Although she would have reached “a very different conclusion” if a dissent had been governing authority in the Fourth Circuit, Bankruptcy Judge Michelle M. Harner of Baltimore temporarily halted proceedings in bankruptcy court in favor of arbitration, even on “core” claims arising under the Bankruptcy Code.

In her June 1 opinion, Judge Harner said that consolidating all disputes in bankruptcy court — rather than allowing arbitration to proceed — would have been “most efficient and fair . . . [and] also most consistent with the objectives of the Code.” Saying she could not “ignore precedent,” Judge Harner instead halted proceedings in bankruptcy court temporarily on disputes between the debtor and its principal creditor, which had filed a proof of claim.

Judge Harner could not have written a more persuasive opinion suggesting that the Fourth Circuit should reconsider Moses v. CashCall, Inc., 781 F.3d 63 (4th Cir. 2015), where the circuit’s per curiam opinion was accompanied by four separate opinions, including a dissent.

Judge Harner was the Francis King Carey Professor of Law and the Director of the Business Law Program at the University of Maryland Francis King Carey School of Law before her appointment to the bankruptcy bench in 2017.

The Uncertain Status of Arbitration in Bankruptcy

In the Supreme Court, the leading authority on the enforceability of arbitration agreements is (had been?) Shearson/American Express Inc. v. McMahon, 482 U.S. 220, 226 (1987). In view of the Federal Arbitration Act, the high court held that an arbitration agreement can only be overridden by a “contrary congressional command.” Id. at 226.

Some circuit courts interpret McMahon more liberally by overriding arbitration agreements in bankruptcy cases, even though the Bankruptcy Code contains no express language barring enforcement of the FAA. For example, the Second Circuit refused to enforce an arbitration agreement and allowed a class action to proceed in bankruptcy court, alleging violations of the discharge injunction. Credit One Bank NA v. Anderson (In re Anderson), 884 F.3d 382 (2d Cir. March 7, 2018), cert denied, 139 S. Ct. 144 (2018). To read ABI’s report, click here.

Similarly, the Fifth Circuit held in Henry v. Educational Finance Service (In re Henry), 944 F.3d 587 (5th Cir. Oct. 17, 2019), that the bankruptcy court has discretion not to enforce an arbitration agreement when a debtor has initiated a class action contending that a creditor had violated the discharge injunction. To read ABI’s report, click here.

Two months after Anderson, the Supreme Court compelled employees to arbitrate wages and hours claims governed by the Fair Labor Standards Act. Epic Systems Corp. v. Lewis, 200 L. Ed. 2d 889 (Sup. Ct. May 21, 2018). Epic said that a statute like the FLSA did not manifest a clear intention to override the Federal Arbitration Act.

Epic raised the following question: Does the Bankruptcy Code manifest a clear intention to override arbitration agreements, or does bankruptcy for some reason represent an exception to Epic’s exacting standard?

Although “a few courts have questioned the ongoing force of McMahon given subsequent Supreme Court decisions, most courts have continued to follow its guidance,” Judge Harner said.

Whatever other circuits may be saying, Judge Harner was bound by CashCall.

Even before Epic, the Fourth Circuit interpreted McMahon more strictly. In CashCall, the Fourth Circuit ruled that a bankruptcy court has discretion to refuse arbitration of “core” claims. 

More specifically, CashCall allowed the bankruptcy court to decide whether a loan bearing 149% interest was void under state law. In other words, the debtor was not compelled to arbitrate a core issue involving the allowance of a claim.

On the other hand, CashCall required arbitration of a noncore claim where the debtor sought damages under state law for a loan that was allegedly void.

The rationale underpinning CashCall lacks clarity because there were five opinions among the three circuit judges on the panel, including the per curiam opinion for the court and a dissent.

The Facts Before Judge Harner

The creditor had an agreement to provide financing for the debtor in return for an interest in some of the debtor’s whistleblower lawsuits. The financing was allegedly secured by recoveries in the lawsuits.

Disputes arose before bankruptcy, and the creditor invoked an arbitration clause in the financing agreement. The arbitration was stayed automatically when the debtor filed a chapter 11 petition.

In bankruptcy, the creditor filed a motion to modify the automatic stay to allow the arbitration to proceed. The creditor also filed an adversary proceeding seeking a ruling that debts were not dischargeable.

The debtor commenced an adversary proceeding making six claims against the creditor.

The parties’ litigations in bankruptcy court and in arbitration fell into three categories: (1) claims on both sides to decide who breached the financing agreement; (2) the debtor’s claims that the creditor violated the federal Fair Debt Collection Practices Act and state law governing the financing agreement; and (3) the debtor’s claims under Sections 502, 510, 523, 543, 544, 547 and 553 of the Bankruptcy Code.

Applying CashCall to the Facts

Judge Harner interpreted CashCall and other authorities for the proposition that characterizing a claim as “constitutionally core is indicative of Congressional intent to limit arbitrations.” The question is more complex, she said, when issues are both core and non-core.

When a claim is constitutionally core, Judge Harner deduced that she had discretion to override an arbitration agreement. Citing a concurring opinion in CashCall, she saw her discretion as “far more limited with respect to non-constitutionally core or non-core proceedings.”

Indeed, Judge Harner interpreted CashCall to mean that she must allow arbitration of “certain state law issues in this case, despite the potential attendant delay and adverse effects on the Debtor’s estate.”

Before ruling definitively, Judge Harner addressed the debtor’s claims arising entirely under the Bankruptcy Code that could not have been asserted before bankruptcy. She found “strong support” that they were constitutionally core. For instance, deciding who breached the financing agreement would be resolved in ruling on the allowance of the creditor’s proof of claim.

The debtor’s fraudulent transfer claims could have been brought under state law, but Judge Harner said that the creditor had filed a proof of claim, “making the alleged fraudulent transfer claim part of the claims administration process and potentially subject to section 502(d) of the Code.”

Judge Harner concluded that the fraudulent transfer claims were “more closely aligned” with a constitutionally core proceeding.

On the other hand, the debtor’s FDCPA claims were aimed at augmenting the estate and were not constitutionally core.

Likewise, the debtor’s claims for breach of contract “are grounded in state law and are likely non-core proceedings” that could be decided under state law either by an arbitrator or a state court. Still, Judge Harner said, “certain of those claims intersect with several of the Debtor’s Bankruptcy Claims, raising the specter of inconsistent results and potential conflicts between this chapter 11 case and the prepetition arbitration proceeding.”

Bifurcation Required by CashCall

Judge Harner interpreted CashCall as requiring “a bifurcation of the constitutionally core and the non-core claims,” but she quoted the dissenter as expressing “concern regarding such bifurcation and its potentially adverse effect on the bankruptcy case and the objectives of the Code.” CashCall, id., 781 F.3d at 66, 88.

In referring to bifurcation, Judge Harner meant the Fourth Circuit majority’s requirement that proceedings must run parallel in bankruptcy court and in arbitration when there are core and non-core claims arising from the disputes.

Although saying that bifurcation was “suboptimal” and that she “agrees with [the dissenter’s] concerns,” Judge Harner found herself “bound both by the circuit’s position in CashCall, as well as other precedent underscoring the important role played by arbitration in the judicial system, including in bankruptcy cases.”

Finding herself required to bifurcate, Judge Harner ruled that the bankruptcy claims must remain in bankruptcy court while non-bankruptcy claims proceed in arbitration.

Judge Harner didn’t like the result. If she were “writing on a clean slate, or if [the dissenter’s opinion] in CashCall had been that of the circuit, the Court likely would have reached a very different conclusion.” Consolidating all disputes in bankruptcy court would have been “not only most efficient and fair to all potentially affected parties, but also most consistent with the objectives of the Code. The Court cannot, however, ignore precedent.”

Bankruptcy Proceedings Temporarily Stayed

Bifurcation “presents opportunities for overlap in facts, duplication in effort, and conflicting results,” Judge Harner said. She therefore sought “procedural mechanisms to protect the parties.”

With regard to the “overlap” between the claims in bankruptcy court and in arbitration, Judge Harner felt “compelled to defer to the arbitrator, but solely on the resolution of the state law and non-bankruptcy claims subject to arbitration.”

If the chapter 11 petition had been filed before arbitration commenced, Judge Harner said she “might reach a different conclusion and delay any requested arbitration pending resolution of the Bankruptcy Claims.”

“Nonetheless,” Judge Harner modified the automatic stay in Section 362(a) “to allow the prepetition arbitration proceeding to continue.” She cautioned the arbitrator not to rule on any bankruptcy claims and precluded the parties from enforcing any arbitration ruling “outside” of the bankruptcy court.

There was more to Judge Harner’s decision because there might be conflicting results or the possibility that one forum could be bound by the other’s decision.

To avoid the “uncertainty introduced” by bifurcation, Judge Harner issued a temporary, 90-day stay halting the debtor’s adversary proceeding and its claims under the Bankruptcy Code. During the stay, the judge said she would “monitor how these matters progress . . . to guard against undue delay or gamesmanship.”

Judge Harner said she “dislike[d] the element of uncertainty introduced by this approach” but decided it was “warranted and most appropriate” in the absence of “clear authority under the Code or case law giving this Court more discretion to refuse arbitration in the context of nonconstitutionally core or non-core claims.”

Observations

Judge Harner’s opinion has shown how bifurcation required by the majority in CashCall is unworkable, in this writer’s opinion and as predicted by the dissenter.

If arbitration proceeds quickly, the arbitrator could make fact findings compelling the result on bankruptcy issues such as dischargeability and claim allowance. Of course, arbitral awards are not subject to appeal, and there is little or no discovery in arbitration. Results might be different in bankruptcy court where there is discovery.

In other words, arbitrators may end up deciding core claims like dischargeability, because the Fourth Circuit requires parallel proceedings in bankruptcy court and in arbitration.

Perhaps the Supreme Court eventually will decide whether or to what extent disputes in bankruptcy cannot be arbitrated. However, the Court denied certiorari in Anderson. A few more certiorari petitions about arbitration in the bankruptcy context may persuade the justices to rule on the question.

Keep this in mind, though: The high court might tell us that arbitration agreements are always enforceable even in bankruptcy cases.