Bankruptcy Overrides Arbitration In A Claim Objection Proceeding (In re Bridger)

This new bankruptcy opinion denies a creditor’s Motion to compel arbitration: Samson v. The LCF Group, Inc. (In re Bridger Steele, Inc.), Adv. No. 2:24-ap-2003 in Montana Bankruptcy Court (decided September 30, 2024; Doc. 10).

What follows is a summary of that opinion’s arbitration-denial analysis.

Background

The intersection of arbitration and bankruptcy presents a conflict of near polar extremes:

bankruptcy policy exerts an inexorable pull towards centralization; while
arbitration policy advocates a decentralized approach to dispute resolution.

When considering whether a bankruptcy dispute should be arbitrated under a pre-petition agreement, courts must weigh the competing bankruptcy and arbitration interests at stake.

Most Courts of Appeals begin their weighing analysis with these rules:

the burden is on the party opposing arbitration to show that Congress intended that the dispute remain in bankruptcy court; and
such Congressional intent can be found from (i) a statute’s text or legislative history, or (ii) an inherent conflict between arbitration and the statute’s underlying purposes.

Courts that have denied enforcement of an arbitration agreement in bankruptcy base their denials on a conflict with the Bankruptcy Code’s underlying purposes. Such bases are reached only after the courts decide that (i) a valid arbitration agreement does exist under state contract laws, and (ii) the agreement does encompass the dispute at issue.

Derivative v. Not-Derivative Claims

When the disputing party is a bankruptcy trustee or debtor-in-possession, the courts must consider whether the trustee/debtor-in-possession is acting independently or asserting derivative claims:

when the trustee/debtor-in-possession asserts claims that are derivative of the debtor’s rights under § 541, the trustee is bound by debtor’s pre-petition arbitration agreement; but
when the trustee/debtor-in-possession asserts claims that are unique to the trustee under the Bankruptcy Code, the trustee/debtor-in-possession is not bound by debtor’s pre-petition arbitration agreement.

That’s because of the rule that only the parties to an arbitration agreement are bound by it.

–Preference Avoidance Action is NOT Derivative

Preference and other avoidance actions under Chapter V of the Bankruptcy Code may be exercised by the debtor in possession or by the trustee, but such actions belong exclusively to creditors, who are not parties to debtor’s pre-petition arbitration agreement.

Accordingly, such actions are not derivative of debtor’s rights and are not subject to debtor’s pre-petition arbitration agreement.

Here, Defendant has failed to find any reported decision supporting the argument that statutory avoidance claims are subject to arbitration.

The Trustee’s preference claim in this case is exclusive to the Trustee: it is being asserted by the Trustee on behalf of the estate. And there is no arbitration agreement between Defendant and the Trustee.

–Claim Objections are NOT Derivative

Defendant filed a proof of claim in Debtor’s Chapter 7 case, and that makes the Trustee’s preference action a part of the claims allowance process.

And the claims Trustee is asserting against Defendant in the Complaint, beyond the preference claim, are part of the Trustee’s objection to Defendant’s proof of claim.

In a trustee’s claim objection under § 502(b)(1), the trustee is representing the bankruptcy estate (see § 323(a)) and the interests of all unsecured creditors—i.e., not merely a subset of creditors or an individual creditor.

The Trustee in this case has a duty to examine Defendant’s proof of claims and object to the allowance of any improper portion thereof, pursuant to § 704(a)(5). In this case, the non-preference portions of the relief requested in Trustee’s Complaint:

are an objection to Defendant’s proof of claim on behalf of the bankruptcy estate under §§ 502(b)(1), 704(a)(5); and
are not derivative of Debtor’s rights.

As a result, the Trustee is not bound by the arbitration agreement between Debtor and Defendant.

Accordingly, the Trustee’s claims asserted in the Complaint are not subject to the arbitration agreement—and the analysis for denying Defendant’s Motion to compel arbitration could stop here.

But there is more.

Core v. Noncore Claims & Code Purposes

An additional factor to consider, under Defendant’s Motion to compel arbitration, is whether (i) the matters are core or noncore, and (ii) enforcing arbitration would conflict with the Code’s purpose.

–The labels “core” and “noncore”

The rules are:

if the disputes are core proceedings, arbitration may be denied if it conflicts with underlying purposes of the Code; and
conversely, if the disputes are noncore, arbitration should be compelled.

Ordinarily, noncore issues are “related to” bankruptcy:

examples of noncore issues include state law slander of title, quiet title, and breach of contract claims; but
context matters, and an issue that might be noncore when considered in isolation may become core when considered in its procedural and statutory context.

A core issue is one that invokes a substantive right created by federal bankruptcy law or a proceeding that could not exist outside of bankruptcy.

28 U.S.C. § 157(b)(2) outlines a non-exclusive list of core proceedings—which includes claim allowance disputes. That’s important here because Defendant argues, incorrectly, that state law issues, such as usury, are noncore:

in a vacuum, and under different circumstances, that might be correct; but
in this case, it is not correct.

Here’s why:

many incidental issues arise in a bankruptcy case that would ordinarily be pure cases at law . . . but in bankruptcy, the bankruptcy court exercises exclusive control over those issues;
the basic federal rule in bankruptcy is that (i) state law governs the substance of claims, and (ii) claims are not analyzed differently solely because they are in bankruptcy; but
bankruptcy courts have authority to decide even state law counterclaims to a filed proof of claim, if the counterclaim would necessarily be decided through the claim allowance process.

–Core v. Noncore Applied

In this case, Defendant argues that Counts 1, 2, and 4 in Plaintiff’s Complaint are state law issues and, therefore, noncore. Such argument is false because Counts 1, 2, and 4 are components of a claim objection and are inextricably tied to a core proceeding—i.e., to a claim allowance proceeding.

Further, when Defendant filed its proof of claim, it elected to share in any distributions of Debtor’s property. Doing so triggers the Trustee’s statutory duty to review Defendant’s proof of claim and object to it on behalf of the estate and other creditors.

Filing the proof of claim also has other consequences: e.g., by doing so, Defendant consents to the Bankruptcy Court entering final orders or judgment;

Accordingly, all issues raised in the Trustee’s Complaint are core proceedings.

The effect is this: if a conflict exists between federal laws on bankruptcy and arbitration in this matter, the Bankruptcy Court may exercise its discretion and deny Defendant’s Motion to compel arbitration.

Conflicts: Bankruptcy vs. Arbitration

–Arbitration

The purpose of the Federal Arbitration Act (“FAA”) is to make agreements for arbitration valid and enforceable:

the FAA exists because, historically, arbitration agreements had been the subject of judicial hostility and were not enforced; and
Congress wanted to place arbitration agreements upon the same footing as other contracts, where it belongs.

Despite that limited purpose, the FAA came to be construed over time as a congressional declaration of a liberal federal policy favoring arbitration agreements.

Recently, however, in Morgan v. Sundance, 596 U.S. 411, 418-19 (2022), the U.S. Supreme Court discouraged such favoritism by declaring that the FAA:

makes “arbitration agreements as enforceable as other contracts, but no more so”;
acts as “a bar on using custom made rules, to tilt the playing field in favor of (or against) arbitration”; and
prevents courts from contorting themselves to “devise novel rules to favor arbitration over litigation.”

–Bankruptcy

The Bankruptcy Code reflects Congress’s intent to afford relief to those struggling financially and on the brink of failure by giving bankruptcy courts exclusive jurisdiction over:

all debtor’s property;
the equitable distribution of that property among debtor’s creditors; and
the ultimate discharge that gives debtor a “fresh start” by releasing him/her/it from further liability for old debts.

The hallmarks of bankruptcy have always been a prompt and effective administration at low cost through collective action on behalf of all creditors—and its guiding premise is the equality of distribution of assets among creditors:

such collective action and equality of distribution is a unique contribution of the Bankruptcy Code that makes bankruptcy different from a collection of actions by individual creditors.

By contrast, here is how creditors’ individualized actions work:

each creditor knows that, by waiting too long, the debtor’s assets will be exhausted by the demands of quicker creditors—and the slower creditor will recover nothing;
the creditors race to the courthouse, all demanding immediate payment of their entire debt; and
like piranhas, they make short work of the debtor—even though:
- through a bankruptcy’s collective action, the debtor might survive to pay off more debts—or at least feed the slower piranhas more equitably.

Federal bankruptcy law seeks to avoid the piranhas scenario by creating a system of federal control designed to bring creditors together and adjust all of the rights and duties of creditors and debtors alike.

In bankruptcy, the distribution of the debtor’s assets is determined by a statutory distribution scheme (§ 726), which:

is a foundational premise of the Bankruptcy Code; and
provides the textual basis for the fundamental principle that creditors of equal priority should receive pro rata shares of the debtor’s property.

In short, the bankruptcy estate is a pie, and the bankruptcy process is about dividing up that pie among creditors:

there is only one pie, and it can be divided up only once;
when the asset values are not enough to go around, the bankruptcy judge must establish priorities and apportion assets among creditors with the same priority—the starting point for doing so is legal entitlements that exist outside of bankruptcy; and
ultimately, the Bankruptcy Code defines the role and duties of the parties and outlines a comprehensive process for allocating and distributing the res of the bankruptcy estate amongst creditors.

Bankruptcy’s Collective Claims Process Overrides Arbitration’s Individualized Process

In bankruptcy, prepetition contracts are scrutinized and restructured, and the Bankruptcy Code provides a forum for doing so. The bankruptcy court and trustee have significant powers to alter the agreements of parties.

A bifurcated, decentralized, or individualized effort to collect debts by creditors is precisely:

the arrangement that exists prepetition between debtors and creditors; and
what arbitration offers and enables.

The Bankruptcy Code, by contrast, manifests a countervailing, collective alternative: a complex, detailed, and comprehensive system under federal control. That bankruptcy system:

provides an organized forum for restructuring creditor-debtor relationships—instead of a pre-petition free-for-all;
establishes a singular forum in which all of the debtor’s and creditors’ rights are modified, adjusted or altered, with a goal of (i) equitable distributions being realized by the creditors, and (ii) debtors receiving a fresh start; and
does not contemplate augmentation with separate individualized arbitrations that multiply the proceedings or costs—inefficiency and higher costs are antithetical to the bankruptcy process.

Here, enforcing arbitration of core issues in a separate forum on a piecemeal basis, and divorced from the whole bankruptcy system, conflicts with the collective claims allowance process in bankruptcy.

Specifically in this case:

Defendant submitted a proof of claim;
Trustee objected to it;
allowing arbitration to proceed would duplicate efforts and costs and create inefficiencies; and
that would fundamentally conflict with the text of the Bankruptcy Code and the policies underlying it.

Conclusion

In re Bridger Steel, Inc., provides a clear and instructive analysis of the relative rights and roles of bankruptcy and arbitration, in a bankruptcy’s claim objection process.

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