Whether a dispute that is subject to arbitration can or must be referred to arbitration after one of the parties to a prepetition arbitration agreement files for bankruptcy has long been a source of disagreement among bankruptcy and appellate courts due to a perceived conflict between the Federal Arbitration Act and the Bankruptcy Code. The U.S. Bankruptcy Court for the Northern District of Illinois recently provided some useful guidance regarding this issue.
In Johnson v. S.A.I.L. LLC (In re Johnson), 649 B.R. 735 (Bankr. N.D. Ill. 2023), the court denied in part and granted in part a motion demanding that certain disputes between a chapter 13 debtor and her prepetition lender be referred to arbitration in accordance with the terms of an arbitration clause in a loan agreement. In so ruling, the court emphasized that, in determining whether a dispute should be arbitrated instead of adjudicated by a bankruptcy court, there is no "bright line" rule dependent on whether the dispute is within the court's "core" jurisdiction. Instead, the court must examine the nature of the dispute, including whether it is core or non-core, to determine whether arbitration would inherently conflict with the policies underlying the Bankruptcy Code. If such an inherent conflict exists, a demand to arbitrate the dispute should be denied.
Arbitration of Disputes in Bankruptcy
Whether a contractual arbitration clause will be enforced by the bankruptcy courts in accordance with the Federal Arbitration Act, 9 U.S.C. §§ 1 et seq. (the "FAA"), has been the focus of debate in bankruptcy and appellate courts for decades. The FAA provides that, with certain exceptions, arbitration agreements "shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract." FAA § 2. Pursuant to the FAA, arbitration agreements must generally be enforced in commercial disputes. See Dean Witter Reynolds, Inc. v. Byrd, 770 U.S. 213, 218 (1985) ("[I]nsofar as the language of the [FAA] guides our disposition of this case, we would conclude that agreements to arbitrate must be enforced, absent a ground for revocation of the contractual agreement.").
In Shearson/Am. Exp. Inc. v. McMahon, 482 U.S. 220, 226-27 (1987), the U.S. Supreme Court ruled that the FAA's mandate may be overridden if a party opposing arbitration can demonstrate that "Congress intended to preclude a waiver of judicial remedies for the statutory rights at issue." According to the Court, such congressional intent can be discerned in one of three ways: (i) the text of the statute; (ii) the statute's legislative history; or (iii) "an inherent conflict between arbitration and the statute's underlying purposes." The party opposing arbitration bears the burden of showing that "Congress intended to preclude a waiver of judicial remedies for the statutory rights at issue." Id. at 227; accord Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20, 26 (1991).
Guided by this mandate, in the past, the consensus among most courts addressing the issue has been that a bankruptcy court can adjudicate a dispute otherwise subject to binding arbitration if the dispute falls within the court's "core" jurisdiction, but in all other cases it must defer to arbitration. See generally Collier on Bankruptcy ("Collier") ¶ 9019.05[2] (16th ed. 2023).
However, the approach adopted by most circuit courts that have considered the issue is more nuanced. Rulings from the Second, Third, Fourth, Fifth, Ninth, and Eleventh Circuits stand for the proposition that arbitration is the favored means of resolving disputes—even some that fall within the bankruptcy court's core jurisdiction. In these circuits, the focus of the inquiry has shifted from an analysis of core versus non-core to determining: (i) whether a dispute is core; and (ii) if so, whether referral of the dispute to arbitration would conflict with the underlying purposes of the Bankruptcy Code. See Continental Ins. Co. v. Thorpe Insulation Co. (In re Thorpe Insulation Co.), 671 F.3d 1011 (9th Cir. 2012); Whiting-Turner Contracting Co. v. Elec. Mach. Enters., Inc. (In re Elec. Mach. Enters., Inc.), 479 F.3d 791 (11th Cir. 2007); MBNA America Bank, N.A. v. Hill, 436 F.3d 104 (2d Cir. 2006); Mintze v. American General Financial Services, Inc. (In re Mintze), 434 F.3d 222 (3d Cir. 2006); Phillips v. Congelton, L.L.C. (In re White Mountain Mining Co.), 403 F.3d 164 (4th Cir. 2005); Ins. Co. of N. Am. v. NGC Settlement Trust & Asbestos Claims Mgmt. Corp. (In re Nat'l Gypsum Co.), 118 F.3d 1056 (5th Cir. 1997).
Therefore, although once hostile to arbitration, bankruptcy courts have for the most part embraced the process as a means of resolving certain disputes. See Collier at ¶ 9019.05[2] ("All in all, the bankruptcy system seems to have, if not embraced arbitration, at least dropped the overall hostility that once characterized its view of that alternative dispute resolution device, and adopted theories recognizing its place in the bankruptcy world.").
Core v. Non-Core Proceedings
A matter falls within a bankruptcy court's "core" jurisdiction if it either invokes a substantive right created by federal bankruptcy law or could not exist outside a bankruptcy case. See 28 U.S.C. § 157(b)(2) (setting forth a non-exclusive list of "core" proceedings). In contrast, "non-core" matters generally involve disputes that have only a tenuous relationship to a bankruptcy case and would in all likelihood have been litigated elsewhere but for the debtor's bankruptcy filing. See In re Seven Fields Dev. Corp., 505 F.3d 237, 256 (3d Cir. 2007) (claims or causes of action arising under state law are not "core proceedings" because they do not invoke "a substantive right provided by title 11 or a proceeding that, by its nature, could arise only in the context of a bankruptcy case").
A bankruptcy court may enter a final judgment in a core proceeding (a proceeding "arising under" or "arising in a case under" the Bankruptcy Code). 28 U.S.C. § 157(b)(1). The court "may also hear a proceeding that is not a core proceeding but that is otherwise related to" a bankruptcy case, but may not render a decision in such a proceeding without the consent of all the parties. 28 U.S.C. §§ 157(b)(1), (c). Unless all the parties consent to a bankruptcy court's final adjudication of a non-core related matter, the court must "submit proposed findings of fact and conclusions of law to the district court, and any final order or judgment shall be entered by the district judge after considering the bankruptcy judge's proposed findings and conclusions and after reviewing de novo those matters to which any party has timely and specifically objected." 28 U.S.C. § 157(c)(1).
The Judicial Code includes certain other jurisdictional and procedural rules pertaining to bankruptcies. A bankruptcy court may not try personal injury or wrongful death claims, which must be tried in the district court. 28 U.S.C. § 157(b)(5). If a party in a proceeding that may be heard by a bankruptcy court has a right to a jury trial, the bankruptcy court may conduct the jury trial if all the parties expressly consent and the court is "specially designated to exercise such jurisdiction by the district court." 28 U.S.C. § 157(e).
In addition to statutory authority, a bankruptcy judge must have constitutional authority to hear and determine a matter. Stern v. Marshall, 564 U.S. 462 (2011). Constitutional authority exists when a matter originates under the Bankruptcy Code or, in non-core matters, where the matter is either one that falls within the "public rights exception," (i.e., cases involving "public rights" that Congress could constitutionally assign to "legislative" courts for resolution), or where the parties have consented, either expressly or impliedly, to the bankruptcy court hearing and determining the matter. See, e.g., Wellness Int'l Network, Ltd. v. Sharif, 135 S. Ct. 1932 (2015) (parties may consent to a bankruptcy court's jurisdiction); Richer v. Morehead, 798 F.3d 487, 490 (7th Cir. 2015) (noting that "implied consent is good enough"). Thus, a proceeding might be statutorily, but not constitutionally, core, thus precluding the bankruptcy court from finally adjudicating the dispute. See Stern, 564 U.S. at 482 ("Although we conclude that § 157(b)(2(C) permits the Bankruptcy Court to enter final judgment on [a] counterclaim, Article III of the Constitution does not.").
If the parties in a bankruptcy case agree to arbitration of a dispute, Rule 9019(c) of the Federal Rules of Bankruptcy Procedure authorizes the bankruptcy court to order final and binding arbitration.
Johnson
Prior to filing a chapter 13 petition in August 2022 in the Northern District of Illinois, Joan Johnson (the "debtor") borrowed $4,000 from S.A.I.L. LLC ("SAIL"), a company whose affiliate made high-interest loans to Illinois residents from storefront locations. The loan agreement executed by the debtor included an arbitration clause providing that all claims and disputes related to the loan agreement "shall be resolved by binding arbitration pursuant to and under the [FAA]."
The debtor disputed the claim (in part secured and in part unsecured) SAIL filed in her bankruptcy case and commenced an adversary proceeding seeking disallowance of the claim and asserting counterclaims. The debtor's complaint stated three counts: (i) disallowance of SAIL's claim and the imposition of punitive damages and other amounts on the ground that the loan was unenforceable because it violated Illinois's Predatory Loan Prevention Act and the Illinois Consumer Fraud and Deceptive Practices Act (the "Consumer Fraud Act"); (ii) an award of damages for violation of the Illinois Interest Act (the "Interest Act") because the loan was usurious; and (iii) disallowance of SAIL's claim and the imposition of punitive damages and other amounts on account of deceptive and misleading representations under the Consumer Fraud Act.
Instead of answering the complaint, SAIL filed a motion to compel arbitration of the dispute, as provided for in the Loan Agreement. According to SAIL, because the debtor agreed to arbitrate all disputes regarding the loan, and the claims asserted by the debtor in the complaint were non-core, the bankruptcy court did not have discretion to deny the motion to compel arbitration. Alternatively, if the court were to determine any of the debtor's claims were core, SAIL asked the court to order arbitration for any non-core claims. The debtor countered that her claim objection and counterclaims were core claims and that the court should deny the motion to compel arbitration of such claims. She also argued that resolution of the dispute was "material" to the confirmation of her chapter 13 plan, and that arbitration of her claims "would substantially interfere with her efforts to reorganize, and also would be inconsistent with the purposes of the Bankruptcy Code."
The Bankruptcy Court's Ruling
The bankruptcy court denied SAIL's motion to compel arbitration of two of the three counts stated in the debtor's complaint, but referred the remaining count to arbitration.
Initially, U.S. Bankruptcy Judge David D. Cleary noted that neither the U.S. Supreme Court nor the U.S. Court of Appeals for the Seventh Circuit has determined whether (or to what extent) arbitration agreements are enforceable in bankruptcy. However, he explained, in McMahon, the Supreme Court held that, as a general rule, an arbitration agreement may be disregarded only upon a showing that "Congress intended to make an exception to the Arbitration Act … [by] an intention discernible from the text, history, or purposes of the statute." Johnson, 649 B.R. at 740 (quoting McMahon, 482 U.S. at 227).
Next, because there was no dispute that the arbitration clause in the loan agreement was valid, Judge Cleary considered whether there was an inherent conflict between arbitration and the underlying purposes of the Bankruptcy Code regarding the dispute between SAIL and the debtor. If such a conflict existed, the judge explained, "it is not relevant whether the dispute is core or non-core" because both core and non-core matters can give rise to an inherent conflict. Id. at 747. Whether a dispute is core or non-core, he wrote, "should not be used as a bright line in determining the enforceability of arbitration clauses." Id.
Examining the three counts stated in the debtor's complaint, Judge Cleary found that two of the counts in the debtor's complaint were core, whereas one was not:
- Count one seeking disallowance of SAIL's claim was "statutorily core" under 28 U.S.C. § 157(b)(2)(B) (providing that the "allowance or disallowance of claims against the estate" is a core proceeding) and section 502(b) of the Bankruptcy Code (stating that the court shall disallow a claim against the estate to the extent "such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law"), and the debtor's request in count one for punitive damages and attorneys' fees would be resolved in adjudicating the claim objection;
- Count two seeking damages under the Interest Act for usury was non-core, insofar as it arose solely under state law and would not "impact" confirmation of the debtor's chapter 13 plan; and
- Count three seeking disallowance of SAIL's claim under the Consumer Fraud Act was core because it involved disallowance of SAIL's claim.
Judge Cleary emphasized, however, that identifying the claims as core or non-core did not end the inquiry. In this case, he noted, declining to decide a claim objection and referring it to arbitration would conflict with the purposes of the Bankruptcy Code, one of which is to "centralize[] decision-making" in the bankruptcy court. Id. at 749. Many other bankruptcy and appellate courts, Judge Cleary explained, have similarly refused to enforce arbitration agreements when doing so would conflict with the purposes of the Bankruptcy Code.
According to Judge Cleary, the progress of the debtor's chapter 13 case—i.e., confirmation of a plan providing for the payment of creditor claims—was "stalled because SAIL would like to arbitrate the Claim it filed in this case." Id. at 752. Finding an inherent conflict between the Bankruptcy Code and the FAA with respect to counts one and three of the debtor's complaint, the bankruptcy court denied SAIL's arbitration demand concerning those counts and referred count two to arbitration. However, the court stayed the arbitration until resolution of the debtor's objection to SAIL's claim.
Outlook
The enforceability of arbitration agreements in bankruptcy has long been a source of uncertainty and dispute among bankruptcy and appellate courts due to the apparent conflict between the Bankruptcy Code and the FAA. In Johnson, the bankruptcy court emphasized that there is no "bright line" rule hinging on the core or non-core nature of disputes that dictates whether an otherwise arbitrable dispute in bankruptcy should be referred to arbitration. Instead, a bankruptcy court must analyze the nature of the dispute, including whether it is core or non-core and, regardless of the answer to that question, consider whether referring the dispute to arbitration would inherently conflict with the policies underpinning the Bankruptcy Code.
On June 23, 2023, a 5–4 majority of the U.S. Supreme Court ruled in Coinbase Inc. v. Bielski, No. 22-105 (U.S. June 23, 2023), that a federal court's denial of a motion to compel arbitration automatically imposes a stay on the entire action in the trial court, pending the resolution of an appeal from the order denying arbitration (section 16(a) of the FAA authorizes an interlocutory appeal of an order denying a motion to compel arbitration). Although Coinbase did not involve an order denying a motion to compel arbitration in a bankruptcy case, it remains to be seen whether the ruling will be construed to mandate a stay in a bankruptcy case whenever such an order is on appeal and, if so, the scope of such a stay.
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