Bankruptcy Court Holds Arbitration Clause Unenforceable When Underlying Contract Is Rejected Pursuant to Section 365 of the Bankruptcy Code

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Overview 

In Highland Capital Mgmt. v. Dondero (In re Highland Capital Mgmt.), Case No. 21-03007-sgj (Bankr. N.D. Tex. 2021), the U.S. Bankruptcy Court for the Northern District of Texas held that a debtor could not be compelled to abide by an arbitration clause in an agreement that was rejected pursuant to Section 365 of the Bankruptcy Code.

Background

Plaintiff Highland Capital Management L.P. (“Highland”) originally filed four adversary proceedings to collect on large promissory notes owed to it (collectively, the “Note Adversary Proceedings”) from the various obligors under the notes (the “Note Obligor Defendants”). Each Note Obligor Defendant was closely related to Highland’s former president, James Dondero, and collectively borrowed tens of millions of dollars from Highland prepetition. 

Subsequently, Highland amended its original complaints in each of the Note Adversary Proceedings to add one of its largest limited partners, Dugaboy Investment Trust (“Dugaboy”), which is a family trust of Dondero, of which the trustee is his sister Nancy Dondero (collectively, the “Defendants”), and to add new counts alleging, among other things, declaratory judgment as to certain provisions of Highland’s limited partnership agreement (the “LPA”), breach of fiduciary duty, and aiding and abetting breach of fiduciary duty (collectively, the “Amended Complaints”). 

Relying on a mandatory arbitration clause (the “Arbitration Clause”) in Highland’s LPA, the Defendants sought to compel arbitration of the Amended Complaints and stay litigation altogether in the Note Adversary Proceedings pending the arbitration. Notably, the LPA was an executory contract that Highland had rejected pursuant to Section 365 of the Bankruptcy Code. Thus, Highland argued that it was no longer bound by the LPA’s provisions that impose specific performance obligations on it — such as the Arbitration Clause — and may only be responsible for monetary damages. 

Opinion 

The court agreed with Highland, holding “that the LPA was an executory contract duly rejected in its confirmed Chapter 11 plan, and that the Arbitration Clause should likewise be considered a separate executory agreement that was rejected.” Id. at 9. Therefore, as the court explained, “Highland cannot be forced to specifically perform under the Arbitration Clause or the LPA by mandatorily participating in arbitration of [the Amended Complaints].” Id.

In reaching its decision, the court relied on a district court opinion from the Northern District of Texas and a law review article by Prof. Jay L. Westbrook. See Janvey v. Alguire, 2014 U.S. Dist. LEXIS 193394 (N.D. Tex. Jul. 20, 2014), aff’d on different grounds at 847 F.3d 231 (5th Cir. 2017) (holding that the court could not require specific performance by the trustee, i.e., to compel arbitration, pursuant to a rejected arbitration agreement); Jay Westbrook, The Coming Encounter: International Arbitration and Bankruptcy, 67 Univ. of Minn. L. Rev. 595 (1983) (“an arbitration agreement is like any other executory contract which the trustee may reject”). The court distinguished a contrary holding from the Delaware bankruptcy court.

Why This Case Is Interesting 

Notably, though not the direct basis for its opinion, the court also found that requiring arbitration would impose an undue and unwarranted burden and expense on the parties to the detriment of Highland’s creditors. This decision is important because it preserves the protection afforded to debtors under Section 365 of the Bankruptcy Code by allowing debtors to reject arbitration provisions when doing so is in the best interest of the estate. The court did not address the impact, if any, of the U.S. Supreme Court’s most recent decision addressing executory contracts in Mission Products. Interestingly, the court also added that the Defendants waived any right to invoke the Arbitration Clause because of their delay in raising the issue after months of litigation.

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