“Release the Kraken” – S.D.N.Y. Affirms Denial of Arbitration, Rules That Determinations Regarding Property of the Estate Belong In Bankruptcy Court

Contributed by Doron P. Kenter.
In a recent case out of the Southern District of New York, the court affirmed a denial of a motion for relief from the automatic stay to proceed with arbitration, ruling that the liquidating trustee was not bound by the arbitration clause in the debtor’s prepetition consignment agreement and holding that the interests of other creditors militated in favor of a determination by the Bankruptcy Court regarding whether certain consigned artwork was property of the estate.
In In re Salander-O’Reilly Galleries, LLC, a prepetition consignor moved the bankruptcy court for relief from the automatic stay to allow arbitration to proceed regarding the proper ownership of a painting, “Madonna and Child,” by Sandro Botticelli, valued at more than $8.5 million.  Prior to Salander-O’Reilly’s bankruptcy, Kraken Investments Limited, a limited company with its principal place of business in Jersey, Channel Islands, entered into a one-year consignment agreement with Salander-O’Reilly, pursuant to which the gallery would feature the painting at an exhibition and use its best efforts to sell the painting.  That agreement referred all disputes between the parties to arbitration in the Channel Islands and stated that Channel Islands law would control in such arbitration.  Kraken delivered the Botticelli to the gallery, but did not file a UCC-1 financing statement registering its interest in the painting.  Days before the gallery’s bankruptcy filing, Kraken commenced a state court action in New York, seeking seizure of the painting.  The action was automatically stayed upon the commencement of Salander-O’Reilly’s bankruptcy case.
Through court-approved procedures in the chapter 11 case, Kraken sought a determination from a special panel (established to handle requests for returns of consigned artwork) that the painting was not property of the estate under section 541 of the Bankruptcy Code, but was instead its own property, and merely on consignment with the gallery.  When mediation through this process failed, Kraken moved for relief from the automatic stay so as to enter into arbitration in the Channel Islands pursuant to the consignment agreement.  The bankruptcy court denied the motion, concluding that (i) the liquidation trustee for the debtor (who had succeeded to the debtor’s interest in the Botticelli) was not a party to the consignment agreement and was therefore not bound by the arbitration clause; and (ii) for policy reasons, the bankruptcy court (and not an arbitrator) should resolve the question of whether the liquidation trustee could avoid unperfected liens pursuant to section 544 of the Bankruptcy Code.
On appeal, the district court affirmed the bankruptcy court’s decision for the same basic reasons.  First, the court observed that the liquidation trustee’s rights (as successor to the estate) to avoid unperfected liens were in its capacity as a creditor of the debtor (rather than as a successor to the debtor’s own interests).  Because the trustee was not “stepping into the shoes” of the debtor, but rather exercising the rights of a creditor (either under section 544 of the Bankruptcy Code or as assignee of a lender’s prepetition lien), it was not a party to the consignment agreement – at least for the purposes of arbitrating the dispute before the court regarding the ownership of the painting.  Indeed, as the court noted, the dispute was “not simply an issue between Kraken and [Salander-O’Reilly],” but rather, between Kraken and the debtor’s estate.  Accordingly, the liquidation trustee was not bound by the arbitration clause.
Second, the district court concluded that, even if the liquidation trustee had been bound by the arbitration clause, the bankruptcy court did not err in denying arbitration on a policy basis, after weighing the conflicting interests of federal arbitration law and the Bankruptcy Code.  The district court first observed that, in appeals regarding core proceedings, it must show due deference to determinations by the bankruptcy court regarding these competing policy interests.  It then held that determinations regarding what constitutes estate property are constructs of section 541 of the Bankruptcy Code and are, at least in this case (and probably in most, if not all, cases), core proceedings “aris[ing] under” the Bankruptcy Code.  The court further noted that determinations regarding estate property have “no existence outside bankruptcy” and would also constitute core proceedings “arising in” the bankruptcy case, and that, in any event, Kraken had filed a proof of claim in the bankruptcy case, thereby triggering core jurisdiction under 28 U.S.C. § 157(b)(2)(B) for “allowance or disallowance of claims against the estate.”
The district court then found that the bankruptcy court had not abused its discretion in concluding that the interests of the Bankruptcy Code – including its goals of aggregating all estate property and of centralizing disputes in a single forum – outweighed the interest of the Federal Arbitration Act, insofar as it recognizes the enforceability of the arbitration clause pursuant to which Kraken wished to protect its own interests.  Indeed, the court observed that, “[i]f every dispute as to whether property was part of the bankruptcy estate … were sent to arbitration pursuant to a pre-petition arbitration agreement, unreasonable delay, costs, and duplication of effort would result for all parties involved in the bankruptcy as well as the courts.”
In so holding, the district court recognized that Kraken’s frustration (even “outrage”) at the possibility that the debtor’s creditors might share in the proceeds of the sale of a painting allegedly owned by Kraken.  It observed that the bankruptcy court had not yet determined the nature and extent of Kraken’s interest in the painting, and that the only issue before the court was whether such dispute should be resolved in the bankruptcy court or by an arbitrator in the Channel Islands.  Though the court’s sympathies are well-taken, they may be cold comfort, as it seems clear under bankruptcy law that the liquidating trustee may avoid a lien where a consignor has failed to perfect its security interest by filing a financing statement.  Though this result may seem unfair to Kraken, the courts in Salander-O’Reilly have provided useful guidance for holders of security interests and for those attempting to enforce prepetition arbitration clauses in bankruptcy proceedings.