19 July 2010
The question of what happens to an international arbitration when a party files for bankruptcy in the United States is arising with increasing frequency. In the United States, the public policy interests that underlie both bankruptcy and arbitration legislation sometimes clash on critical points. The federal courts have developed competing approaches to addressing these issues. This fractured caselaw introduces uncertainty at the intersection of arbitration and bankruptcy.
US Bankruptcy Code
Under the US Bankruptcy Code, bankruptcy courts serve as a centralized forum for resolving all disputes related to the debtor’s property and other assets, including, at least in some cases, arbitration claims against the debtor. Centralized dispute resolution helps to ensure efficient organization and limits the debtor’s need to expend estate resources in multiple courts.
Section 362 of the US Bankruptcy Code automatically stays claims against the debtor. This forces parties that contracted for a private means of dispute resolution to participate, at least initially, in a judicial bankruptcy proceeding. As for the debtor’s own claims, whether to prosecute them will no longer be a unilateral decision of the debtor but likely will be decided by a trustee or, if the debtor retains possession of the estate, be subject to the court’s approval. Further complicating matters is the fact that some foreign tribunals, including arbitral bodies, may not give effect to a stay order entered by a US bankruptcy court.
The Federal Arbitration Act
The Federal Arbitration Act (FAA) reflects congressional policy to enforce valid arbitration agreements. However, while the Supreme Court has consistently recognized the importance and validity of this policy, the Court has not addressed the inherent conflict between bankruptcy law and arbitration law. Whereas bankruptcy law centralizes all debtor-related disputes into one judicial forum and seeks to give the debtor time to reorganize or liquidate, arbitration law enforces agreements to expeditiously resolve disputes out of court.
Notwithstanding its strong support for arbitration agreements, the Supreme Court has repeatedly recognized that the FAA’s mandate to enforce private contracts may be “overridden by a contrary congressional command” or be qualified by “an inherent conflict” between the FAA and another statute’s “underlying purpose.”1 While it is generally agreed that the Bankruptcy Code does not represent a “congressional command” contrary to the FAA, some US courts have wrestled with whether these two bodies of law inherently conflict and, if so, how to reconcile them. The result has been inconsistency between jurisdictions and troubling uncertainty.
Inconsistent and Uncertain Caselaw
To enforce an arbitration agreement against a debtor, a party must first demonstrate that the arbitration agreement is valid and that the dispute falls within the agreement’s scope. Then, to defeat the arbitration agreement, the burden shifts to the debtor to show that the Bankruptcy Code’s purpose would be significantly impaired by enforcing the agreement.
This inquiry, in turn, generally depends on whether the bankruptcy court deems the arbitration a “core” or “non-core” proceeding. Core proceedings are those that are central to resolving a bankruptcy case. A non-exhaustive list of core proceedings may be found in the Judicial Code, 28 U.S.C. § 157. Whereas bankruptcy judges have full authority to adjudicate core proceedings, in non-core proceedings they can only make recommendations to district court judges, and in some cases cannot hear the case at all.
Core claims may be further categorized as “procedurally core” or “substantively core.” Procedurally core claims are “garden variety pre-petition contract disputes dubbed core because of how the dispute arises or gets resolved.”2 The arbitration of a procedurally core dispute rarely conflicts with any policy of the Bankruptcy Code unless the resolution of the dispute fundamentally and directly affects a core bankruptcy function. Substantively core claims are more likely to be intertwined with the bankruptcy reorganization and thus are far less likely to be referred to arbitration.
Whether an arbitration claim presents a core or non-core issue may be difficult to predict. The distinction generally rests on whether the bankruptcy court views the claim as “arising” out of the bankruptcy or instead as materially “relating” to the bankruptcy. This is sometimes a difficult distinction that generally rests on the materiality of the dispute to the reorganization.
Most US jurisdictions follow this core versus non-core analysis. They tend to hold that bankruptcy courts generally must enforce arbitration agreements with respect to non-core claims, and that they may refuse to enforce the agreements with respect to core claims, depending on the nature of the claims and the facts of the particular bankruptcy.3 Some jurisdictions, however, take a different approach. They focus on whether referring the case to arbitration would jeopardize the objectives of the Bankruptcy Code without regard to whether the proceeding involves core or non-core claims.4
Generally, bankruptcy courts will enforce arbitration agreements unless doing so would interfere with the debtor’s reorganization, particularly when it is the debtor seeking to enforce the agreement. But the lack of a dependable framework heightens uncertainty, complexity and cost. First, the determination of whether an arbitration proceeding is core or non-core can itself be an expensive and time-consuming procedural battle. Second, the significance of the core/non-core distinction to an arbitration agreement may vary between jurisdictions, and even within the same jurisdiction, and often results in further procedural battles.
Courts are divided over other issues involving the intersection of bankruptcy and arbitration law as well. For example, courts have reached different results in determining whether an arbitration clause contained in an executory contract is enforceable where the bankruptcy court had previously rejected the underlying contract.5 Other issues, such as the impact of a bankruptcy in a foreign country on an arbitration being conducted in the United States, or the impact of a bankruptcy in the United States on a foreign arbitration proceeding, raise unsettled questions of a type that courts throughout the world are being forced to consider as bankruptcies proliferate.6
It should also be noted that even if the bankruptcy court enforces an arbitration provision, the arbitration will serve only to liquidate claims against the debtor. To impose a remedy, the prevailing party will ultimately have to work through the bankruptcy court.
Given the uncertainty in this area, parties may find it in their interest, when negotiating arbitration agreements, to seek to find a way to protect against a potential bankruptcy, i.e., seek guarantors where bankruptcy is a potential issue.
1. Shearson/Am. Express, Inc. v. McMahon
, 482 U.S. 220, 226-27 (1987).
2. In re S.W. Bach & Co.
, 2010 WL 810128, at *6 (Bnkrcy S.D.N.Y. Mar. 10, 2010).
3. E.g., In re U.S. Lines
, 197 F.3d 631, 640 (2d. Cir. 1999).
4. In re Mintze
, 434 F.3d 222, 231 (3d Cir. 2006); In re D&B Swine Farms, Inc.
, 2010 WL 358493, at *4-6 (E.D.N.C. Jan. 23, 2010).
5. Compare Moglia v. Public Employers Ins. Co.
, 547 F.3d 835, 837 (7th Cir. 2008) (arbitration agreement not enforceable) with In re Fleming Cos.
, 2007 WL 788921, at *1-3 (D. Del. Mar. 16, 2007) (arbitration agreement enforceable).
6. See Vivendi S.A. v. Deutsche Telekom A.G.
, No. 4A_428/2008 (Swiss Federal Tribunal 2009); Syska v. Vivendi
 EWHC 2155 (Comm.); see also Victrix S.S. Co., S.A. v. Salen Dry Cargo A.B.
, 825 F.2d 709, 715 (2d Cir. 1987) (refusing to enforce arbitral award in deference to Swedish bankruptcy proceeding).