Locke Lord QuickStudy: ‎The FAA and the Bankruptcy Code: A Delicate Balance

With the specter of COVID-19 and its concomitant impact on the world economy, the US is poised to see an increase in bankruptcy filings during 2020 across any number of business sectors.  A debtor’s bankruptcy calls into question whether an arbitration agreement executed by the debtor continues to be enforceable.  The resolution of that question is factually intensive and involves the interplay between the Federal Arbitration Act (“FAA”) and the Bankruptcy Code.

The FAA establishes a federal policy favoring arbitration by providing that arbitration agreements “shall be valid, irrevocable, and enforceable, save upon grounds as exist at law or in equity for the revocation of any contract.” 9 U.S.C. § 2.  However, “[l]ike any statutory directive, the FAA’s mandate may be overridden by a contrary congressional command.”  See Shearson/American Express, Inc. v. McMahon, 482 U.S. 220, 226, 107 S.Ct. 2332, 2337 (1987).

The Bankruptcy Code’s central purpose is “to provide a procedure by which insolvent debtors can reorder their affairs, make peace with their creditors and enjoy a new opportunity in life with a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.”  Grogan v. Garner, 498 U.S. 279, 286, 111 S. Ct. 654, 659 (1991).  To attain this goal, “Congress intended to grant comprehensive jurisdiction to bankruptcy courts so that they might deal efficiently and expeditiously with all matters connected with the bankruptcy estate.”  Celotex Corp. v. Edwards, 514 U.S. 300, 308, 115 S.Ct. 1493, (1995).

These two mandates create a tension between the FAA and the Bankruptcy Code as to which prevails.  In cases where tension arises between the FAA and another statute, the Supreme Court has established a framework for resolving that tension.  A party seeking to prevent enforcement of an applicable arbitration agreement must demonstrate that “Congress has evinced an intention to preclude a waiver of judicial remedies for the statutory rights at issue.”  Green Tree Fin. Corp. v. Randolph, 531 U.S. 79, 90, 121 S.Ct. 513, 521 (2000). That intent is to be ascertained from (1) the statute’s text; (2) its legislative history; or, (3) “an inherent conflict between arbitration and the statute’s underlying purposes.”  McMahon, 482 U.S. at 227, 107 S.Ct. at 2338.

In determining whether to enforce an arbitration agreement, the bankruptcy courts, when applying the McMahon factors, typically find that there is no evidence within the text or the legislative history of the Bankruptcy Code that Congress intended to create an exception to the FAA.  The question, therefore, devolves into whether there is an inherent conflict between arbitration and the Bankruptcy Code.

In addressing this question, the bankruptcy courts initially distinguish between “core” and “non-core” proceedings.  A proceeding is non-core “[if] the proceeding does not invoke a substantive right created by the federal bankruptcy law and is one that could exist outside of bankruptcy.”  Cont’l Nat’l Bank v. Sanchez (In re Toledo), 170 F.3d 1340, 1348 (11th Cir.1999) (quoting Wood v. Wood (In re Wood), 825 F.2d 90, 97 (5th Cir. 1987)).  If the proceeding is non-core, the bankruptcy court does not have the discretion to decline to enforce the arbitration agreement and must order the parties to arbitration.

A core proceeding involves a right created by the federal bankruptcy law or a proceeding that would arise only in bankruptcy.  Id.  The Bankruptcy Code provides a non-exhaustive list of 15 proceedings considered core, including matters concerning the administration of the estate, allowance or disallowance of claims against the estate and proceedings to determine, avoid or recover preferences.  28 USC § 157.  In those instances in which a core proceeding is involved, the bankruptcy court has the discretion to deny arbitration.  In the exercise of that discretion, however, the court must analyze whether enforcing a valid arbitration agreement would inherently conflict with the underlying purposes of the Bankruptcy Code.  See Ins. Co. of N. Am. v. NGC Settlement Trust & Asbestos Claims Mgmt. Corp., (In re National Gypsum), 118 F.3d 1056, 1067 (5th Cir. 1997).  Only if there is an inherent conflict may the court deny enforcement of an agreement to arbitrate.

There is no bright line for determining whether a valid arbitration agreement would inherently conflict with the underlying purposes of the Bankruptcy Code.  Typically, the courts have found little difficulty ordering arbitration of disputes where resolution would not involve matters of federal bankruptcy law.  For example, a bankruptcy court will frequently grant a motion for relief from stay (which is a core matter) to allow a non-core dispute to proceed to arbitration or to allow an existing arbitration of a non-core dispute to continue. Cases in which the underlying dispute is a core matter or where a possible inherent conflict exists present more difficult questions for the courts with the resolution being dependent on a thorough analysis of the issues to be arbitrated and the interplay of those issues with the debtor’s estate.

In the end, the bankruptcy court must make a nuanced examination of the underlying controversy subject to arbitration and the ultimate effect of the resolution of that controversy on the debtor’s estate before declining to enforce a valid arbitration agreement.

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