Bankruptcy Judge David D. Cleary of Chicago decided that some claims by a debtor against a creditor are subject to arbitration while others are not.

When the chapter 11 plan had been confirmed and did not depend on the debtor’s success in a suit against the creditor, arbitration was enforced. When the debtor’s other claims turned on questions of bankruptcy law, however, Judge Cleary ruled against arbitration in his March 4 opinion.

The debtor was a subcontractor in a construction contract with the contractor-creditor. The contract called for arbitration of “all disputes.”

The debtor walked off the job and initiated an arbitration. The parties selected an arbitrator, who scheduled an arbitration hearing. Before the hearing commenced, the debtor filed a petition for reorganization under Subchapter V of chapter 11, bringing the arbitration to a halt.

The creditor did not file a claim, nor did it object to confirmation. Judge Cleary confirmed the plan. He said that the “plan does not rely on liquidation of prepetition receivables.”

Two months after confirmation, the debtor filed an adversary proceeding in bankruptcy court against the creditor, seeking a money judgment for about $430,000. In the complaint, the debtor also wanted Judge Cleary to declare that the creditor could not assert a claim of setoff since the creditor had not filed a claim, and claims were discharged by confirmation and consummation of the plan.

The creditor responded with a motion to compel arbitration and to dismiss the adversary proceeding. The outcome was a split decision.

Grounds for Arbitration

On the merits, Judge Cleary said that the creditor took “an overly aggressive position in the Arbitration Motion, suggesting that arbitration is mandatory when such clauses are found in contracts between parties, even if one of those parties is a debtor in bankruptcy court.”

Responding, Judge Cleary said, “In fact, this court is not required to compel arbitration.” He added that the creditor “ignore[d] the analysis in which this court must engage as a result of the tension between the Federal Arbitration Act and the Bankruptcy Code.”

Judge Cleary quoted one of his own decisions from 2023:

Generally, in commercial disputes, an arbitration agreement between parties must be enforced . . . . However, there is no national policy favoring arbitration. The federal policy is about treating arbitration contracts like all others, not about fostering arbitration.

When an arbitration demand is made in a bankruptcy case, however, a conflict exists as to whether a bankruptcy court should enforce the bilateral arbitration agreement, or its in rem jurisdiction over the claims under the Bankruptcy Code. The court must address the two statutory schemes — the [Federal Arbitration Act] and the Bankruptcy Code — and the potential conflict between them.

Johnson v. S.A.I.L. LLC (In re Johnson), 649 B.R. 735, 740–41 (Bankr. N.D. Ill. March 28, 2023). To read ABI’s report on Johnson, click here.

The creditor argued that arbitration was mandatory because the dispute only involved the contract and state law. Judge Cleary countered by noting how the creditor had raised bankruptcy issues in its papers on the arbitration motion. For instance, the creditor alluded to bankruptcy law with regard to the right of setoff and judicial estoppel for the debtor’s failure to schedule an account receivable owing by the creditor.

Judge Cleary therefore said that he was required to “engage in the required analysis in order to determine if it should enforce the agreement to arbitrate, or its in rem jurisdiction under the Bankruptcy Code.” He noted that the debtor’s complaint had two claims: a money judgment for $430,000, and a declaration that the creditor could not assert a setoff defense.

The parties agreed that the arbitration agreement covered both claims. Still, Judge Cleary said, the question “is whether that agreement to arbitrate should be enforced here.” More particularly, he said, the “‘key question . . . is whether there is an inherent conflict between arbitration and the underlying purposes of the Code in relation to the particular dispute for which a party seeks to enforce an arbitration clause.’ Johnson, 649 B.R. at 747 (emphasis added).”

In the case at hand, Judge Cleary said that “the particular disputes involve liquidation of the amounts that each party owes to the other, and whether the court should issue a declaratory judgment that [the creditor] is estopped from asserting the defense of setoff against any amount it owes Debtor.”

Regarding the validity of the debtor’s claim for money damages against the creditor, Judge Cleary said that “it does not support a finding that resolution of [the debtor’s] claim against [the creditor] is unsuitable for arbitration.” [Emphasis in original.] Next, the debtor contended that the complaint was core because it seeks a turnover of estate property.

The argument, Judge Cleary said, “quickly returns to the question of whether [the creditor] will be allowed to exercise any right to setoff of claims.” Similarly, he noted that the plan does not rely on the liquidation of accounts receivable. He saw “no danger that allowing the arbitrator to liquidate the parties’ claims against each other would conflict with the purposes of the Bankruptcy Code.”

Judge Cleary held that the “Debtor has not met its burden of proving that liquidation of its claim against [the creditor] and of [the creditor’s] claim against Debtor is not suitable for arbitration.” He therefore “grant[ed] the Arbitration Motion to the extent [of] Debtor’s claim against [the creditor], and [the creditor’s] claim against Debtor.”

Arbitrate Claims, Not Bankruptcy Defenses

But there was more. What about setoff as a defense to the debtor’s claim: Arbitrate, or not?

When claims between a debtor and a creditor have been resolved in arbitration, Judge Cleary said that “the parties can return to this court for adjudication of the remaining claim for relief under the Complaint — whether the court should issue a declaratory judgment that [the creditor] is estopped from asserting the defense of setoff against any amount it owes to Debtor.”

Why arbitrate some but not all claims that are within the scope of the arbitration agreement? Judge Cleary answered the question by saying that the creditor’s right to assert setoff “presents questions of bankruptcy law rather than a dispute under the Subcontract.”

Judge Cleary noted that the bankruptcy questions include whether the creditor had a right of setoff under Section 553(a), whether the creditor retained an enforceable claim since it failed to file a claim, and whether the creditor had a right of recoupment rather than a right of setoff.

[Resolution of those questions will entail, for instance, the idea that discharge bars enforcement of claims but does not eradicate claims. And if setoff is unavailable, can the creditor assert a right of recoupment as to which the automatic stay did not apply?]

“These issues are centered on core bankruptcy principles and affect the Debtor and its estate,” Judge Cleary said.

Judge Cleary denied the creditor’s motion to dismiss the complaint but held the adversary proceeding in abeyance until the arbitrator resolves the claims between the creditor and the debtor. “Once the arbitration is concluded,” Judge Cleary said, he would “lift the stay on this adversary proceeding and determine whether to issue a declaratory judgment that [the creditor] is estopped from asserting the defense of setoff against any amount it owes to Debtor.”