MCLE Article: Bound in Bankruptcy

A recent circuit court opinion has made it clear that, in most cases, bankruptcy courts must enforce arbitration agreements

By Randall G. Block

Randall G. Block is a partner at Sedgwick, Detert, Moran & Arnold LLP in the firm's San Francisco office. Block is a litigator who focuses on commercial litigation, creditors' rights, and bankruptcy law, with an emphasis on representing businesses in commercial and real estate disputes.

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Until recently, the enforceability of arbitration agreements in bankruptcy courts was the subject of confusion. While a number of decisions held that arbitration agreements were generally enforceable, other courts--particularly within the Third Circuit--had ruled that an arbitration agreement was not enforceable when 1) the dispute to be arbitrated involved a "core" bankruptcy matter, or 2) the arbitration would otherwise jeopardize the policy and purposes of the Bankruptcy Code.

Now, the Third Circuit has clarified its prior decisions, holding that the distinction between core and noncore matters is irrelevant to the question of enforcing arbitration agreements. Rather, the issue is whether Congress, in enacting provisions of the Bankruptcy Code, intended to preclude a waiver of judicial remedies for the rights embodied in those provisions. Courts must discern this intent from the text of the provisions or their legislative history, or they must determine whether an inherent conflict exists between the underlying policies of the provisions and arbitration. Under this formulation, there is little room under the Bankruptcy Code to argue that arbitration agreements should not be enforced in ordinary tort or contract disputes, even when they may have a significant effect on the bankruptcy estate. Whether other disputes in bankruptcy, including core bankruptcy matters, are subject to arbitration continues to be determined on a case-by-case basis.

The Federal Arbitration Act (FAA) generally applies when parties have agreed to "[a] written provision in any...contract evidencing a transaction involving [interstate] commerce to settle by arbitration any controversy thereafter arising."1 A transaction typically involves "interstate commerce" within the meaning of the FAA when goods or services are sold across state lines or within a state but affecting commerce across a state line, or in circumstances in which one of the contracting parties is a resident of one state and the other party is a resident of another.2 In short, the reach of the FAA is as broad as the power of Congress to legislate and, more often than not, will apply in connection with a transaction of even modest size.3

The FAA establishes a federal policy favoring arbitration of commercial disputes, and the U.S. Supreme Court has instructed courts to enforce arbitration agreements rigorously.4 Any arbitration agreement covered by the FAA "shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract."5 One court noted that arbitration should not be denied "unless it can be said with positive assurance that an arbitration clause is not susceptible of an interpretation which would cover the dispute at issue."6

Federal law requires courts to stay an action pending completion of arbitration:

If any suit or proceeding be brought in any of the courts of the United States upon any issue referable to arbitration under an agreement in writing for such arbitration, the court in which such suit is pending, upon being satisfied that the issue involved in such suit or proceeding is referable to arbitration under such an agreement, shall on application of one of the parties stay the trial of the action until such arbitration has been had in accordance with the terms of the agreement, providing the applicant for the stay is not in default in proceeding with such arbitration.7

Under Section 3 of the FAA, a stay of proceedings is mandatory.8 The "Federal Arbitration Act 'leaves no place for the exercise of discretion by a...court, but instead mandates that...courts shall direct the parties to proceed to arbitration on issues to which an arbitration agreement has been signed.'"9 Indeed, under established case law, a court may go further. A court will dismiss an action with prejudice when "the arbitration clause [is] broad enough to bar all of the plaintiff's claims."10

Application of the FAA in Bankruptcy Courts

The strong federal policy favoring enforcement of arbitration clauses is now recognized to be applicable to disputes in bankruptcy court:

In enacting the Federal Arbitration Act in 1925, Congress declared that federal policy favors arbitration where the parties have agreed to it....In the past the applicability of this provision in a bankruptcy case has generally been questioned....The recent trend [recognized in 1995], however, has been to enforce arbitration clauses in bankruptcy cases....11

Notwithstanding the general recognition that arbitration agreements should be enforced in bankruptcy courts, a number of decisions, particularly within the Third Circuit, were often cited for the proposition that a bankruptcy court has discretion to deny enforcement of an arbitration agreement depending upon whether the matter is core or noncore.12 However, in In re Mintze, the Third Circuit expressly rebuffed the core/noncore distinction for determining whether an arbitration agreement may be enforced.13

Mintze involved the debtor's claims to rescind a prepetition loan agreement. The parties stipulated that the claims comprised core proceedings. The bankruptcy court determined that because the proceedings were core, it had the discretion to deny enforcement of the arbitration clause. Since, in the bankruptcy court's view, the outcome of the claim would affect the bankruptcy plan and the distribution of monies to other creditors, the court ruled that the matter was best resolved in bankruptcy court. The district court affirmed, but the Third Circuit disagreed:

The core/non-core distinction does not...affect whether a bankruptcy court has the discretion to deny enforcement of an arbitration agreement. It merely determines whether the bankruptcy court has the jurisdiction to make a full adjudication.14

In rejecting the notion that the bankruptcy court has discretion whether to enforce an arbitration agreement, the Third Circuit in Mintze followed the U.S. Supreme Court's decision in Shearson/American Express, Inc. v. McMahon.15 The Supreme Court had ruled that, to override the FAA's mandate for the enforcement of arbitration, the party opposing arbitration must demonstrate that "Congress intended to preclude a waiver of judicial remedies for the statutory rights at concern." This requires a determination made by reference to statutory language or legislative history or a finding of an inherent conflict between the policies of the Bankruptcy Code and arbitration.16 Applying McMahon's holding to the dispute before it, the court in Mintze found that the debtor failed to raise any statutory claims created by the Bankruptcy Code.17 The court also found no inherent conflict between arbitration of the debtor's claim for rescission and the underlying purposes of the Bankruptcy Code.18

The Third Circuit also took the opportunity in Mintze to explain its earlier decision in Hays v. Merrill Lynch, a case that has been frequently miscited for the proposition that a court has discretion to determine whether to order arbitration in core matters.19 In Hays, the court held:

[T]he district court lacked the authority and discretion to deny enforcement of the arbitration clause unless [the trustee] had met its burden of showing that the text, legislative history, or purpose of the Bankruptcy Code conflicts with the enforcement of an arbitration clause in a case of this kind, that is, a non-core proceeding brought by a trustee to enforce a claim of the estate in a district court.20

While the court in Hays held that the arbitration agreement at issue must be enforced, the decision was thereafter construed by a number of courts to limit enforcement of arbitration agreements to disputes involving noncore proceedings. In Mintze, the Third Circuit explained that Hays is not limited to noncore proceedings, and it found that the standard articulated in Hays applies to core and noncore cases alike.21

The Third Circuit in Mintze also addressed In re U.S. Lines, a case decided by the Second Circuit, in which a motion to compel arbitration was denied.22 U.S Lines involved 12,000 employees who had filed 18,000 separate claims for asbestos-related injuries sustained while sailing on ships in the debtors' fleet over four decades.23 The case involved the insurers' motion to compel arbitration of the declaratory judgment proceedings in bankruptcy court regarding the insurance policies that were the only potential source available to the personal injury creditors. The court held that under the particular circumstances of the case--a "complex factual scenario involving...multiple claims, policies and insurers" and "mass tort actions involving claims against an insolvent debtor"--the bankruptcy court did not err in finding that arbitration would jeopardize the policy and purposes of the Bankruptcy Code.24 Although the U.S. Lines court applied a standard that would, at least theoretically, comport with Mintze, the court did not further elaborate about the actual manner in which arbitration and the Bankruptcy Code were at odds. Nor is it obvious why arbitration would jeopardize the policy and purposes of the Bankruptcy Code in that case.

Nonetheless, the court in Mintze explained that U.S. Lines "actually support[s] the contention that Hays applies to core proceedings."25 It noted that in U.S. Lines, the finding that a proceeding was core did not automatically give the bankruptcy court discretion regarding arbitration, since the McMahon standards governed.26

Finally, another case that is sometimes cited in support of a looser, discretionary standard for enforcement of arbitration agreements is In re First Alliance Mortgage Company.27 First Alliance involved "a rather large case that includes enforcement actions...brought by various states, the Federal Trade Commission, and several private claimants" against an officer of First Alliance and debtors--including First Alliance and other mortgage lenders, among others--for alleged violation of consumer protection laws.28 The officer sought to compel arbitration of the class claims against him. The court denied the motion and, in the context of the enforcement actions by state and federal agencies and other actions by private litigants, stated:

The decision to compel or deny arbitration is discretionary with the bankruptcy judge. A bankruptcy judge does not abuse his discretion when he refuses to compel arbitration where the determination in such a proceeding would affect the amount, existence and priority of claims to be paid out of the general funds and, thus involve the interests of other creditors.29

Had the First Alliance court followed Mintze, discretion would have played no role in the decision whether to compel arbitration. The Third Circuit's logic in that regard, following McMahon, appears unassailable. The involvement of other creditors is not by itself enough to deny arbitration. Indeed, it is questionable whether, in light of Mintze, the First Alliance court would have decided that case as it did.

Enforcement of the Agreement to Arbitrate

These developments leave open the question of what disputes in bankruptcy are subject to arbitration. The obligation to arbitrate, undertaken as a matter of contract, is particularly strong when one of the litigants is seeking benefits under the terms of the contract. Fundamentally, a plaintiff cannot enforce only the "beneficial" parts of a contract without assuming the burdens of the contract. Citing to this basic tenet, California courts have held that a party was precluded from seeking the benefit of a contract, in the form of damages, while seeking to avoid an arbitration clause.30 Indeed, the Bankruptcy Code itself provides that, with respect to executory contracts, a debtor cannot assume part of a contract but instead must accept the burdens as well as the benefits.31 A debtor that wishes to recover damages under the terms of a contract containing an arbitration clause ordinarily would be required to arbitrate the dispute.

In re Elcom Technologies Corporation is illustrative of a case in which the plaintiffs, seeking to benefit from a contract, were held bound by its arbitration provision.32 In Elcom, the bankruptcy court enforced an arbitration clause against the former directors of the debtor on coverage issues brought under directors and officers (D&O) policies. The plaintiffs, the former directors of the debtor, filed an action in bankruptcy court against the insurers to determine whether the insurers were required to defend and indemnify the plaintiffs in the trustee's action in the bankruptcy court against the plaintiffs for breach of various duties owed to the debtor's creditors and the bankruptcy estate. The bankruptcy court granted the insurers' motion to compel arbitration of the coverage dispute based on the terms of the policies. The district court affirmed the bankruptcy court's order, finding that the proceeding involved a dispute that did not jeopardize the objectives of the Bankruptcy Code and that the arbitrators would not have to resolve any issue concerning bankruptcy law.

It is generally not relevant to the issue of determining whether a dispute is subject to arbitration that persons who did not agree to arbitration might be involved--a frequent occurrence in bankruptcy matters. The U.S. Supreme Court has ruled that under the FAA, an arbitration agreement must be enforced notwithstanding the fact that persons who are parties to the action are not signatories to the arbitration agreement.33

In Moses H. Cone Memorial Hospital v. Mercury Construction Corporation,34 a hospital filed an action against a construction contractor and an architect. The contract between the hospital and the contractor included an arbitration clause, but there was no arbitration agreement between the hospital and the architect. Even though the architect was a party to the action but not a signatory to the agreement, the U.S. Supreme Court enforced the arbitration agreement.35 The Court explained that a party may be forced to resolve related disputes in two different forums--in court and in arbitration--because federal law requires resolution of each part of an action sequentially when necessary to give effect to an arbitration agreement.

Many other cases have reached the same result.36 One court, quoting another, noted:

If arbitration...could be foreclosed simply by adding as a defendant a party not a party to an arbitration agreement, the utility of such agreements would be seriously compromised. If [a] Court were to allow [a plaintiff] to prevent the arbitration of these issues by naming of [a nonsignatory] as a party to this action, the Federal policy in favor of arbitration would be thwarted.37

Disputes Not Subject to Arbitration

In determining the kinds of bankruptcy disputes that might not be subject to mandatory arbitration, there are few cases on point. This is due perhaps to the fact that courts and parties alike previously accepted the distinction between core and noncore matters as the basis for deciding whether a dispute could be arbitrated. Now that the Third Circuit has clarified that this distinction is irrelevant to the question of enforcement, the issue is likely to arise more frequently and, at least initially, with somewhat unpredictable results.

Clearly, there are no express prohibitions in the Bankruptcy Code against arbitration. And legislative history is silent about enforcement of arbitration agreements in bankruptcy court. Moreover, with respect to the resolution of noncore matters, it is difficult to argue that arbitration could be contrary to the purposes of the Bankruptcy Code, since the bankruptcy courts have no authority to issue a final resolution in these matters.

Nonetheless, the nature of certain rights in bankruptcy arguably evinces an inherent conflict between arbitration and the Bankruptcy Code's underlying policies. For example, those rights that, according to courts, cannot be invalidated by parties in their contracts may not be subject to a mandatory agreement to arbitrate. A party might be able to avoid arbitration of a motion for relief from the automatic stay, since courts have found that the automatic stay constitutes an inalienable right under the Bankruptcy Code. Similarly, an agreement to resolve through arbitration any dispute concerning the automatic stay might be considered antithetical to basic bankruptcy policy.38

Other provisions in the Bankruptcy Code that require the bankruptcy court to make findings or approve certain actions are arguably inconsistent with resolution through arbitration. For example, the confirmation of a plan, sale of property outside the ordinary course, use of cash collateral, or assumption or rejection of executory contracts all require express authorization by the court. Arguably, this authorization requirement does not comport with allowing disputes over these matters to be handled through arbitration. The substance of these actions under the Bankruptcy Code and the need for quick resolution of them might be cited in opposition to any effort to require that they be arbitrated. Nevertheless, a broad spectrum of matters in a bankruptcy case must to some extent be approved by the bankruptcy court, and the reasons why a dispute over them could not be successfully resolved through arbitration are not necessarily compelling. Indeed, there may be ample room to argue that disputes involving the use of cash collateral or assumption of an executory contract must be arbitrated when the underlying agreement includes an arbitration clause.

Although these issues remain to be settled, the Mintze decision has clarified the test for deciding when an arbitration provision is enforceable in the bankruptcy context. Mintze has helped to usher in a more principled approach to the enforcement of arbitration agreements in bankruptcy courts. How the courts develop this law in future cases could alter the way in which disputes are resolved in bankruptcy courts.

Endnotes

1 9 U.S.C. §2.
2 See Sims v. Clarendon Nat'l Ins. Co., 336 F. Supp. 2d 1311, 1316 (S.D. Fla. 2004) (A health insurance policy involved interstate commerce within the meaning of the FAA because the policy was issued by a New Jersey insurer to a Florida resident.); Hart v. Orion Ins. Co., 453 F. 2d 1358 (10th Cir. 1971) (The FAA applied to an arbitration provision in an insurance policy issued by an Illinois insurer to a Montana resident.).
3 Even if the subject of the arbitration were covered only under state law because it did not involve interstate commerce, the result would presumably be the same. Although the federal court might not have the power to enforce an arbitration agreement subject to state and not federal law, it would unquestionably have the power to stay an action subject to arbitration pending in federal court under its general authority to control its own docket. Nevertheless, no authority has been found on this point.
4 Moses H. Cone Mem'l Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24 (1983) (FAA §2 "is a congressional declaration of a liberal federal policy favoring arbitration agreements, notwithstanding any state substantive or procedural policies to the contrary."); Shearson/Am. Express, Inc. v. McMahon, 482 U.S. 220, 226 (1987) (The FAA policy favoring arbitration is not diminished when a party bound by an agreement raises claims based on statutory rights.).
5 9 U.S.C. §2.
6 Neal v. Hardee's Food Sys., Inc., 918 F. 2d 34, 37 (5th Cir. 1990).
7 9 U.S.C. §3.
8 Id.
9 Quackenbush v. Allstate Ins. Co., 121 F. 3d 1372, 1380 (9th Cir. 1997) (quoting Dean Witter Reynolds, Inc. v. Byrd, 470 U.S. 213, 218 (1985)). See also McMahon, 482 U.S. at 226 (The FAA requires a court to "stay its proceedings if it is satisfied that an issue before it is arbitrable under the agreement."); Wagner v. Stratton Oakmont, Inc., 83 F. 3d 1046, 1048 (9th Cir. 1996) ("The Federal Arbitration Act requires a court to stay an action whenever the parties to the action have agreed in writing to submit their claims to arbitration.").
10 Sparling v. Hoffman Constr. Co., Inc., 864 F. 2d 635, 638 (9th Cir. 1988); C.H.I. Inc. v. Marcus Bros. Textile, Inc., 930 F. 2d 762, 763-64 (9th Cir. 1991).
11 Kipperman v. Kidder Peabody & Co. (In re TreScalini, Inc.), 178 B.R. 237, 239 (Bankr. C.D. Cal. 1995) (citations omitted) (citing Graham Oil Co. v. Arco Prods., Inc., 43 F. 3d 1244 (9th Cir. 1994)); MCI Telecomms. Corp. v. Gurga (In re Gurga), 176 B.R. 196 (B.A.P. 9th Cir. 1994).
12 See In re Mintze (Mintze II), 2003 U.S. Dist. LEXIS 21101 (E.D. Pa. 2003); Hays v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 885 F. 2d 1149 (3d Cir. 1989); In re Oakwood Homes Corp., 2005 Bankr. LEXIS 429 (Bankr. D. Del. 2005); In re Am. Classic Voyages Co., 298 B.R. 222 (D. Del. 2003).
13 In re Mintze (Mintze III), 434 F. 3d 222 (3d Cir. 2006).
14 Id. at 229.
15 Shearson/Am. Express, Inc. v. McMahon, 482 U.S. 220, 226 (1987).
16 Id. at 227.
17 Mintze III, 434 F. 3d at 231.
18 Id. at 232.
19 Hays v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 885 F. 2d 1149 (3d Cir. 1989).
20 Id. at 1156.
21 Mintze III, 434 F. 3d at 230.
22 In re U.S. Lines, 197 F. 3d 631, 640 (2d Cir. 1999).
23 Id. at 631.
24 Id. at 641, 643.
25 Mintze III, 434 F. 3d at 231.
26 Id.
27 In re First Alliance Mortgage Co., 280 B.R. 246 (C.D. Cal. 2002); compare In re Mor-Ben Ins. Mkts. Corp., 73 B.R. 644, 647 (B.A.P. 9th Cir. 1987) ("Absent a Congressional mandate to preclude arbitration in the bankruptcy context, or a compelling situation seriously affecting the rights of creditors in a bankruptcy, a valid clause in an...agreement to arbitrate a dispute must be enforced.").
28 First Alliance, 280 B.R. at 252.
29 Id. at 251 (quoting In re F&T Contractors, Inc., 649 F. 2d 1229, 1332 (6th Cir. 1981)).
30 Metalclad Corp. v. Ventana Envtl. Org. P'ship, 109 Cal. App. 4th 1705, 1717 (2003); see also Norcal Mut. Ins. Co. v. Newton, 84 Cal. App. 4th 64, 84 (2000).
31 11 U.S.C. §365.
32 In re Elcom Techs. Corp., 2000 U.S. Dist. LEXIS 14368 (E.D. Pa. 2000).
33 Moses H. Cone Mem'l Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 20 (1983). See also First Allmerica Fin. Life Ins. Co. v. Sumner, 212 F. Supp. 2d 1242, 1244 (D. Or. 2002) (holding that the federal policy in favor of arbitrability "holds true even if to do so would require a 'piecemeal resolution' of all outstanding issues and even if not all parties to the federal court action are parties to the arbitration"); Martin K. Eby Constr. Co. v. City of Arvada, 522 F. Supp. 449, 450 (D. Colo. 1981) ("Enforcement of arbitration under the FAA will not be denied as to the two parties [plaintiff and defendant] to the arbitration clause even when other parties [a third-party defendant] to the dispute cannot be ordered to arbitrate.").
34 Moses H. Cone Mem'l Hosp., 460 U.S. 1, 24.
35 Id. at 20.
36 See, e.g., Cosmotek Mumessillik Ve Ticaret Ltd. Sirkketi v. Cosmotek USA, Inc., 942 F. Supp. 757, 759-61 (D. Conn. 1996) ("Plaintiffs cannot avoid the arbitration for which they had contracted simply by adding a nonsignatory defendant, lest the efficacy of contracts and the federal policy favoring arbitration be defeated."); Lawson Fabrics, Inc. v. Akzona, Inc., 355 F. Supp. 1146, 1151 (S.D. N.Y. 1973).
37 Lawson Fabrics, 355 F. Supp. at 1151 (quoting Hilti, Inc. v. Oldach, 392 F. 2d 368 n.2 (1st Cir. 1968)).
38 See, e.g., In re Sky Group Int'l, Inc., 108 B.R. 86, 88 (Bankr. W.D. Pa. 1989) (A debtor's agreement to automatic relief from stay is not self-executing.); In re Powers, 170 B.R. 480, 484 (Bankr. D. Mass. 1994) (The "existence of a waiver [agreement] does not preclude third parties, or the debtor, from contesting" a motion for relief from stay.).

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