Arbitration in Bankruptcy -- Discharge, the Easy Case

Now that the major work of the ABI Commission on Consumer Bankruptcy is done, I seem to have this thing called "time" again. One of the topics that I have been wanting to post about is arbitration in bankruptcy. If I follow through on my intentions, this will be the first of a few posts on arbitration in bankruptcy.

Arbitration has come to the bankruptcy courts. In the coming years, how the Federal Arbitration Act intersects with the Bankruptcy Code will become an increasingly prominent issue. What I want to talk about in this post is arbitration of a violation of the discharge injunction itself. In the typical factual set-up, a debtor alleges a violation of the discharge injunction, and the creditor moves to send the question to an arbitrator under a predispute arbitration clause, almost always embedded in a form contract. Given the ubiquity of these form contracts in consumer transactions, the only thing at stake is the effectiveness of the consumer bankruptcy system.

We can first exclude one approach to the topic that I occasionally see. It goes something like this. The Supreme Court keeps sending disputes to arbitration and thus has signaled repeatedly it favors arbitration. Therefore, the Court would hold that bankruptcy disputes can be arbitrated. This is not how law works. The Court's tendencies are not "law." One of the Supreme Court justices has famously declared he favors a certain malted beverage, but that hardly makes it the drink of the land (although I also would not be against making it so).

An analysis that actually does come from the Supreme Court's case law is that a court should order arbitration unless (i) there is evidence of congressional intent under the "other" law "to prohibit waiver of the judicial forum" or (ii) that the law presents "an inherent conflict" with the Federal Arbitration Act. This analysis tends to come down to whether the "other" law is important enough to override the Federal Arbitration Act. Parties have argued that the purpose of various employment laws, consumer laws, and securities laws would be eviscerated if disputes under these laws had to go to arbitration. All of those arguments have fallen short at the Supreme Court. Maybe bankruptcy will be the exception that proves the rule, but that is not the argument I want to explore when it comes to the bankruptcy discharge.

As I explained more fully in a post two year ago, the discharge is inherently nonarbitrable. A bankruptcy petition initiates a process from which the discharge flows. A creditor can no more ask for arbitration of the discharge than it can ask for arbitration of the petition itself. Last year, the Second Circuit held exactly that in a case called Credit One v. Anderson. In its opinion, the court cited an amicus brief from Ralph Brubaker, Bruce Markell, and me that provides a more formal legal analysis than either you or I want to see in a blog post. The discharge is enforced through a court injunction, which only the court has the authority to enforce. The injunction's locus in section 524 of the Bankruptcy Code is beside the point, as both the brief and my last blog post detail.

The discharge is the easy case. The automatic stay likewise is a pretty clear case for nonarbitrability. Dischargeability of individual debts is harder, and I am still thinking that one through. The road to bankruptcy court may be paved with good intentions, but my intent is to post on these other issues in the near future.

Comments

[Bradley Jones]

Maybe I'm misunderstanding the issues. But since arbitration clauses are contractual, my initial thought is that the arbitration provision in a pre-petition form contract should be an executory contract in the Debtor's bankruptcy. When the Trustee doesn't accept it, the contract is deemed rejected. The Debtor should then leave bankruptcy with a discharge free from the arbitration obligation unless there is some new contract or transaction between the parties. It could be the Courts have rejected that argument but that'd be my instinct from first principles.

[Bob Lawless]

I am not sure that will work, Bradley. Rejection of an executory contract is deemed to be a prepetition breach of the contract, see § 365(g), not a nullification of the contract. A party's breach of a contract does not excuse any contractual obligation that party has to arbitrate.

[Wolfgang P Hirczy de Mino PHD]

Thank you for this update.

For anyone interested in the interplay of the “strong” public policy in favor of arbitration and other “strong” public policies at the state level, several recent cases in Texas can serve as examples.

FAA VS. STATUTE THAT REQUIRES COURT APPROVAL FOR CONTRACT TO BE VALID

A recent Texas Supreme Court case, RSL Funding LLC v. Newsome No. 16-0998 (Tex. Dec. 21, 2018), involved a dispute arising under the Structured Settlement Protection Act (which requires court approval for contracts to transfer periodic payments in exchange of a lump sum) and, as a second issue, the question whether a challenge to the validity of a prior court approval order entered under the Act, which had been raised through a common-law bill-of-review proceeding, was subject to arbitration, based on the arbitration clause in transfer agreement that the Court had approved.

The Agreement at issue selected the FAA as the controlling arbitration law and expressly delegated arbitrability to the arbitrator.

The Texas Supreme Court reversed the Dallas Court of Appeals and ordered arbitration, but also found briefing waiver with respect to the contract-formation issues that could have rendered the delegation clause immaterial. So, ultimately, it is not clear whether the court-approval requirement under the Structured Settlement Act operates as a condition precedent for the formation of a valid arbitration agreement, which would make the court the appropriate decisionmaker, as opposed to the arbitrator deciding both arbitrability and challenges that go to enforceability and legality under state law, or other contract avoidance theories, such as fraudulent inducement.

The Texas Supreme Court sent the case to the arbitrator for – at the minimum – a determination of arbitrability, leaving open the possibility that the arbitrator might conclude that only the court has the power to make and unmake orders that are statutorily mandated by the Structured Settlement Act, and that only the court can grant bill-of-review relief to set aside its own prior order that was erroneously entered.
The High Court also noted that the FAA would preempt contrary state law, but that would presumably not reach the contract-formation issue if properly presented in the next case of similar nature.

ARBITRATION UNDER A CONTRACT THAT DOES NOT COMPLY WITH A STATE REGULATORY REQUIREMENT THAT OPERATES AS A STATUTE OF FRAUDS

For consumer-protection purposes, the Texas Government Code requires contingent fee agreements for legal services to be in writing and signed by both the attorney and the client. Tex. Gov’t Code § 82.065(a). The FAA, by contrast, does not require mutual signatures.

So what happens when legal services were performed under an unenforceable contingent-fee agreement that contains an arbitration clause; the client fires the law firm; and the law firm then sues the client for fees, or initiates an arbitration proceeding with the AAA against the client, or does both? Is the arbitration agreement enforceable against the former client even though the contract of which it is a part is not enforceable as against public policy (although this does not foreclose a quantum meruit claim in Texas)? And who gets to decide arbitrability?

In two recent contingent-fee-disputes involving a prominent Texas personal injury lawyer, the trial courts issued orders against arbitration. In Cavanaugh v. Law Office of Thomas J. Henry, the Dallas Court of Appeals reversed an arbitration stay in favor of arbitration and the supreme court later denied (discretionary) review. The Court of Appeals observed in a footnote that the trial court was required to decide the question of arbitrability because the AAA rules that contain the delegation provisions had not been introduced into evidence. The AAA rules were incorporated into the arbitration clause by reference. The arbitrator will get to decided whether the law firm can recover under its noncompliant fee contract (or in quantum meruit as an alternative, I would add). See Law Office of Thomas J. Henry v. Cavanaugh, No. 05-17-00849-CV, 2018 WL 2126936 (Tex.App. – Dallas, May 7, 2018, pet. denied Nov. 16, 2018).

The second case involved an almost identical contingent-fee contract by the same law firm, which did not sign the contract but performed a significant amount of litigation activity before being fired. The trial court stayed arbitration. This case is still pending in the Texas Court of Appeals for the Thirteenth District. Case Style: Law Office of Thomas J. Henry v. Priscilla Ann Garcia, No. 13-18-00275-CV (Tex.App. – Corpus Christi, argued and awaiting opinion).

In Texas, the trend seems to be for an ever more extensive farmout of traditional judicial functions, and public accountability incident to their exercise, in favor of private arbitration. That includes contracts that are void/voidable as against public policy.

Wolfgang P. Hirczy de Mino, Ph.D. (Political Science) (Univ. of Houston 1992)
[email protected]
SSRN Author page: https://ssrn.com/author=2845050

[Nate J.]

I’m guessing you are going to get to this in an upcoming post, but many courts hinge their analysis on the core/non-core distinction. What I haven’t seen, but what it seems you are getting at, is a more fundamental distinction: case under title 11 vs arising under/arising in/related to title 11.

I think a lot of judges just skip the distinction and begin their opinions with a formulaic “this is a core proceeding under 157(b)(2)(whatever).” But some things, like commencing the case upon receipt of the petition, are clearly not merely “proceedings,” but the case itself. I don’t think that there has been much discussion of the distinction, and the line is often blurred. For example, proceedings related to contesting an order for relief in an involuntary are definitely the “case.” But what about a motion to dismiss after the order for relief is entered? Or a complaint to revoke a discharge for fraud? When does it cease to be the “case” and start to be a “proceeding” which could arguably be referred to arbitration?

[Bob Lawless]

Nate, yes, we are thinking along the same lines.Courts seem to have been distracted by the core/noncore distinction perhaps because "core" sounds like "important." We make the point about the petition being the case itself in the amicus brief.

And, rarely has the word "formulaic" been a more apt description of a line of case law.

[Bashar H. Malkawi]

At the end of the day, it is a matter of competing interests between the Bankruptcy Code and other laws. Not claims or issues can be arbitrated in bankruptcy cases. The are issues that cannot be arbitrated by the nature of the claim even though the arbitration clause is mentioned in the contract. Bashar H. Malkawi