The Supreme Court has yet to say whether enforcement of an arbitration agreement can bring a bankruptcy case to a grinding halt. More specifically, the Court has not said whether (or to what extent) arbitration agreements are enforceable in bankruptcy.
In settings not involving bankruptcy, the Court has been adamant about enforcing arbitration agreements. On the other hand, the justices have said that arbitration clauses are enforceable just like other contracts and that there is no strong federal policy favoring arbitration.
With no controlling authority from the Supreme Court or the Seventh Circuit, Bankruptcy Judge David D. Cleary of Chicago found an inherent conflict between the Federal Arbitration Act and the Bankruptcy Code when it comes to an objection to the allowance of a filed claim. He refused to enforce the arbitration clause even though the outcome of the claim objection could result in an affirmative judgment against the creditor that would enhance the estate.
Significantly, Judge Cleary said that the characterization of the dispute as core or non-core was not determinative in terms of enforcing an arbitration agreement.
The Claim and the Counterclaim
Before bankruptcy, the debtor borrowed $750 from a lender that evidently specialized in making small loans to consumers. Perhaps to evade state statutes regulating lenders of the type, the lender allegedly made a $3,750 loan but kept $3,000 in a bank account in its own bank. The lender only disbursed $750 to the debtor.
In chapter 13, the debtor scheduled the $750 claim as unsecured, and the lender filed an unsecured claim for $750 plus a secured claim for $3,000. The plan called for paying all claims in full.
The debtor mounted an adversary proceeding against the lender. In sum, the complaint sought to disallow the $750 claim for allegedly violating state law. The counts in the complaint also sought punitive damages and attorneys’ fees.
The lender countered with a demand to enforce an arbitration agreement contained in the loan documents. The debtor objected.
Having said that the court could not confirm the debtor’s plan until the objection to the claim was resolved, Judge Cleary wrote an opinion on March 28 where the debtor won, for all intents and purposes.
General Statements from the Supreme Court
Quoting Katchen v. Landy, 382 U.S. 323, 328-29 (1966), Judge Cleary said that one of “the ‘chief purpose[s] of the bankruptcy laws is to secure a prompt and effectual administration and settlement of the estate . . . within a limited period.’” He also alluded to Celotex Corp. v. Edwards, 514 U.S. 300, 308 (1995), where he said that “Congress intended [for the bankruptcy court to] be able to ‘deal efficiently and expeditiously with all matters connected with the bankruptcy estate[.]’”
More to the point, Judge Cleary cited Shearson/American Exp., Inc. v. McMahon, 482 U.S. 220, 227 (1987), where the Supreme Court said that disregarding an arbitration agreement calls for a showing that “Congress intended to make an exception to the Arbitration Act . . . an intention discernible from the text, history, or purposes of the statute.”
The lender contended that the debtor’s claims were non-core and that arbitration must proceed, even on the claim objection.
Core vs. Non-Core Isn’t Controlling
There being no dispute that there was a valid arbitration agreement, Judge Cleary was called upon to decide “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,” citing McMahon, supra, at 227.
In distinction to how some other courts have analyzed similar circumstances, Judge Cleary said that “if there is an inherent conflict between arbitration and the purposes of the Bankruptcy Code, then it is not relevant whether the dispute is core or non-core.” Although both core and non-core matters can give rise to an inherent conflict, he said that the distinction “is a fact to consider.”
In the case at hand, Judge Cleary said that the debtor’s objection to the lender’s claim was core given the allegation that the claim was unenforceable under state law. Moreover, some of the debtor’s counterclaims were constitutionally core because they would be resolved in ruling on the allowance of the creditor’s claim.
Although the Seventh Circuit has no decisions on the subject, Judge Cleary cited opinions from other circuit courts and lower courts that, he said, “have affirmed a bankruptcy court’s rejection of a request to send a disputed matter to arbitration when doing so would conflict with the purposes of the Bankruptcy Code.”
Having laid the groundwork, Judge Cleary analyzed the three counts in the debtor’s complaint.
The first count sought to disallow the lender’s claim, saying that it was unenforceable for having violated state consumer protection laws. To that extent, Judge Cleary said that the count was constitutionally core and represented grounds not to enforce the arbitration clause.
The first count also sought punitive damages and attorneys’ fees. Judge Cleary would not permit arbitration, because those issues would be resolved in passing on the allowance of the claim.
The second count sought damages for violation of a particular state consumer protection statute. The count, Judge Cleary said, was non-core, arose solely under state law and would not “impact” confirmation of the debtor’s plan. He ruled that arbitration could proceed on the second count.
In the third count, the debtor sought to void the creditor's claim under another state consumer protection statute that permits an award of damages. Like the first count, Judge Cleary said that the third count entailed the allowance of the lender’s claim and would therefore proceed in bankruptcy court, not in arbitration.
Concluding his opinion, Judge Cleary dealt another defeat to the lender.
While permitting arbitration of the debtor’s second count, Judge Cleary stayed arbitration until “resolution” of the debtor’s objection to the creditor’s claim. Consequently, the rulings by the bankruptcy court might invoke res judicata or collateral estoppel to govern the outcome of the one count still subject to arbitration.
The Supreme Court has yet to say whether enforcement of an arbitration agreement can bring a bankruptcy case to a grinding halt. More specifically, the Court has not said whether (or to what extent) arbitration agreements are enforceable in bankruptcy.
In settings not involving bankruptcy, the Court has been adamant about enforcing arbitration agreements. On the other hand, the justices have said that arbitration clauses are enforceable just like other contracts and that there is no strong federal policy favoring arbitration.
With no controlling authority from the Supreme Court or the Seventh Circuit, Bankruptcy Judge David D. Cleary of Chicago found an inherent conflict between the Federal Arbitration Act and the Bankruptcy Code when it comes to an objection to the allowance of a filed claim. He refused to enforce the arbitration clause even though the outcome of the claim objection could result in an affirmative judgment against the creditor that would enhance the estate.
Significantly, Judge Cleary said that the characterization of the dispute as core or non-core was not determinative in terms of enforcing an arbitration agreement.