constitutes property of the debtor’s estate (e.g., whether funds are trust funds held for the benefit of a non-debtor party);
- Actions to recover preference or fraudulent transfers;
- Orders involving the debtor’s use of cash collateral;
- Claim subordination issues; and
- Automatic stay or discharge injunction issues.
“Procedurally” core matters, on the other hand, do not implicate the substantive rights granted parties under the Bankruptcy Code and bankruptcy law. Rather, procedurally core matters are those matters that could have arisen outside of the bankruptcy context. For example, a debtor’s estate may have a counterclaim against a third-party. The right to bring this counterclaim may be a breach of contract claim. The debtor’s breach of contract claim is one that could have been brought by the debtor regardless of whether the debtor filed for bankruptcy protection.
If the court finds the matter to be a substantively core matter, then the court has discretion to compel or refuse to compel arbitration of the matter. If the court finds that the matter is non-core or a procedurally core matter, then the bankruptcy courts will generally find that they lack discretion to refuse to compel arbitration. For example, the Court of Appeals for the Eleventh Circuit held in In re Electric Mach. Enterprises, Inc., 479 F.3d 791 (11th Cir. 2007) that a determination of a debtor-subcontractor’s claim against a general contractor for payment from part of the general contractor’s settlement with a project owner over delay damages would have arisen irrespective of the debtor-subcontractor’s bankruptcy filing. As such, the bankruptcy court lacked discretion to refuse to compel arbitration of the dispute.
Although the core versus non-core analysis is an important step in determining whether an inherent conflict exists, bankruptcy courts also examine other factors – such as interference with the administration of the bankruptcy estate, piecemeal litigation, cost-efficiency considerations to arbitrate in a different venue, and the types of claims involved.
In short, whether an inherent conflict exists between the Bankruptcy Code and liberal enforcement of a valid agreement to arbitrate under the FAA is case and fact-specific. Seemingly minor differences – such as whether the bankruptcy case is in its infancy or near completion – may result in different determinations. Parties should proceed with caution once a bankruptcy case is filed to protect their rights, including the potential for waiving their right to arbitration.