View Full Version : Conflict Betwee Federal Arbitration and Bankruptcy Laws

A.J. Comparetto
01-02-2009, 02:31 PM
Thursday, January 1, 2009

Happy New Year Members!

This beginning-of-the-month thread is about protecting yourself from lawsuits by enforcing well-written mandatory binding arbitration agreements governed by the New York Conventions, a treaty with more than 100 countries as signatories.

I believe that it is important for any business or professional person, including an adult entertainment entrepreneur, to take website user agreements/terms of service agreements to the next level, by insuring that there is a valid mandatory binding arbitration agreement. To the extent possible, arbitration shall be governed by the so-called "New York Convention", a treaty with more than 100 countries as signatories, currently codified at Title 9, Sections 201 - 208 of the United States Code. To that end, below is a discussion about enforcing arbitration agreements for our members' consideration, in consultation with their respective counsel.

With a well-drafted agreement, parties engaged in international commerce are able themselves to choose whether to arbitrate their disputes, whom the decision-makers will be, where the arbitration will take place, and what procedures will be applied. See, e.g., the rules of arbitration institutions including Chamber of Commerce (ICC) Rules, Art. 7(1), London Court of International Arbitration (LCIA) Rules, Articles 5.2 and 6, American Arbitration Association (AAA) Rules, Art. 7 and UNCITRAL Model Law Article 12.

In the international sphere, the interests of promoting international trade and international comity have proved important factors in persuading the courts to treat certain types of dispute as arbitrable. However, there are conflicts between the federal arbitration and bankruptcy laws. This segment is about those conflicts.



Whether an arbitration clause in a contract will be enforced by the bankruptcy courts in accordance with the Federal Arbitration Act has been the focus of numerous court decisions over the last few years. Recently, two bankruptcy decisions, In re Charter Behavioral Health Sys., LLC, 277 B. R. 54 (Bankr. D. Del. 2002) and Kittay v. Landegger (In re Hagerstown Fiber Ltd. Píship), 277B. R. 181 (Bankr. S.D.N.Y. 2002) have addressed the issue. These decisions affirm prior case law holding that an arbitration clause should be upheld by the bankruptcy court in disputes that do not implicate the bankruptcy courtís "core" jurisdiction as well as in certain disputes that do. I would certainly commend them to your (and/or your legal counsel's) reading.

An Overview of the Federal Arbitration Act.

The Federal Arbitration Act (the "FAA") requires a federal court to enforce an arbitration agreement and stay litigation that contravenes it. In enacting the FAA, Congress declared a liberal federal policy favoring arbitration agreements. This congressional policy is so strong that an arbitration agreement must be enforced notwithstanding the presence of other persons who are parties to the underlying dispute but not to the arbitration agreement.

When faced with a motion to compel arbitration a court must consider the following factors: (1) whether the parties agreed to arbitrate; (2) whether the dispute falls within the scope of their arbitration clause; (3) if federal statutory claims are raised, whether Congress intended those claims to be arbitrable; and (4) if the court concludes that some but not all of the claims are arbitrable, whether it should stay the non-arbitrable claims pending the conclusion of the arbitrtration. In applying these factors, courts look initially to the arbitration agreement. The first question is whether the arbitration clause is broad or narrow. If the clause is broad, arbitration will be presumed. If narrow, the court must determine whether the dispute is on its face within the purview of the clause, or instead, involves a collateral agreement or issue that is somehow connected to the main agreement that contains the arbitration clause. The resolution of this issue hinges on the factual allegations underlying the dispute between the parties.

If the arbitrable dispute involves a federal statutory right, the court must determine whether Congress intended to except the dispute from arbitration. In addition, assuming some but not all claims are arbitrable, the court must determine whether to stay litigation with respect to the claims that are not. A blanket stay may be appropriate where the arbitrable claims predominate the lawsuit and the non-arbitrable claims are of questionable merit, or where the stay will promote judicial economy, avoidance of confusion and possible inconsistent results without working an undue hardship on or prejudicing the plaintiff

Arbitration in the Course of Pending Bankruptcy Proceedings.

When arbitration law meets bankruptcy law an inherent conflict exists, i.e., should the goal of adjudicating all matters relating to a debtor before the bankruptcy court to effectuate the efficient administration of the debtorís estate trump the liberal policy of enforcing arbitration agreements between the debtor and third parties. In the seminal case of Hays & Co. v. Merrill Lynch Pierce Fenner & Smith, Inc., 885 F.2d 1349 (3rd. Cir. 1989), the United States Court of Aooeals for the Third Circuit held that a bankruptcy trustee was bound by an arbitration clause contained in the debtorís prepetition contract. In so holding, the court ruled that a lower court is required to enforce arbitration of "non-core" claims brought by the trustee unless the trustee can demonstrate that the purpose of the Bankruptcy Code somehow conflicts with the enforcement of an arbitration clause.

A matter falls within a bankruptcy courtís "core" jurisdiction if it either invokes a substantive right created by federal bankruptcy law or could not exist outside of a bankruptcy case. By contrast, "non-core" matters generally involve disputes that have only a tenuous relationship to the bankruptcy case and would in all likelihood have been litigated elsewhere but for the broad nexus created by the debtorís bankruptcy filing. For example, a contract dispute between the debtor and a third party is a non-core matter. The distinction between core and non-core matters is a crucial, yet not necessarily determinative, one in defining a bankruptcy courtís discretion when confronting an arbitrable dispute.

In In re National Gypsum Co., 118 F 3d 1065 (5th. Cir. 1997), the United States Court of Appeals for the Fifth Circuit addressed the issue of whether a bankruptcy court should compel arbitration in "core" matters. Although the court refused to compel arbitration, it recognized that the core nature of a dispute is in and of itself insufficient to create the kind of inherent conflict with the FAA that would permit a bankruptcy court to refuse to enforce an arbitration agreement. The court held that where a cause of action arises entirely from rights conferred by the Bankruptcy Code (i.e. is within the courtís "core" jurisdiction), the bankruptcy court retains significant discretion to determine whether arbitration would be inconsistent with the purposes of the Bankruptcy Code. This approach was recently followed by the Second Circuit Court of Appeals in a tandem of carefully reasoned decisions. Delaware and New York bankruptcy courts were likewise asked to address the interaction between the FAA and the Bankruptcy Code in In re Charter Behavioral Health Sys., LLC and In re Hagerstown Fiber Ltd. Píship.

The Bottom Line.

Assuming the parties have agreed to arbitrate a particular dispute, a bankruptcy court must then determine whether it has discretion to adjudicate it. If the dispute represents a non-core matter, the bankruptcy court will lack this discretion. If the matter is core, the court cannot refuse to compel arbitration without performing further legal analysis. It must first evaluate the nature and reason as to why the dispute is a "core" as opposed to a "non-core" matter. If a proceeding is core only as a matter of procedure, by way of example, it arguably has some impact on the liquidation of the assets of the bankruptcy estate or the adjustment of the debtor-creditor relationship, then it stands to reason that the enforcement of an arbitration clause will likely not conflict with the policy of the Bankruptcy Code, and the bankruptcy court should, as a matter of prudence, defer to arbitration. On the other hand, if a proceeding is core as a matter of substantive law, meaning the dispute involves rights or duties created under the Bankruptcy Code, the parties likely did not (and perhaps could not, as a matter of law) agree to arbitrate the dispute and the bankruptcy court retains the discretion to refuse to compel arbitration.

The analysis of the legal conflicts between the FAA and the Bankruptcy Code becomes much more complex when the bankruptcy court deals with arbitration under the New York Convention (Chapter 2 of the FAA) or the Panamanian Convention (Chapter 3 of the FAA). This is because, as a matter of long-standing United States policy, treaties are on a very high legal pedestal. Therefore, the bankruptcy court would owe greater deference to arbitration, even in "core" matters.

The foregoing is a simplified treatment of the conflicts between the FAA and the Bankruptcy Code. It is offered for educational purposes only. Any application to individualized facts and circumstances may require extensive legal research. If the reader believes that he or she needs legal advice, the services of a competent attorney licensed in the appropriate jurisdiction should be retained.