Are Arbitration Clauses Enforceable in Bankruptcy?

By KENNETH ROSEN

Are arbitration clauses enforceable in bankruptcy? Not always.

The enforceability of arbitration clauses in bankruptcy cases depends on factors such as the nature of the proceeding and the statutory claims involved. Enforcement is subject to a balancing test between the Federal Arbitration Act (FAA) and the Bankruptcy Code. The FAA establishes a liberal federal policy favoring arbitration agreements. This mandate may be overridden, however, when arbitration would conflict with the Bankruptcy Code.

The potential conflict of arbitration with the goals of the Bankruptcy

Code often arises in cases involving “core” bankruptcy matters, which include issues like claim allowance, avoidance of fraudulent transfers, and property turnover. Bankruptcy courts have greater discretion to refuse to compel arbitration of core bankruptcy proceedings. Courts are more likely to enforce arbitration clauses in non-core proceedings, as these do not directly impact the central administration of the bankruptcy case.

The question posed earlier on arbitration clauses is important because the cost of resolving contested matters with traditional courtroom litigation is often disproportionate to the likely recovery, while arbitration is less expensive. There are other benefits to arbitration as well:

• Arbitration often can resolve disputes more quickly than traditional courtroom litigation.

• Arbitration allows for more flexible scheduling and procedural rules, and the discovery process is usually more limited than in litigation.

• Arbitrators with specialized knowledge in the specific industry that is involved can lead to more accurate and fair outcomes for the parties involved.

• Arbitration proceedings are typically private, allowing debtors and creditors to keep their financial and business information confidential.

• Arbitration decisions are binding and offer limited grounds for appeal.

Public Policy Considerations

Bankruptcy courts also will consider public policy considerations such as:

1. Whether the efficiency of the bankruptcy claims-allowance process would be undermined if arbitration results in piecemeal litigation.

2. The aims of the Bankruptcy Code for a centralized resolution of disputes related to the bankruptcy estate, minimizing costs and ensuring equitable treatment of all parties.

3. Diversion of resources away from the estate and further complication of the equitable distribution of assets.

4. Power to enforce its own orders by the bankruptcy court. Arbitration of disputes that directly implicate bankruptcy-specific rights, such as automatic stay and discharge injunctions, undercut the court’s ability to effectively manage the bankruptcy case and protect the rights of the debtor and creditors.

5. The ability of parties opposing arbitration to show that Congress intended to preclude the waiver of judicial remedies for the statutory rights at issue.

For instance, in the Highland Capital Management v. Dondero (In re Highland Capital Management) case, the court found that enforcing an arbitration clause would conflict with the objectives of the Bankruptcy Code. The court noted that the arbitration agreement had been part of a rejected executory contract and enforcing it would interfere with the centralized resolution of the debtor’s estate, which is a core function of bankruptcy proceedings. An executory contract is a  contract where parties have continuing obligations to perform, and unperformed obligations remain on both sides.

Similarly, in In re Acis Capital Management, L.P., the court declined to compel arbitration despite a valid arbitration agreement. It concluded that enforcing the arbitration would disrupt the core bankruptcy functions, such as the equitable and expeditious distribution of the debtor’s assets.

In summary, when a bankruptcy court is asked to enforce an arbitration clause, it must carefully weigh the policy favoring arbitration against the specific objectives and policies of the Bankruptcy Code, including the efficient administration of the bankruptcy estate, the centralized resolution of disputes, the protection of the estate and creditors, and the enforcement of bankruptcy-specific rights and orders.

Tips For Enforcing An Arbitration Clause

1. Assess whether the dispute is a core or non-core proceeding. Highlight the non-core nature of the dispute.

2. Arbitration is more likely to be approved where the judge does not have the requisite specialized expertise to resolve the dispute.

3. Develop a plan for fast-track arbitration, which may give the court more comfort that arbitration will not cause delay.

4. Emphasize that any exceptions to the FAA mandate should be narrowly construed.

5. Demonstrate how arbitration will not conflict with the central purposes of the Bankruptcy Code, such as the equitable distribution of assets, the debtor’s fresh start, and the efficient reorganization of the debtor.

6. Consider the timing to bring the dispute to a head. The earlier, the better to avoid the court finding that arbitration could unreasonably delay the case.

7. Show that arbitration can be conducted in a way that complements the bankruptcy process and does not undermine the centralized administration of the bankruptcy estate. Demonstrate that enforcing the arbitration clause will not negatively impact other creditors or the overall administration of the bankruptcy case.

8. Demonstrate how the arbitration can proceed independently without interfering with the court’s oversight of the bankruptcy case.

9. Argue that arbitration can be a more efficient and cost-effective method of resolving the dispute, potentially benefiting all parties involved, including the bankruptcy estate.

10. If appropriate, propose conditional enforcement where certain issues are resolved in arbitration, while others remain under the bankruptcy court’s jurisdiction.

11. Ascertain whether the judge’s calendar already is backlogged. If so, the bankruptcy court may favor arbitration because its own calendar cannot accommodate a multi-day trial.

Kenneth Rosen advises on the full spectrum of restructuring solutions, including Chapter 11 reorganizations, outof-court workouts, financial restructurings, and litigation. He works closely with debtors, creditors’ committees, lenders, landlords, and others in such diverse industries as paper and printing, food, furniture, pharmaceuticals, health care, and real estate. He can be reached at ken@kenrosenadvisors.com