In Kansas, Arbitration in Bankruptcy is Not Granted Cavalierly

Contributed by Joshua Nemser
Following on the heels of our recent bundle of bankruptcy in arbitration posts (see here), today we bring you a decision from the home state of Dorothy Gale of Wizard of Oz fame, the great state of Kansas.  The recent memorandum opinion handed down by Judge Somers of the United States Bankruptcy Court for the District of Kansas in In re Brooke Corp. addresses several issues related to bankruptcy and arbitration, including (i) who can compel arbitration, (ii) how one can waive their ability to compel arbitration, and (iii) what is arbitrable in bankruptcy proceedings.
In 2008, an insurance agency franchisor, Brooke Corporation, filed for protection under chapter 11 of the Bankruptcy Code.  The case was subsequently converted to a liquidation under chapter 7.  The dispute at issue in Brooke revolved around the relationship among Brooke, two Brooke-franchised insurance agencies, Bucheli Insurance Agency and Hosford Insurance Agency, and the principal equity holder of the insurance agencies, Fausto Bucheli.
In 2009, Bucheli, along with the Brooke franchised insurance agencies, filed a proof of claim against Brooke for unpaid commissions and fraudulent inducement.  The same parties later filed a second proof of claim for breach of the franchise agreement between Brooke and the Brooke franchised insurance agencies.  In 2010, the Brooke chapter 7 Trustee filed an adversary proceeding against each of the Brooke franchised insurance agencies to recover unpaid statement balances.  In addition, the complaint sought recovery fraudulent conveyances under section 548(a)(1)(B) of the Bankruptcy Code, recovery of avoided transfers under section 550, and disallowance of the proofs of claim under section 502(d).  Because Bucheli executed a guaranty below the signature line of each of the relevant franchise agreements, he was named as an additional defendant.
In 2012, nearly two years after the commencement of the adversary proceeding, the defendants filed a motion to dismiss on the grounds that the claims were subject to arbitration.  The franchise agreement between Brooke and each of the insurance agencies contained a mandatory arbitration provision.  In his holding, Judge Somers addressed three important issues relating to arbitration and bankruptcy.
To Compel Arbitration, You Must Have Been Party to the Agreement Containing the Arbitration Provision
Although Bucheli executed a guaranty following the signature lines of each of the franchise agreements, the court found that the guaranty could not be incorporated by reference to the franchise agreements.  As the court noted, “Although the guaranty refers to the franchise agreement, there is no language of incorporation.”  Because the guaranty was not incorporated into the franchise agreement, under Kansas law, Bucheli could not be held to the arbitration provisions within the franchise agreements.  Accordingly, even if the adversary complaint were arbitrable as between the Brooke chapter 7 trustee and the insurance agencies, it was not arbitrable vis-à-vis Bucheli.
A Party Can Waive Its Right to Compel Arbitration
The Brooke chapter 7 trustee argued that because the insurance agencies had participated in the adversary proceeding for two years before filing their motion to dismiss, they had waived their right to arbitrate the dispute.  The court noted that “[w]aiver of arbitration occurs in most cases when a party initiates litigation or participates in a lawsuit in violation of the arbitration agreement.”  In conducting its analysis of whether the insurance agencies had waived arbitration, the court considered six factors enumerated by the United States Court of Appeals for the Tenth Circuit in Peterson v. Shearson/American Express, Inc..
In concluding that the insurance agencies had waived their right to compel arbitration, the court made a number of meaningful observations.
First, the court found that “the filing of a proof of claim seeking bankruptcy court resolution of a claim against a debtor that is covered by a mandatory arbitration agreement, without seeking relief from stay to pursue the claim before an arbitrator or otherwise preserving the right to arbitrate, evidences a waiver of the agreement to arbitrate.”  Thus, the 2009 proof of claim filed by the defendants was a significant factor in the court’s decision to deny the motion to dismiss.  The court specifically noted that the proof of claim “makes no attempt to preserve the right to arbitrate.”
Second, the defendants had participated in the adversary proceeding “for more than two years before seeking arbitration,” which is “inconsistent with the intent to enforce” arbitration clauses.  The court noted that the defendants had filed several motions to dismiss (the first unrelated to arbitration), had participated in discovery, and also filed an answer to the complaint.  Addressing the defendants’ delay in moving to dismiss in favor of arbitration, the court found that the defendants were “attempting to manipulate the judicial process” by waiting “to raise the arbitration issue until arbitration became an attractive defensive litigation tactic.”
Claims Unique to a Bankruptcy Trustee Are Not Subject to Arbitration
In addressing the counts of the adversary proceeding complaint related to fraudulent conveyances, recovery of avoided transfers, and disallowance of proofs of claim, the court found that they are “core” bankruptcy claims “unique to the trustee and not derivative of the debtor” and that such claims are accordingly not subject to any analysis regarding arbitrability.  Citing a secondary source, the court held that because such claims are “[c]ore bankruptcy claims or causes of action,” they are not subject to arbitration.  Although this portion of Judge Somers’s opinion contained only a page of discussion, it did take a clear position that “core” bankruptcy disputes are not arbitrable.  As we have noted, this matter is one of considerable debate.  For example, in In re Cardali, the Bankruptcy Court for the Southern District of New York held that even “core” bankruptcy actions might be arbitrable if they share “common questions of fact” with an underlying contract dispute.  The Cardali decision, however, is not without its critics.
The decision reaches three discrete conclusions regarding the ability to arbitrate in bankruptcy: (i) one must actually be party to an agreement containing an arbitration provision in order to enforce it, (ii) a party to an agreement containing an arbitration provision, by its conduct alone, can waive its right to arbitrate, and (iii) some bankruptcy courts will refuse to enforce an arbitration provision when the underlying claim arises under the Bankruptcy Code.  With respect to the issue of waiver, the case highlights the steps a party to a bankruptcy proceeding should take in seeking to compel arbitration.  In a nutshell, the Brooke decision espouses one piece of advice: do not rest on your laurels, and assert your rights to arbitrate early.  Of course, the outcome may be different if you’re not in Kansas anymore.