Automatic Stay Must Give Way: Bankruptcy Court Lets Non-Core Claims Be Decided Through Arbitration

In a recent opinion, the Bankruptcy Court for the District of Maryland dealt with a conflict between the strong presumption in favor of enforcing arbitration agreements and the Bankruptcy Code’s emphasis on centralization of claims. Based on an analysis of the two statutory schemes and their underlying policies and concerns, the Court decided to lift the automatic stay to allow the prepetition arbitration proceeding to go forward with respect to non-core claims.

Background

Prior to petitioning for bankruptcy, John McPherson (“McPherson” or the “Debtor”) had entered into a Litigation Funding Agreement (the “Agreement”) with Camac Fund, L.P. (“Camac”). The Agreement provided that Camac would extend financing to McPherson in exchange for a percentage of McPherson’s interest in certain whistleblower ligation cases. The Agreement also contained an arbitration clause, based on which Camac initiated an arbitration proceeding once disputes arose between the parties. The arbitration was stayed upon the commencement of McPherson’s chapter 11 case. Additionally, the Debtor filed an adversary proceeding against Camac.

The Court categorized the parties’ claims in the prepetition arbitration proceeding and the pending adversary proceedings as follows: (i) contract claims arising from the breach of the Agreement (the “Contract Claims”); (ii) claims under the Fair Debt Collection Practices Act (the “Non-Bankruptcy Claims”); and (iii) claims arising under the Bankruptcy Code (the “Bankruptcy Claims”), including under sections 502, 510, 523, 543, 544, 547, and 553 of the Code. The question before the Court was whether these claims should be resolved by the Bankruptcy Court as part of the chapter 11 case or through arbitration.

Discussion

The Court noted that Camac’s request to lift the automatic stay to allow most of the parties’ claims to be decided through arbitration was substantively similar to a motion to compel arbitration. Accordingly, it applied the “arbitrability analysis” that courts undertake when evaluating requests to compel arbitration. Arbitrability analysis is a four-part test which requires a court to determine: (1) whether the parties agreed to arbitrate; (2) whether the claims at issue fall within the scope of the arbitration agreement; (3) whether, if federal statutory claims are asserted, Congress intended those claims to be non-arbitrable; and (4) whether, if the court concludes that some, but not all, of the claims in the case are arbitrable, it should stay the balance of the proceedings pending arbitration.

The first prong, an agreement to arbitrate, was not disputed. As to the second prong, the parties failed to adequately brief whether each of the claims were covered by the language of the Agreement. The Court, therefore, proceeded to analyze the third prong.

With respect to the third prong, the Court analyzed the potentially conflicting emphases of the Federal Arbitration Act (the “FAA”) and the Bankruptcy Code. The Court noted that the Bankruptcy Code greatly favors centralization of claims. Specifically, chapter 11 is designed to facilitate a timely, cost-efficient resolution of claims against a debtor, in part by deterring gamesmanship among creditors and producing legally consistent results across claims. The Court emphasized that a timely and cost-efficient resolution of claims can be critical to a debtor’s success as well as the maximization of value for all creditors. Accordingly, the Bankruptcy Code stays all civil proceedings against the debtor for the duration of the bankruptcy, and at the same time provides bankruptcy courts with original and exclusive jurisdiction over the bankruptcy case, and original and non-exclusive jurisdiction over related civil proceedings.

Important policy considerations such as efficiency and fairness underlie the FAA as well, but in the broader context of commerce. In Dean Witter Reynolds Inc. v. Byrd, the U.S. Supreme Court recognized that the FAA requires the rigorous enforcement of arbitration agreements. 470 U.S. 213, 221 (1985). And in Shearson/American Exp., Inc. v. McMahon, the Supreme Court held that the FAA’s mandate may be overridden only “by a contrary congressional command.” 482 U.S. 220, 226 (1987). The Bankruptcy Court noted that several courts held that the characterization of a claim as constitutionally core is indicative of Congressional intent to limit arbitration.

In the context of bankruptcy proceedings, a cause of action is constitutionally core when it stems from the bankruptcy itself or would necessarily be resolved in the claims allowance process. Thus, with respect to constitutionally core proceedings, the bankruptcy court has the discretion to retain the proceeding and refuse to enforce the parties’ arbitration agreement, but its discretion is far more limited with respect to non-core proceedings. In this case, the Court held that the Bankruptcy Claims were non-arbitrable because they would not exist absent the bankruptcy case and thus extended from the bankruptcy itself. The Court recognized that a debtor may be able to plead an action in a way that transforms certain pure state law claims into claims under the Bankruptcy Code but found that those concerns were not warranted in this case. Because the FDCPA Non-Bankruptcy Claims and the Contract Claims were claims that existed prior to and independently of the bankruptcy proceedings, the Court held that these categories of claims were non-core and lifted the stay to allow the arbitration proceedings to continue.

Finally, the Court decided to temporarily stay the proceedings with respect to the Bankruptcy Claims since some of the Contract Claims intersected with the Bankruptcy Claims and the Court was wary of conflicting results. It noted that taking account of the policies underlying the FAA and the Bankruptcy Code, if the Court was not bound by clear Fourth Circuit precedent regarding the arbitrability of non-core claims, the Court would have likely reached a very different result. Similarly, the Court stated that if the bankruptcy case had been filed prior to either party invoking the arbitration clause, the Court might have stayed the arbitration proceeding pending resolution of the Bankruptcy Claims first.

Takeaways

Bankruptcy Courts are generally reluctant to stay arbitration proceedings. This is so because of the unique concerns underlying the FAA’s strong presumption in favor of arbitration. A bankruptcy court, however, has solid grounds to deny arbitration of core bankruptcy claims, even where the claims are related to the non-core claims to be decided in arbitration. Further, when a set of related claims is bifurcated into those to be decided through arbitration and those that the bankruptcy court will decide, which forum proceeds first may very well depend on whether the arbitration proceeding or the bankruptcy petition was filed first.

Read the opinion >>