Will Your Arbitration Agreement Survive Bankruptcy?
Will Your Arbitration Agreement Survive Bankruptcy?

Several recent U.S. Supreme Court cases have emphasized that there is a strong federal policy in favor of arbitration.  Yet, an arbitration agreement is not impenetrable or always enforceable.  It is beneficial for businesses to understand the areas in which the interest in enforcing arbitration agreements may not be as strong as other interests at issue.  The enforceability of arbitration agreements in the bankruptcy context is one such area, which the U.S. Supreme Court has recently been asked to address.  As it now stands in the Fourth Circuit and several others, an arbitration agreement may be held unenforceable at the discretion of the Bankruptcy Court under certain circumstances.  The U.S. Supreme Court has been asked to decide this issue on the heels of the recent decision from the Ninth Circuit Court of Appeals in Continental Ins. Co. v. Thorpe Insulation Co. (In re Thorpe Insulation Co.), 671 F.3d 1011 (9th Cir. 2012) which upheld the Bankruptcy Court’s denial of a motion to compel arbitration of claims alleging that the debtor breached a pre-bankruptcy petition settlement agreement, in part, based on actions the debtor undertook while attempting to restructure during the bankruptcy proceeding.  The Ninth Circuit “joined” the Fourth Circuit and others in ruling on the standard applicable for analyzing the issues presented in In re Thorpe Insulation Co.  See 671 F.3d at 1020-21.  We will discuss the Fourth Circuit’s view here.

In 2005, the Fourth Circuit Court of Appeals addressed the enforceability of arbitration agreements in the context of bankruptcy proceedings in Phillips v. Congelton, L.L.C. (In re White Mountain Mining Co.), 403 F.3d 164 (4th Cir. 2005).  In this case, prior to the company filing for Chapter 11 bankruptcy, a demand for international arbitration was issued by one foreign owner of the company (“Owner A”) to resolve whether money previously advanced to the company by another owner (“Owner B”) was a capital contribution or a loan which was required to be repaid.  After the company filed a bankruptcy petition, Owner B initiated an adverse proceeding to resolve the same question.  The Bankruptcy Court denied Owner A’s motion to compel arbitration of Owner B’s claims, reasoning that Owner B’s complaint involved a core proceeding under 28 U.S.C. § 157(b)(2)(B) because it sought to determine that Owner B was owed money by the company, and the proceeding presented issues that were critical to the formation of the company’s Plan of Reorganization.  Because the arbitration similarly was seeking to determine claims against the company and the equity holders in the entity, the core bankruptcy proceeding trumped the arbitration. In re White Mountain Mining Co., 403 F.3d at 167.

The Fourth Circuit recognized that there is a strong federal policy favoring arbitration, especially in the context of international arbitration.  However, in line with the Second Circuit Court of Appeals, the Fourth Circuit found that "[i]n the bankruptcy setting, congressional intent to permit a bankruptcy court to enjoin arbitration is sufficiently clear to override even international arbitration agreements." Id. at 168 (citations omitted).  The Fourth Circuit’s reasoning:

  •  We need not decide today whether the statutory text itself demonstrates congressional intent to override arbitration for core claims because this case may be decided under [Shearson/Am. Express, Inc. v. McMahon, 482 U.S. 220, 227, 96 L. Ed. 2d 185, 107 S. Ct. 2332 (1987)] third line of analysis -- whether congressional intent is deducible "from an inherent conflict between arbitration and the statute's underlying purposes." 482 U.S. at 227Id. at 169.
  • “Arbitration is inconsistent with centralized decisionmaking because permitting an arbitrator to decide a core issue would make debtor-creditor rights ‘contingent upon an arbitrator's ruling’ rather than the ruling of the bankruptcy judge assigned to hear the debtor's case.”  Id. (citations omitted).  Id.
  • “The ‘fundamental purpose’ of chapter 11 is rehabilitation of the debtor….To protect reorganizing debtors and their creditors from piecemeal litigation, the bankruptcy laws ‘centralize all disputes concerning [a debtor's legal obligations] so that reorganization can proceed efficiently, unimpeded by uncoordinated proceedings in other arenas.’” Id. at 170 (citations omitted).
  • “The inherent conflict between arbitration and the purposes of the Bankruptcy Code is revealed clearly in this case, in which both the adversary proceeding and the London arbitration involved the core issue of whether [Owner B’s] advances to the debtor were debt or equity.”  Id.

The Fourth Circuit upheld the lower court’s decisions denying Owner A’s motion to compel arbitration.  Id.

The Petition for Writ of Certiorari was filed in In re Thorpe Insulation Co. on April 30, 2012.  It remains to be seen whether the Fourth Circuit view (which aligns with the Second and Ninth Circuit views) will stand, and whether the Supreme Court will decide to review the issue.  The Response to the Cert Petition is due July 2, 2012.

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