Supreme Court Decision on Arbitration Has Ominous Implications for Bankruptcy

Justice Brett M. Kavanaugh wrote his first opinion for the Supreme Court in what The New York Times called a “minor arbitration case.”

If Justice Kavanaugh’s ruling in Henry Schein Inc. v. Archer & White Sales Inc. is applied rigorously in bankruptcy, it’s a “really big deal,” because bankruptcy judges will not be able to bar creditors from initiating arbitrations over “core” issues such as allowance of claims, objections to dischargeability of debts, and even adequate protection.

Indeed, Schein could be interpreted to mean that the bankruptcy court cannot bar a creditor from initiating arbitration against an individual or corporate debtor, even if the call for arbitration was frivolous.

‘Wholly Groundless’

Schein was argued on October 29 and decided for the unanimous Court by Justice Kavanaugh on January 8. By contract, the parties agreed to arbitrate before the American Arbitration Association and according to AAA rules.

Later, the plaintiff filed suit under federal and state antitrust laws, seeking damages and an injunction. The contract called for arbitration “except for actions seeking injunctive relief . . . .” The rules of the AAA call for the arbitrator to decide issues of arbitrability.

Invoking the Federal Arbitration Act, 9 U.S.C. § 2, the defendant responded to the complaint by asking the district judge to refer the case to arbitration. Adopted in 1925, the FAA provides that a contract calling for arbitration “shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.”

Following Fifth Circuit authority, the district court refused to compel arbitration, finding that the demand for arbitration was “wholly groundless” because the plaintiff was seeking an injunction. The Fifth Circuit affirmed.

The Circuit Split

The circuits were split. The Fourth, Fifth, Sixth and Federal Circuits have held that a federal court could refuse to compel arbitration if the demand was “wholly groundless.”

The Tenth and Eleventh Circuits ruled to the contrary, holding that the arbitrator alone is entitled to rule on the arbitrability of the dispute, if the contract so provides.

To resolve the split, the Court granted certiorari on June 25.

Justice Kavanaugh’s Rationale

In substance, Justice Kavanaugh said the Court had already decided the question. In 2010, the high court ruled that the parties may agree by contract that an arbitrator, not the court, will resolve threshold arbitrability questions, not just the merits of the dispute. Rent-A-Center West Inc. v. Jackson, 561 U. S. 63, 68−70 (2010).

Justice Kavanaugh said that “some federal courts nonetheless will short-circuit the process” by deciding the arbitrability question if the demand for arbitration is “wholly groundless.” Those courts, he said, adopted the “wholly groundless” exception to Rent-A-Center “to block frivolous attempts to transfer disputes from the court system to arbitration.”

Reversing the Fifth Circuit, Justice Kavanaugh held that the “court possesses no power to decide the arbitrability issue” if “the parties’ contract delegates the arbitrability question to an arbitrator.”

Justice Kavanaugh reaffirmed the principle that a court can decide whether there was a valid arbitration agreement before referring a dispute to arbitration. “But,” he said, “the court may not decide the arbitrability issue” if “a valid agreement exists, and if the agreement delegates the arbitrability issue to an arbitrator.”

Justice Kavanaugh rejected the policy argument that the “wholly groundless” exception is “necessary to deter frivolous motions to compel arbitration.” He said that arbitrators can quickly and efficiently dispose of frivolous cases, imposing costs and attorneys’ fees on the movant “under certain circumstances.”

Because the lower courts had not considered the issue, Justice Kavanaugh remanded the case for the Fifth Circuit to rule on whether the agreement “in fact delegated the arbitrability question to an arbitrator.” He said the judge “‘should not assume that the parties agreed to arbitrate arbitrability unless there is clear and unmistakable evidence that they did so,’” quoting First Options of Chicago Inc. v. Kaplan, 514 U.S. 938, 944 (1995).

Fewer and Fewer Exceptions to Arbitration

The implications of Justice Kavanaugh’s opinion for bankruptcy cases are better understood in the context of the progression of recent Supreme Court authority.

In 1987, the Supreme Court ruled that a court could decline to enforce an arbitration agreement if there was an inherent conflict between arbitration and the statute’s underlying purpose. Shearson/American Express Inc. v. McMahon, 482 U.S. 220, 227 (1987).

Building on McMahon, the Second, Fourth, Fifth and Ninth Circuits have held in bankruptcy cases that the court may decline to compel arbitration if the issue is “core” and arbitration would represent a “severe conflict” with the Bankruptcy Code.

Last year, the Second Circuit utilized that concept to override an arbitration agreement when a debtor mounted a class action contending that the creditor had violated the discharge injunction. One Bank NA v. Anderson (In re Anderson), 884 F.3d 382 (2d Cir. March 7, 2018), cert. denied Oct. 1, 2018.

Anderson and the other circuit decisions overriding arbitration agreements in bankruptcy cases were all decided before Epic Systems Corp. v. Lewis, 138 S. Ct. 1612, 1624 (May 21, 2018), where the Supreme Court held last term that the language of a statute must be “clear and manifest” before a court can disregard an arbitration agreement. In Epic, the Supreme Court nixed a class action and required individual arbitration of a former employee’s claim that the employer’s failure to pay overtime violated the Fair Labor Standards Act.

Epic was a 5/4 decision, with the justices divided on ideological grounds.

Applying Epic and Schein to Bankruptcy Cases

Assume that a debtor and a creditor had a prebankruptcy agreement to arbitrate all disputes, including any arising in bankruptcy, such as the allowance of claims, counterclaims, preferences, and adequate protection. Further assume that the agreement called for the arbitrator to decide whether the dispute was arbitrable, even following bankruptcy.

If Epic and Schein were applied rigorously, the bankruptcy judge arguably would have no right to bar the creditor from initiating arbitration. If the dispute raised a core issue — such as the allowance of a claim, dischargeability or adequate protection — the bankruptcy judge might have no power to bar arbitration even if there was a “severe conflict” with bankruptcy law.

A chapter 11 debtor could find itself defending dozens of arbitrations, giving the bankruptcy judge little ability to confirm a plan or avoid liquidation. Or, an individual debtor might be fighting dischargeability in several arbitrations.

The prospect of arbitrating dischargeability is not fanciful. See Williams v. Navient Solutions LLC (In re Williams), 564 B.R. 770 (Bankr. S.D. Fla. 2017) (debtor compelled to arbitrate student loan dischargeability); but see Golden v. JP Morgan Chase Bank NA (In re Golden), 587 B.R. 414 (Bankr. E.D.N.Y. 2018), and Roth v. Butler University (In re Roth), 18-50097, 2018 BL 427188 (Bankr. S.D. Ind. Nov. 16, 2018) (arbitration of dischargeability of student loan not permitted). For ABI’s discussion, click here.

Supreme Court authority on arbitration seems headed to a pivotal case for the justices to decide whether bankruptcy represents a general exception to the enforceability of arbitration agreements.

In that regard, bankruptcy cases have an element not present in Epic and Schein. The underpinning of the Bankruptcy Code is centrality of administration. Bankruptcy law has always recognized that an individual cannot win a fresh start and a company cannot reorganize if issues related to bankruptcy must be litigated in several forums. Bankruptcy is designed so one judge decides all core disputes. Even if there is a Stern problem, the case goes to a district judge in the same courthouse.

Epic’s requirement of a statute’s “clear and manifest” exception to arbitration may be found in the centrality of administration of bankruptcy cases. And if that’s not enough, the most conspicuous feature of bankruptcy is the automatic stay.

Surely, a creditor cannot continue or initiate arbitration without relief from the automatic stay. If the automatic stay is not a “clear and manifest” exception to arbitration, it’s hard to imagine what is.

Justice’s Kavanaugh’s opinion reaffirms the power of courts to determine in the first instance whether an arbitration agreement is valid. An arbitration clause purportedly enforceable in bankruptcy could be viewed as an invalid agreement, just like an agreement is invalid if it waives the automatic stay or precludes the filing of bankruptcy.

But the question remains: Is a contract calling for arbitration of bankruptcy issues an invalid contract that the bankruptcy court can override, or does Schein require the bankruptcy court to refer the dispute to an arbitrator who will decide whether bankruptcy questions are arbitrable?

To read ABI’s discussion of Anderson, click here, here and here.