Structured Arbitration: Effective Risk-Management ADR Option for Resolving Bankruptcy Disputes

Unlike the more common pre-dispute arbitration agreement in which the contracting parties agree to arbitrate disputes if and when they occur, a structured arbitration agreement is a negotiated contract created after a dispute arises. It is customized to fit the facts and risks facing the parties and includes dispute-specific procedural rules applicable to both the parties and the arbitrator or arbitration panel.

Pre-dispute arbitration agreements tend to be one or two paragraph inserts in goods or services contracts as an incidental matter to the primary focus of the contract.[1] These agreements sometimes require the parties to arbitrate under the procedural rules of an industry arbitration organization, such as the Financial Industry Regulatory Authority (FINRA) or the American Arbitration Association. In contrast, most structured-arbitration agreements are multi-page negotiated contracts created by the disputing parties, with or without the assistance of a third-party neutral, in which the arbitration process itself is the focus of the contract and the procedures are those to which the parties contractually agree.

This article suggests that structured arbitration is a significant alternative-dispute resolution (ADR) option for efficiently resolving many types of disputes that occur in bankruptcy proceedings and achieving the purposes of ADR, especially if it is considered complimentary to and not competitive with mediation. This article discusses (1) the authority supporting bankruptcy court referral of disputes to arbitration, (2) ADR selection considerations, and (3) implementation issues.

Authority Supporting Bankruptcy Court Referral of Disputes to Arbitration

Rule 9019‌(c) of the Federal Rules of Bankruptcy Procedure states simply, “On stipulation of the parties to any controversy affecting the estate the court may authorize the matter to be submitted to final and binding arbitration.” Four federal statutes provide the foundation for Rule 9019‌(c): the Federal Arbitration Act,[2] the Judicial Improvements and Access to Justice Act of 1988,[3] the Civil Justice Reform Act of 1990[4] and the Alternative Dispute Resolution Act of 1998.[5] Unlike the Federal Arbitration Act, the latter three significantly restrict parties’ rights.[6] For that reason, a structured arbitration agreement and the referring court order should state that the referral is being made pursuant to the Federal Arbitration Act.[7]

ADR Selection: Structured Arbitration, Mediation or Both

Avoiding expensive and protracted litigation is the fundamental purpose of the ADR process.[8] The motivation for ADR referrals by courts, however, differs from the motivation for ADR participation by litigants. For courts, ADR is a tool for managing dockets, but for litigants, it is a tool for managing the almost boundless expense that is associated with protracted litigation, as well a variety of other trial risks (such as public disclosure of sensitive information, loss of a business opportunity and outlier judgments).[9]

“Settle or litigate” mediation — a process that has been described as an often inefficient “twiddle your thumbs exercise” that needs improvement[10] — achieves the ADR docket and risk-management objectives, but only if the parties settle. However, as noted by Bankruptcy Judge Janice Miller Karlin (D. Kan.; Topeka), mediation often fails for a variety of reasons. A failed mediation returns the parties to the courtroom after additional delays and expense; the court can then expect to devote its time and attention to a wide variety of trial and pretrial issues.

In general, an ADR referral should be considered, but only if it gives parties a reasonable opportunity to materially reduce the expected costs in time and money of a dispute resolution.[11] The results of survey data compiled by the Federal Judicial Center in ADR in the Federal District Courts: An Initial Report (hereinafter, the “ADR report”)[12] indicates that parties and their attorneys believe that this objective is most often accomplished when they are involved in selecting the ADR process instead of when a particular ADR process is court-imposed. In other words, when a court provides a menu of ADR options but limits its role to assisting in the selection of a method, odds improve that expensive and protracted litigation will be avoided.

The Federal Judicial Center’s Guide to Judicial Management of Cases in ADR (hereinafter, the “ADR guide”)[13] describes eight basic types of ADR processes, including mediation, arbitration and a combination of the two (termed “med-arb”). The ADR report indicates that federal courts have regularly adopted only four of the eight processes: mediation, arbitration, judicially hosted settlement conferences and early neutral evaluation. The report did not indicate any use of “med-arb.”

Extensive arbitration data maintained over a five-year period by FINRA, the securities regulatory organization that operates the largest securities dispute-resolution forum in the U.S., suggests that a significant number of ADR proceedings classified in the ADR report as “arbitration” were more likely “med-arb” proceedings. During the calendar years 2011-15, approximately 20,000 arbitration proceedings were filed with FINRA. Even though FINRA statistics do not include what percentage of the arbitration cases that were filed were unsuccessfully mediated, its statistics provide the following information: 20 percent of the filed cases actually were resolved by arbitration hearing, 50 percent were resolved by negotiations between or among the parties prior to any arbitration hearing, and 10 percent were resolved by pre-hearing mediation. These percentages were consistent year to year over the five-year period.[14]

The FINRA data is significant and logical. Arbitration competes with litigation, not mediation, as a dispute-resolution process. Both litigation and arbitration are adjudicatory (i.e., the participants relinquish to a third party the right to decide the result). An agreement to arbitrate does not preclude the parties from exploring and consummating their own solution. Based on FINRA data, it can reasonably be expected that the parties that agree to an arbitration referral by the court will voluntarily resolve their dispute prior to arbitration and therefore no adjudicatory process will be required.

FINRA’s experience parallels earlier results experienced by federal court litigants. During the 1980s, the Federal Judicial Center conducted extensive research to evaluate the effectiveness of arbitration in the federal judicial system and published the results in a 162-page report in 1990. The research included input from arbitration participants, notably 3,501 attorneys, 723 parties and 62 judges. In sum, the report concluded that (1) most cases referred to arbitration settled prior to arbitration; (2) almost all the parties considered the arbitration process fair, effective and not a “second-class procedure”; and (3) the process reduced both the cost and time needed to resolve a variety of civil cases.

A relevant example supporting the use of structured arbitration as a bankruptcy ADR process can be found in the chapter 11 case of In re The Catholic Diocese of Tucson.[15] In that case, a structured arbitration process was created during the negotiated and generally consensual third amended chapter 11 reorganization plan.[16] It gave certain personal-injury tort claimants the option of litigating their claims or arbitrating with a single, designated arbitrator.[17]

The chapter 11 plan and associated documents, particularly the approved disclosure statement, detailed this optional arbitration process, which was designed to both resolve the disputes and protect the privacy concerns of the abuse victims and the Tucson Diocese.[18] Hon. Lina Rodriquez was approved as the arbitrator to “evaluate, liquidate and allow or disallow” the claims of several classes of tort claimants.[19] Her qualifications were disclosed, as well as her arbitration responsibilities, the process for dealing with unexpected events, and the evidence that she could consider in reaching a final decision on any claim. Importantly, the plan provided that her decision was “final and nonappealable.”[20]

The effectiveness of Tucson Diocese’s structured arbitration agreement is hard to question because all of the qualified claimants opted for arbitration instead of litigation.[21] At that point (i.e., when all of the claimants had selected the arbitration option), a primary objective of ADR was realized, since the bankruptcy court then became reasonably certain that it would not have to try any of these cases or deal with pre-trial matters.

Between plan approval and arbitration, the appointed arbitrator attempted to mediate all disputes. All claims were settled during this mediation effort — except one. When the arbitrator ruled against that claimant, he appealed first to the bankruptcy court and then to the Ninth Circuit Bankruptcy Appellate Panel (BAP) on various grounds, including a contention that he had the right of trial de novo pursuant to § 657 of the ADR Act.[22] The appeal was denied by the bankruptcy court[23] and the BAP. In affirming the arbitrator’s decision, the BAP held that the ADR Act’s “trial de novo requirement” only applied to court-ordered arbitration, not to agreed arbitrations subsequently adopted by court order. The BAP concluded that the claimant’s election to arbitrate bound him to the plan provision that the arbitrator’s decision was final and nonappealable.[24] In Tucson Diocese, the arbitration agreement was efficient and effective for a variety of reasons, including the structure of the agreement itself and the detailed research supporting claims that litigation would be costly and protracted.[25]

Implementation Issues

The threshold determination that has to be made in deciding whether structured arbitration is a viable option is whether the matter is suitable for out-of-court adjudication. There are several types of bankruptcy matters that are not suitable for binding out-of-court resolution because persons with significant interests in the outcome are not before the court (e.g., objections to discharge under 11 U.S.C. § 727).

The ADR guide suggests the following five additional types of cases that might not be suitable for adjudication outside of trial: (1) cases involving novel legal issues, ambiguous precedent, constitutional issues or public policy where a judgment could contribute to the development of the law; (2) cases where the public should have information about the case and its resolution; (3) cases where there are many issues and many parties; (4) cases that generally can be decided on the papers; and (5) complex cases such as class actions or mass torts. The court and parties also have to determine whether they can effectively obtain the discovery and information during the arbitration process that is necessary for a fair adjudication of their dispute.

Finally, the parties have to draft the structured arbitration agreement, obtain an appropriate court order, and identify the arbitrator or arbitration panel. The task of identifying arbitrators and providing acceptable compensation terms does not need to be daunting. There are numerous sources available to find qualified and affordable arbitrators, and most federal districts maintain a panel listing vetted arbitrators, along with their qualifications and compensation requirements.

Conclusion

By nature of the process, litigation requires its participants to endure many uncertainties. It is these uncertainties that can create unacceptable risks, including jurisdictional risks. ADR provides choices for managing or avoiding those risks, and Tucson Diocese illustrates this potential for managing risks incurred in bankruptcy matters.

Since structured arbitration is designed to adjudicate disputes, parties can manage risk — even if consensual settlement is not achievable — although an election to participate in structured arbitration preserves the opportunity for later consensual resolution. Selecting structured arbitration during mediation is an option to trial and total settlement and an option to a mediation impasse.