By upholding a district judge’s decision in the liquidation of Lehman Brothers Inc., the Second Circuit adopted the notion that an arbitration clause cannot be enforced when the issue concerns the subordination of hundreds of employees’ claims.

Long before bankruptcy, the Lehman broker established a deferred compensation plan permitting higher-level executives to set aside some of their income in exchange for retirement benefits to be paid years or decades later. To comply with tax laws, the executives’ claims were contractually subordinated to all other creditors’ claims if Lehman were to go bankrupt.

The plan allowed the executives to compel arbitration in the stock exchange. Hoping to prevent the bankruptcy judge from deciding whether their claims were subordinated, hundreds of employees locked arms and filed a motion in bankruptcy court to compel arbitration on the question of subordination.

The bankruptcy judge denied the arbitration motion and was upheld in September 2015 by District Judge Edgardo Ramos in Manhattan. The executives appealed again, only to lose once more, this time in a non-precedential summary order by the Second Circuit on Oct. 6.

In deciding whether to compel arbitration of an issue otherwise in bankruptcy court, the Second Circuit reiterated the two-part test.

On the first prong, the appeals court easily concluded that the issue was “core.”

The second test asks whether arbitration “would severely conflict with the text, history, or purpose of the Bankruptcy Code.” If there is sufficient conflict, the bankruptcy judge has discretion to preclude arbitration.

Quoting Bankruptcy Judge Shelley C. Chapman, the circuit court said that “‘Congress simply could not have intended to turn over the determination of the relative priority of claims’” to the “‘financial industry regulatory authority to be decided under the rules of the New York Stock Exchange.’”

Giving “due deference to the bankruptcy court’s decision to stay arbitration,” the circuit court found no abuse of discretion and upheld the district court’s judgment.

To read ABI’s discussion of the district court opinion, click here.