The Emerging Use of Arbitration in Bankruptcy Matters

Readers of this blog (as well as my other published articles) should be familiar with my advocacy for use of arbitration in resolving commercial finance disputes. Certainly, in matters involving disputes between secured creditors (e.g., intercreditor disputes), I have long expressed my view that things like these should be resolved privately, not through a public forum. This is a great benefit of arbitration. I am also inclined to privately resolving disputes between lenders and borrowers through arbitration. In those rare instances when a lender may have crossed the line and is subject to liability, isn’t it better to keep that dispute under the cover of a confidential arbitration?

Over the past 30 years, the use of mediation has become common in bankruptcy disputes. But the question has long been raised whether arbitration clauses would be enforced in the context of a bankruptcy case. That issue was addressed in a recent decision from the Bankruptcy Court for the District of Maryland. While this decision may not be the first to address this question and enforce a prepetition arbitration private provision, the scholarship of this decision certainly makes it ripe to present.

The Maryland Bankruptcy Court wrote:

The filing of a chapter 11 bankruptcy case generally stops all matters affecting the debtor’s financial affairs and consolidates the resolution of those matters in one forum, the bankruptcy court. That collective process is intended to, among other things, allow a debtor to catch its financial breath and develop a cohesive reorganization plan; provide consistency and certainty in the resolution of matters potentially affecting the debtor’s reorganization; and ensure fair and equal treatment of the debtor’s creditors. …A frequent question…. is how these basic principles apply to an arbitration clause in a prepetition contract between the debtor and just one creditor.

Prior to the filing of his personal bankruptcy case, the debtor entered into a litigation funding agreement whereby the lender extended financing to fund the cost of the lawsuit in exchange for a percentage of the debtor’s interest in a whistleblower litigation. When the lender and borrower found themselves in a dispute, the lender invoked the arbitration clause contained in its agreement and the debtor filed a Chapter 11 case. The lender moved for relief from the automatic stay to allow the arbitration to proceed. The debtor objected.

The lender argued that the Bankruptcy Court was required to enforce the prepetition arbitration agreement, while the debtor argued that enforcement would conflict with the objectives of the Bankruptcy Code.

The [Federal Arbitration Act] and the [Bankruptcy] Code both are grounded in important policy considerations concerning efficiency and fairness. The FAA focuses on these notions in the context of, among other things, private contracts affecting commerce, creating a strong presumption in favor of the parties’ threshold agreement to arbitrate disputes. …The Code …  is not party- or contract-specific but seeks to balance the rights of many parties with many different contracts, rights, and interests involving a single debtor.

The Court turned to whether the dispute was a core proceeding:

If a claim is a constitutionally core proceeding, the bankruptcy court has the discretion to retain the proceeding and not enforce the terms of the parties’ arbitration agreement. …[T]his discretion arises from the inherent conflict in allowing an arbitrator to resolve proceedings that are grounded in the Code itself or that are integral to the debtor’s reorganization efforts…. A bankruptcy court’s discretion is far more limited with respect to nonconstitutionally core or non-core proceedings.

Some circuit courts have ruled that a bankruptcy court has no discretion to refuse arbitration of non-core claims. The Court quoted a New York case for the steps to follow in evaluating requests to compel arbitration:

[F]irst, it must determine whether the parties agree to arbitrate; second, it must determine the scope of that agreement; third, if federal statutory claims are asserted, it must consider whether Congress intended those claims to be nonarbitrable; and fourth, if the court concludes that some, but not all, of the claims in the case are arbitrable, it must then decide whether to stay the balance of the proceedings pending arbitration.

In doing its analysis, the Court determined that this was a hybrid case involving constitutionally core and non-core proceedings with the state law contract claims being subject to the prepetition arbitration agreement. The Court further noted that those claims could be separated from the bankruptcy and fair debt collection claims – “even if that may not be the most procedurally efficient approach….” In light of legal precedent in the Fourth Circuit Court of Appeals, the Bankruptcy Judge felt compelled to bifurcate the claims and allow the contract and nonbankruptcy claims to proceed to arbitration.

The Court acknowledges that, if the arbitrator resolves the Contract Claims or the Non-Bankruptcy Claims prior to this Court addressing the Bankruptcy Claims, the parties could face conflicting results, or one forum may be bound by the other’s decision under the doctrine of claim or issue preclusion. The Court is not prepared to rule on such matters at this time, but will by separate order issue a temporary stay of proceedings on the Debtor’s Complaint to monitor how these matters progress and to guard against undue delay or gamesmanship. The Court dislikes the element of uncertainty introduced by this approach but, absent clear authority under the Code or case law giving this Court more discretion to refuse arbitration in the context of non-constitutionally core or non-core claims, the Court finds this approach warranted and most appropriate under the circumstances.

The takeaway in this developing area of the law is, that while bankruptcy claims must be resolved in the Bankruptcy Court, nonbankruptcy claims that are the subject of an arbitration agreement may be compelled to be resolved by an arbitration tribunal. I will continue to keep an eye on this doctrine and continue to advocate the use of arbitration for the resolution of commercial finance disputes.

 

In re: John McDonnell McPherson v Camac Fund, L.P., Bankr. MD, June 1, 2021, 2021 WL 2232351

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