Bankruptcy and Arbitration: Like Oil and Vinegar?

Co-contributed by Debra A. Dandeneau and Joshua Nemser.
Uncertainty lurks at the crossroads of arbitration and bankruptcy law.  It is well settled that bankruptcy courts will permit arbitration of non-bankruptcy issues, but when it comes to “core” issues arising under bankruptcy law, the line becomes blurred.  The overall arbitrability of bankruptcy issues is unpredictable, and recent caselaw highlights the tension between the policies underlying federal bankruptcy law and arbitration:  bankruptcy courts attempt to apply the strong public policy in favor of arbitration, but recognize that such public policy must have its limits when bankruptcy principles are the predominant issue before the court. 
Members of the legal community generally appreciate the benefits of arbitration, which is a speedy and cost-effective alternative to litigation.  In 1925, Congress enacted the Federal Arbitration Act, codifying a now longstanding policy preference in favor of arbitration.  The Federal Arbitration Act requires courts to honor arbitration agreements, and the United States Supreme Court has repeatedly enforced this mandate.  The bankruptcy process, however, presents unique circumstances that may tilt the scales against favoring arbitration.  Unlike traditional litigation, which typically pits one or more plaintiffs against one or more defendants, a chapter 11 case brings together a multitude of parties with a variety of alignments into a single forum.  A significant policy goal of bankruptcy is to centralize disputes involving the debtor.  Any creditor or equity holder of a debtor is generally considered a “party in interest” with standing to be heard on bankruptcy disputes.  Moreover, bankruptcy courts are accustomed to dealing with requests for emergency relief.  Arbitration, however, not only removes a dispute from the main bankruptcy forum, to the potential exclusion of other parties in interest, but also sets in motion a dispute resolution process that may be antithetical to the timing needs of a bankruptcy case. 
The Rubric
Arbitration is enforced under the Federal Arbitration Act so long as Congress has not expressed an intent to remove a dispute from the scope of arbitration.  Such contrary intent “can be deduced from the statute’s text or legislative history, or from ‘an inherent conflict between arbitration and the statute’s underlying purposes.’”  Neither the Bankruptcy Code nor its legislative history contains evidence of an intent to disallow or otherwise dissuade the enforcement of arbitration provisions.  Thus, courts uniformly focus on whether an “inherent conflict” exists between arbitration and a provision of the Bankruptcy Code, or more particularly, whether arbitration would “‘necessarily jeopardize’ the objectives of the Bankruptcy Code.”  It is settled law that courts have no discretion to deny arbitration in “non-core” matters merely “related to” a bankruptcy case.  Courts now recognize that even many “core” matters do not pose any “inherent conflict” with arbitration.  The Second Circuit has directed bankruptcy courts to undertake a “particularized inquiry,” taking the facts and circumstances of the particular case into consideration.  It is the circumstantial nature of this inquiry that leads courts to arrive at different conclusions on very similar issues.
The Automatic Stay
The leading Second Circuit case on arbitrability in bankruptcy, Hill, addresses arbitration and the automatic stay imposed by section 362 of the Bankruptcy Code.  The applicability of the automatic stay is a traditional “core” bankruptcy issue, but that alone is not enough to preclude arbitration.  In its analysis, the Hill court took care to identify important purposes of the automatic stay: protection of assets of the estate and compulsory centralization of disputes.  Finding, among other things, that the debtor’s chapter 7 estate already had been administered — her case had been closed and the debtor had received a discharge — the court found no conflict with bankruptcy principles in requiring post hoc litigation over violation of the automatic stay to be governed by the parties’ agreement to arbitrate disputes.
Following Hill, the Bankruptcy Court for the Southern District of New York recently upheld arbitration of a claim for willful violation of the automatic stay, finding that it was “inextricably intertwined” with an arbitrable breach of contract claim.  The court found that the debtor could not “sustain its burden that arbitration of the claim [would] seriously jeopardize the objectives of the Bankruptcy Code.”  The Bankruptcy Court for the District of New Jersey approvingly cited Hill and TexStyle in similarly finding that a stay violation claim should be arbitrated along with other closely related tortious interference claims.
Hill does not stand without its critics.  In In re Merrill, the Bankruptcy Court for the District of Maine held that arbitration of a debtor’s stay violation claim “would conflict with [the] court’s duty to safeguard the automatic stay’s fundamental protection for debtors.”  A significant distinction in Merrill was that the debtor’s assets were not yet fully administered.  Even then, the court went to significant lengths to explain that because the stay litigation involved the adjudication of bankruptcy rights, arbitration was not appropriate.
Cash Collateral
In In re Hostess Brands, Inc., the Bankruptcy Court for the Southern District of New York recently denied a request by ACE American Insurance Company to arbitrate the issue of whether a collateral agreement was breached in the context of the debtor’s request to use cash collateral under section 363 of the Bankruptcy Code.  The Bankruptcy Court found that determining whether to authorize the use of cash collateral was a “substantially core” issue “central to the bankruptcy process that Congress contemplated as substantially altering otherwise existing and enforceable rights under applicable non-bankruptcy law. . . .”  Because the use of cash collateral “is not at all rooted” in a pre-bankruptcy right, the Bankruptcy Court concluded that the parties could not have agreed to arbitrate its use.  Moreover, although Congress never provided that cash collateral disputes were not arbitrable, it expressly provided for bankruptcy courts to make such determinations under the Bankruptcy Code.  The Hostess court also was concerned with the ability of other parties in interest in the bankruptcy to appear and be heard on the cash collateral issues – isolating a cash collateral dispute to an arbitration proceeding conducted in accordance with customs of the insurance industry would not allow for such participation.  Hostess is notable for its reliance upon bankruptcy principles as a reason to deny the arbitration request and its emphasis on the effect that arbitration has on the ability of other parties in interest to participate in a dispute. 
Preferences and Fraudulent Transfers
Hostess is at odds, however, with the decision of another bankruptcy judge in the Southern District of New York in connection with a fraudulent transfer action, In re Cardali.  The Cardali court acknowledged that fraudulent transfer actions may arise under the Bankruptcy Code and are typically “core,” but because the actions under scrutiny shared “common questions of fact” with an underlying contract dispute, and further because the actions “closely resemble, and sometimes overtly cite, underlying state law,” arbitration was appropriate.  The Cardali court focused on the hybrid nature of fraudulent transfer actions – section 548 of the Bankruptcy Code creates a bankruptcy right to recover fraudulent transfers, but the principles are derived from state law.  The Hostess court, in dicta, disagreed, noting that the Cardali view “frankly, conflicts with numerous other cases.”  Although the Hostess court did not cite any particular cases in connection with this statement, it likely was referring to In re Bethlehem Steel Corp., which found that it is “well-settled law” in the Second Circuit that “motions to compel arbitration of statutory avoidance claims be denied.”  The Bethlehem court extended its rationale to preference claims, which does not have an analogue in state law.  Thus, even within the Southern District of New York, opinions differ in this area.
Property of the Estate
One District Court in the Southern District has held that the determination of property of the estate under section 541 of the Bankruptcy Code is within the ambit of bankruptcy courts and outside of the scope of arbitrability.  The court clearly enunciated its rationale:  if these sorts of disputes were sent to arbitration, “unreasonable delay, costs, and duplication of effort would result for all parties involved in the bankruptcy as well as the courts.”
Contrast the arbitration process against the familiar bankruptcy practice of notice and hearing.  Under arbitration, proceedings are reduced to discrete two party disputes adjudicated by those not necessarily familiar with the nuances of bankruptcy law.  Alternatively, the bankruptcy process provides interested parties with notice of contested proceedings, and more importantly, a right to intervene.  It also places a bankruptcy judge in the position to make the “final call” with respect to the bankruptcy-related decision.  Arbitration is undoubtedly a useful method of alternative dispute resolution, but it should be employed judiciously in the unique context of bankruptcy.
Reprinted with permission from the February 20, 2013 issue of the New York Law Journal. © 2013 ALM Media Properties, LLC.  Further duplication without permission is prohibited. All rights reserved.