Understanding the Relationship Between Arbitration and Bankruptcy

It is becoming more common for businesses to make arbitration agreements part of contracts. This, in turn, leads to bankruptcy court judges frequently deciding whether an arbitration agreement is valid. Is arbitration in the case of bankruptcy a way of getting around the administration of bankruptcy law? Or, is arbitration a legitimate type of contractual agreement that should be enforced?

What is the Purpose of Bankruptcy?

Understanding the place of arbitration begins by understanding the place of bankruptcy filings. There are two reasons for the bankruptcy code. First, to relieve a debtor and so allow that debtor to become a contributing member of the community once again. Second, to ensure that creditors do not lose everything and all creditors get as much as possible back. In theory, no one creditor can collect at the expense of other creditors’ legitimate claims.

How Does Bankruptcy Accomplish These Goals?

When a party files for Chapter 11, assets are frozen by an automatic stay. All collection efforts against the debtor stop and creditors can now only collect through the bankruptcy process through bankruptcy filings in court. Meanwhile, the assets of the bankrupt party are held in trust by a Debtor-in-Possession, or DIP, who also pursues all claims against third parties that could improve the position of the debtor or add to the assets available for paying out to creditors. One example of this sort of claim could be personal injury litigation.

What is the Purpose of Arbitration?

Arbitration is largely overseen by the Federal Arbitration Act of 1925. The goal of this law was to require that the courts enforce arbitration agreements and require parties to go through arbitration if they had a contractual agreement to do so with another party. It is primarily applicable to commercial contracts.

What’s the Problem?

Arbitration can sometimes get in the way of adjudication.

The XYZ Company

The XYZ company has five contracts to buy oranges from five different orange growers in order to make their secret Citrus Muscle Growth pill. Orange Grower A has a contract that requires arbitration, while Orange Growers B, C, D, and E do not. The XYZ Company’s miracle pills don’t work, they lose money, and they cannot pay the orange growers. XYZ Company then files for Chapter 11 in an effort to stay viable so they can try again with a new product: Grape Muscle Growth pill.

XYZ Goes to Bankruptcy Court

XYZ Company files for Chapter 11, and Orange Grower A immediately files a stay because they have a clause requiring arbitration when the contract is breached. Orange growers B-E have no so such clause, so the danger is that in the arbitration between XYZ and Orange Grower A, all of XYZ’s assets will go to one creditor while the others stand by helplessly. The bankruptcy judge may see this arbitration as interference with his or her authority and the legitimate interests of the state and the rights of other creditors. At the same time, refusing to honor arbitration clauses can render the whole idea of a contract pointless and cause other legal and logistical problems down the line.

Fixing the Problem

Various methods have been proposed for resolving the issue between arbitration and adjudication when it comes to bankruptcy. In general, the higher courts have approached this issue from two fronts.

When Arbitration Violates the Purpose of Bankruptcy Law

Some courts have made this a test of whether an arbitration case can go forward or not. Irregardless of whether a claim was created by bankruptcy law, if there is a conflict between the arbitration and the larger purpose of bankruptcy law, then arbitration loses.

Core and Noncore

The courts have also considered two different types of claims. Core claims only arise because of the bankruptcy code or a case filed in bankruptcy court. A noncore claim exists independent of these and would be pursued whether or not bankruptcy existed or had been filed. Courts have largely upheld that noncore claims must be upheld and, assuming arbitration clauses and contracts are otherwise valid, the arbitration clause must be enforced.

Arbitration is a valuable and cost-effective way of resolving issues between and is often in the public interest to enforce. What is needed is clearer legal definitions for when it interferes with the legitimate interests of bankruptcy law.

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