Arbitrate? You Can’t Make Me! Rejection Trumps Arbitration, Says Texas Bankruptcy Court

Overview

In a recent decision, In re Highland Cap. Mgmt., L.P.,¹ Judge Stacey G. Jernigan of the Bankruptcy Court of the Northern District of Texas (the “Court”) held that a debtor’s rejection of an executory contract with an arbitration clause precludes the court from compelling the debtor to arbitrate—notwithstanding the strong federal policy supporting enforcement of arbitration clauses, even in bankruptcy.  Although rejection of a contract constitutes a breach and may give rise to a claim for monetary damages, the Court found that specific performance of an arbitration clause was not an appropriate remedy post-rejection.  Highland provides an example of how bankruptcy courts may disregard contractual provisions—including an agreement to specifically perform—where they may irreconcilably conflict with the policy of the Bankruptcy Code.

Background

The debtor, Highland Capital Management L.P. (“Highland”), commenced adversary proceedings to recover under promissory notes (collectively, the “Notes Adversary Proceedings”).  Highland initially alleged breach of contract and sought turnover of amounts owed from obligors under the notes, but it subsequently amended its complaints to add alternate theories of liability and defendants, including Mr. Dondero, Dugaboy Investment Trust and Nancy Dondero (collectively, the “Dondero Defendants”).²  The Dondero Defendants, which included one of Highland’s largest partners and related parties, countered by filing motions to compel arbitration and stay the Notes Adversary Proceedings based on a mandatory arbitration clause (the “Arbitration Clause”) in Highland’s Limited Partnership Agreement (the “LPA”).

Legal Analysis

The Court denied the motions to compel arbitration, holding that (i) the LPA and the Arbitration Clause within the LPA were separate, executory contracts, (ii) Highland validly rejected such contracts under section 365 of the Bankruptcy Code, and (iii) as a result, specific performance of the Arbitration Clause could not be enforced against Highland. 

The Court weighed the significance of contract rejection against the strong federal principle of adhering to the Federal Arbitration Act (the “FAA”).  It noted that as a matter of federal policy, arbitration provisions should be enforced in accordance with their mutually agreed-upon terms and that bankruptcy courts are not subject to any exception to the contrary.³  Thus, most courts hold that arbitration provisions in bankruptcy must be enforced in non-core matters and generally should be enforced in core matters unless doing so would “irreconcilably conflict with the purposes or goals of the Bankruptcy Code.”⁴ 

Even though the matter before her was non-core, Judge Jernigan found the facts of Highland to be distinguishable from the standard precedent on arbitration in bankruptcy due to Highland’s rejection of the LPA (and corresponding Arbitration Clause).⁵  In reaching this decision, Judge Jernigan relied heavily on District Court Judge David Godbey’s decision in Janvey v. Alguire, a federal receivership case that nonetheless invoked bankruptcy law and section 365 of the Bankruptcy Code.⁶  In Janvey, Judge Godbey held that the arbitration clauses in the various relevant agreements should be treated as separate, executory contracts based on the nature of the agreement and “arbitration case law regarding severability.”⁷  Because the Receiver in Janvey rejected the “arbitration agreement,” the defendants could not enforce the arbitration clause against the Receiver in a lawsuit commenced by the Receiver.”  The court reasoned that the appropriate remedy for the injured party to a rejected contract could not be compelling arbitration because that would mean the court requiring specific performance by the Receiver, which is improper.⁸  Judge Godbey also found that forcing the Receiver to arbitrate in the case before him would be unjust, inequitable, and greatly burden the debtor’s estate.⁹ 

Notably, the Fifth Circuit affirmed Janvey on other grounds and declined to adopt “Judge Godbey’s ‘broader policy argument’ that the federal receivership statutes were at odds with the FAA’s mandate in favor of arbitration,” noting instead that further guidance from the Supreme Court was needed on the issue.¹⁰

Following Janvey, Judge Jernigan declined to enforce arbitration due to Highland’s rejection of the LPA and Arbitration Clause under section 365 of the Bankruptcy Code, despite the strong federal policy in favor of enforcement of arbitration provisions in contracts.  Although rejection constitutes a breach of contract and “arbitration survives the contract as a matter of contract law,” specific performance under the Arbitration Clause could not be ordered because a trustee must be able to avoid all executory obligations through rejection.  In so holding, the court explicitly disagreed with a Delaware bankruptcy court case, In re Fleming Companies, Inc.,¹¹ that held an arbitration agreement in a contract enforceable even though the debtor had rejected the contract.  Judge Jernigan found Janvey to be “more persuasive” and “possibly binding” on the court and also noted the distinction that in Fleming, it was the debtor seeking to invoke the arbitration clause in the contract it had rejected.  The Court also found that arbitration “would impose undue and unwarranted burdens and expenses on the parties to the detriment of Highland’s creditors.”¹²

Interestingly, Judge Jernigan did not discuss the recent United States Supreme Court case, Mission Product Holdings, Inc. v. Tempnology, LLC, which held that agreements rejected by a debtor in bankruptcy are not deemed terminated or rescinded.¹³  Instead, the United States Supreme Court found that following rejection, the non-debtor party retains any rights it has or may have under applicable non-bankruptcy law following the debtor’s breach of the agreement.  In that case, the debtor/licensor argued that the rejection of its trademark license agreement terminated the rights of the non-debtor party/licensee to use the trademark.  However, the Court held that because the debtor/licensor’s breach of the trademark license agreement under state law would not terminate the licensee’s rights to use the trademark outside of bankruptcy, neither does rejection.  While Mission Product dealt with a rejected trademark license, the United States Supreme Court case emphasized that its decision applied broadly to every type of agreement rejected by a debtor.  It is interesting to consider how Judge Jernigan would have decided the case had the parties put the Mission Product case in front of her.  Further information regarding Mission Product can be found on our prior post here. 

Takeaways

The Dondero Defendants have filed a notice of appeal of the Court’s decision to deny their motions to compel arbitration, which we will follow and report on, as appropriate.  Regardless of the outcome on appeal, the main takeaway from Highland is that contract counterparties should be aware that agreed-upon terms in a contract may not always be enforced if the counterparty ends up in bankruptcy, even usually sacrosanct arbitration clauses.  Relevant to this inquiry is how the challenged terms may affect the debtor’s estate regardless of the parties’ intentions when entering into the contract.  Notably, while the Highland Court was unwilling to order specific performance and compel arbitration, it did confirm that a debtor’s rejection of an executory contract could still give rise to a prepetition claim.  Accordingly, a contract counterparty who is unable to obtain specific performance as a remedy may still be entitled to monetary damages as a result of a debtor’s breach of contract.