Clash of the Statutory Titans: Federal Arbitration Act vs. Bankruptcy Code

Whether a particular dispute arising in a bankruptcy case must be decided by arbitration or litigation before the bankruptcy court is itself an issue that has been the subject of much litigation in bankruptcy courts. The issue arises when a private agreement contains a provision requiring all or certain disputes between the parties to be resolved by arbitration, but one of the parties to the agreement becomes a debtor under the Bankruptcy Code and litigation is thereafter brought by the debtor or his trustee that arguably implicates the arbitration provision. [1] When such litigation arises “involving both the Bankruptcy Code...and the Arbitration Act, 9 U.S.C. § 1, et seq., [it] presents a conflict of near polar extremes: bankruptcy policy exerts an inexorable pull toward centralization while arbitration policy advocates a decentralized approach towards dispute resolution.”[2] In short, “[w]hen arbitration law meets bankruptcy law head-on, clashes inevitably develop.” [3] The source of arbitration law in this context is the Federal Arbitration Act (FAA), [4] which “provides that a court must stay its proceedings if it is satisfied that an issue before it is arbitrable under the agreement” and authorizes a federal district court to issue an order compelling arbitration if there has been noncompliance with the arbitration agreement. [5]

Arbitration of Statutory Claims 
As observed by the Supreme Court in Shearson, “the Arbitration Act establishes a federal policy favoring arbitration,” requiring courts to “rigorously enforce agreements to arbitrate.” [6] This obligation applies with equal force when a party bound by an agreement to arbitrate raises a claim based on statutory rights, [7] such as rights or causes of action arising under the Bankruptcy Code. The right to arbitration should be enforced unless the party opposing it can show that Congress intended for the courts to adjudicate the statutory right at issue. [8] Such a showing can be made “from the statute’s text or legislative history...or from an inherent conflict between arbitration and the statute’s underlying purpose.” [9] For bankruptcy matters, courts have found no evidence of an intent to override the FAA in the text or legislative history of the Code, and have thus focused on whether there is an inherent conflict between arbitration and the underlying purposes of the Code in determining whether a particular bankruptcy dispute is arbitrable or should remain with the bankruptcy court for adjudication. [10]

Arbitration of Disputes in Bankruptcy 
The analytical approach that courts have followed in deciding this question for bankruptcy matters has not been uniform, [11] but several recurring themes have emerged. First, in non-core, “related-to” matters,[12] a bankruptcy court will generally lack discretion to prevent an arbitration from going forward. [13] Second, even in core proceedings, a bankruptcy court will lack discretion to override an arbitration agreement unless it finds an inherent conflict between the nature of the claims or rights asserted and the FAA, or that arbitration would necessarily jeopardize the objectives of the Bankruptcy Code. [14] Only if a “severe conflict is found” may a court conclude that “with respect to the particular Code section involved, Congress intended to override the Arbitration Act’s general policy favoring the enforcement of arbitration provisions.” [15]

Although courts have eschewed absolutes in this area, the question of whether bankruptcy litigation should yield to arbitration for core proceedings has often expressly or implicitly turned on “whether the underlying dispute concerns rights created under the Bankruptcy Code or non-bankruptcy issues derivative of the debtor’s pre-petition activities.”[16] “In the former situation, the bankruptcy court has discretion to refuse arbitration, but in the latter it does not.” [17]

Code-Created Rights
Examples of core proceedings that were not considered appropriate candidates for arbitration because they asserted Code-created rights have included preference and fraudulent-transfer claims, [18] improper set-off and avoidable post-petition transfer claims, [19] equitable-subordination claims [20] and claims for violation of the automatic stay.[21] Actions for nondischargeability under § 523(a)(2), (4) or (6) ordinarily should not be sent to arbitration, [22] but when the underlying debt that is claimed to be nondischargeable has not yet been liquidated, arbitration has been ordered for that purpose. [23] The reason for refusing to compel arbitration of disputes asserting Code-created causes of action is that the trustee or debtor in possession is suing on behalf of the creditors, who did not agree to arbitration of such claims. [24]

Other “Core” Claims
The more difficult cases in this area have involved claims based on some pre-petition conduct, the resolution of which will significantly impact the administration of the estate, and what several courts from the Southern District of New York have characterized as “procedurally core” claims, which are defined as “garden variety pre-petition contract disputes dubbed “core” because of how the dispute arises or gets resolved.” Although acknowledging that arbitration of these type of disputes will rarely conflict with any bankruptcy policy, the 800-pound exception that these courts have identified is when “resolution of the dispute fundamentally and directly affects a core bankruptcy function.” [25] The decisions on whether to compel arbitration in these more difficult cases defy precise categorization, but some general observations can be made.

In what are perhaps the most common types of proceedings in bankruptcy cases, most courts do agree that objections and counterclaims to proofs of claim that are covered by an arbitration clause should be resolved by arbitration, [26] but even here, there are exceptions. For example, the bankruptcy court in In re Mirant refused to allow a lease-rejection claim to be decided by arbitration, principally because the debtor was a party to numerous other agreements with arbitration provisions, and to allow one claim to be decided by arbitration could expose the debtor to piecemeal litigation. [27]

Nonbankruptcy causes of action affirmatively asserted by a debtor or trustee against a creditor or other party are frequently the subject of disputes over arbitrability. Common among such disputes are claims asserted by consumer debtors for violation of consumer protection or truth-in-lending laws. The tendency of the courts in these types of matters is to enforce the arbitration clause when properly raised by the defendant. [28]

Arbitrable and Nonarbitrable Claims in Same Proceeding
As a practical matter, nonbankruptcy claims are often brought together with Code-created causes of action. In such cases, courts are faced with determining whether one set of claims should be stayed until resolution of the other, or whether all claims should be decided by the same tribunal. In resolving such questions, courts generally consider which of the two sets of claims predominates and whether they overlap. For example, in Matter of Gandy, it was held that since the debtor in possession’s claims for fraudulent transfer of her interests in a partnership predominated her state law claims, all of the claims should be tried in bankruptcy court in the interest of judicial efficiency. [29]

The difference in results reached in In re Hagerstown Fiber Limited Partnership and In re S.W. Bach & Company illustrates that deciding whether arbitrable or nonarbitrable claims predominate a proceeding is decidedly in the eye of the beholder. Although the trustee’s complaint in Hagerstown was evenly divided between fraudulent transfer and turnover claims on the one hand and state law claims on the other, [30] all arising out of contractual disputes over the construction of a plant, the court concluded that the fraudulent-transfer claims should be stayed pending conclusion of an arbitration since at their core, the trustee’s claims were contractual in nature. [31]

In contrast, in In re S.W. Bach & Co., where the trustee’s claims were for fraudulent transfer under § 548 of the Code, aiding and abetting breach of fiduciary duty and restitution and unjust enrichment, [32] all arising out of a pre-petition transfer for no consideration of customer accounts serviced by the debtor, [33] the court concluded that the arbitrable state law claims should be stayed until the fraudulent-transfer claim could be adjudicated in bankruptcy court. [34] The difference in result from Hagerstown was attributed to the lack of a direct connection between the arbitrable state law claims of unjust enrichment/restitution and aiding and abetting breach of fiduciary duty and the nonarbitrable fraudulent-transfer claim, [35] although an element of the unjust-enrichment claim was lack of consideration. [36]

Waiver of Arbitration
A waiver of the right to arbitrate may occur by failing to timely raise the arbitration provision and/or by participating in litigation in bankruptcy court. [37] The factors considered in determining whether this has occurred are “(1) the time elapsed from commencement of litigation to the request for arbitration, (2) the amount of litigation (including any substantive returns and discovery), and (3) proof of prejudice.” [38] The determination of waiver in this context is highly fact-specific. [39]

Conclusion
The strong and liberal policy favoring arbitration is observed in bankruptcy cases, but not without limitation. As is typical of most disputes arising in bankruptcy court, the road to arbitration is paved with unique bankruptcy considerations. They should be carefully weighed before embarking on litigation over where to litigate.

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