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Ninth Circuit Limits the Use of Arbitration Against Debtors in Bankruptcy Cases

July 17, 2012

The Federal Arbitration Act (the "FAA") evinces a strong public policy in favor of the enforcement of contractual arbitration clauses. Thus, the FAA provides that a written provision in a contract providing for the resolution of disputes by arbitration "shall be valid, irrevocable, and enforceable, save upon grounds as exist at law or in equity for the revocation of any contract." In two recent cases, however, the United States Court of Appeals for the Ninth Circuit has taken a narrow view of the enforcement of arbitration clauses when one of the parties to the agreement is a debtor in a bankruptcy proceeding. The Ninth Circuit's narrow view is arguably at odds with the approaches taken by other circuit courts on the same issue. The result is that non-debtor parties to arbitration agreements may have less ability to compel arbitration within the Ninth Circuit than in other circuits. 

In In re Eber, 2012 U.S. App. LEXIS 13915 (9th Cir. July 9, 2012), the debtor entered into a pre-bankruptcy contract in connection with the construction and operation of his hair salon. The contract contained a provision requiring all disputes to be resolved by arbitration. Shortly after the other parties to the contract commenced an arbitration proceeding to address their fraud, breach of fiduciary duty, and breach of contract claims against the debtor, the debtor filed a Chapter 7 bankruptcy petition, which had the effect of automatically staying the arbitration. 

The claimants, relying on the FAA and the arbitration provision of the contract, filed a motion seeking an order compelling the continuation of the arbitration proceeding and another motion to lift the automatic stay of the arbitration. The bankruptcy court denied the claimants' motions because it concluded that the arbitration would effectively determine whether the claimants' claims were dischargeable in the debtor's bankruptcy case, a matter which fell within the exclusive province of the bankruptcy court.

After the district court affirmed the bankruptcy court's rulings, the case was appealed to Ninth Circuit, which defined the issue as "whether there is an inherent conflict between arbitration and the underlying purposes of the Bankruptcy Code." The claimants asserted that their fraud, breach of fiduciary duty, and breach of contract claims were not core to the debtor's bankruptcy case and should therefore be decided in the arbitration. Dischargeability was a separate matter and could be addressed later in the bankruptcy court, they argued.

The Ninth Circuit, like the district court and bankruptcy court before it, rejected the argument. In reaching this result, the Ninth Circuit referred to decisions of other circuit courts which held that bankruptcy courts typically "do not have discretion to refuse to compel arbitration of non-core matters because they are generally only tangentially related to a bankruptcy case," while the court "may exercise discretion to refuse to compel arbitration in core bankruptcy matters, which implicate ‘more pressing bankruptcy concerns.'"  

However, the Ninth Circuit held that the core vs. non-core distinction was not dispositive. While the court acknowledged that fraud, breach of contract, and breach of fiduciary duty claims are generally   non-core in nature, it held that the claimants' non-core claims in this case were "so closely intertwined" with the core issue of dischargeability that allowing the arbitration to proceed would "conflict with the underlying purposes of the Bankruptcy Code." In reaching this conclusion, the appellate court noted that the doctrine of collateral estoppel applies in dischargeability proceedings before the bankruptcy court. Under the Bankruptcy Code, fraud and breach of fiduciary duty are often grounds for determining that a claim is non-dischargeable. If an arbitrator were to find the debtor liable on the grounds of fraud or breach of fiduciary duty, that finding could be binding in a dischargeability proceeding before the bankruptcy court. Thus, according to the Ninth Circuit, the arbitrator might, in deciding liability, effectively also be determining the core issue of dischargeability, and allowing the arbitrator rather than the bankruptcy judge to determine dischargeability would be contrary to the policy underlying the Bankruptcy Code.1 

The Eber decision does not stand alone in the Ninth Circuit with respect to limiting the scope of arbitration in bankruptcy. Indeed, Eber builds on the Ninth Circuit's ruling earlier this year in In re Thorpe Insulation Co., 671 F.3d 1011 (9th Cir. 2012), where the court refused to enforce an arbitration clause in a settlement agreement between an insurance company and a debtor. Unlike in Eber, the party seeking to compel arbitration in Thorpe Insulation had filed a proof of claim against the debtor's bankruptcy estate. The Ninth Circuit held that the resolution of proofs of claim filed against the debtor's estate were core bankruptcy matters, which are traditionally decided by the bankruptcy court.2 What makes Eber potentially significant is the fact that the Ninth Circuit has apparently now extended its restricted view on arbitration in bankruptcy to non-core matters. 

A petition for certiorari to the United States Supreme Court in the Thorpe Insulation case is currently pending. One of the asserted bases for certiorari is that the Ninth Circuit's standards for enforcing arbitration clauses in bankruptcy conflict with the standards used by other circuit courts, such as the Third and Fifth Circuits, which more strictly adhere to the policy favoring the enforcement of arbitration clauses. In the interim, until a resolution of this apparent conflict among circuit courts is resolved, clients should be aware that their arbitration agreements may not be enforced in the Ninth Circuit if the other party to the contract becomes a debtor in a bankruptcy proceeding.

1The Ninth Circuit's decision in Eber notes that the trustee had filed a no asset report with the bankruptcy court, which indicated that there would likely be no distribution of funds to creditors of the debtor's bankruptcy estate. Thus, while not explicitly stated by the appellate court, a determination of liability and the amount of the claimants' claim in the arbitration would be irrelevant in the absence of a determination that such claim would be not be discharged because the claimants could not recover any monies on account of their claims in the absence of a determination of non-dischargeability.

2 The Thorpe Insulation court further held that the lower courts properly exercised their discretion in refusing to compel arbitration in a core matter. The Ninth Circuit held that the claimant's breach of contract claim was "inextricably intertwined" with the debtor's bankruptcy case. The court determined that resolving the insurer's breach of contract claim required the "adjudication of whether in conducting and administering its Chapter 11 case, the debtor had somehow violated the settlement agreement," and that as "a matter of fundamental bankruptcy policy, only a bankruptcy court should decide whether the manner in which someone has administered a bankruptcy estate gives rise to damages."

For more information, please contact the professional(s) listed below, or your regular Crowell & Moring contact.

Mark D. Plevin
Partner – San Francisco, Washington, D.C.
Phone: +1.415.365.7446, +1.202.624.2801