For years now, more and more legal disputes are being resolved in arbitration. Given the Federal Arbitration Act’s (FAA) strict enforcement of arbitration agreements, many assume that a well-drafted arbitration clause is a guarantee of arbitration. However, to many contracting parties’ surprise and consternation, if a bankruptcy proceeding has been initiated, their well-drafted provision may be of little help and, depending on the nature of the claim, they may find their arbitration rights whittled away by a bankruptcy court.

The FAA mandates that federal courts enforce all valid and binding arbitration agreements by compelling arbitration of all arbitrable claims. The Bankruptcy Code directs that all actions against the debtor—including a proceeding in arbitration—must be automatically and immediately stayed after a debtor seeks the protection of bankruptcy. When the two collide, federal courts are presented with a difficult conflict. This article addresses the standards that have developed that can aid in predicting under what circumstances the Bankruptcy Code prevails and a bankruptcy court has the authority to deny enforcement of a valid arbitration agreement.

Federal Courts Strictly Enforce Valid Arbitration Agreements
Touting the benefits of arbitration as a streamlined alternative to litigation, in 1947 Congress enacted the FAA. The FAA directs that a written provision in a contract “evidencing a transaction involving commerce” to settle through arbitration any disputes arising out of the contract “shall be valid, irrevocable, and enforceable.”1

Congress enacted the FAA to ensure the “rapid and unobstructed enforcement of arbitration agreements.”2 The FAA therefore establishes a public policy that strongly favors the arbitration of disputes and requires courts to stringently enforce arbitration agreements.3 Once an arbitration agreement is established, a court will not deny arbitration “unless it can be said with positive assurance that the arbitration clause is not susceptible of an interpretation that covers the asserted dispute.”4

Federal Bankruptcy Courts Must Automatically Stay Arbitration
The Bankruptcy Code strongly favors the centralization of all disputes against a debtor in the bankruptcy court. “By centralizing all prebankruptcy civil claims against a debtor in the bankruptcy court, the debtor is granted a ‘breathing spell’ during which he is relieved of the financial pressures that drove him to bankruptcy.”5 Additionally, the centralization of all claims “permits the assets of the debtor’s estate to be marshaled for distribution to creditors in an orderly and equitable fashion.”6 Thus, when a debtor files a bankruptcy petition, any action against the debtor—including an arbitration proceeding—is stayed automatically, and a creditor must show cause to obtain relief from the automatic stay in order to pursue arbitration against the debtor.7

Finding Middle Ground
The first appellate court to address the conflict between the FAA and the Bankruptcy Code was the Third Circuit when in 1983 it decided Zimmerman v. Continental Airlines.8 There, the court held that “because the underlying purposes of the Bankruptcy Reform Act impliedly modify the Arbitration Act, the granting of a stay pending arbitration, even when the arbitration clause is contractual, is a matter left to the sound discretion of the bankruptcy judge.”9 Accordingly, Zimmerman held that bankruptcy courts had broad discretion to refuse to compel arbitration.

Four years later, the FAA’s mandate of strict enforcement of arbitration agreements was confirmed and intensified by the U.S. Supreme Court in Shearson/American Express Inc. v. McMahon.10 There, the Supreme Court held that the FAA, “standing alone, ...mandates enforcement of agreements to arbitrate statutory claims.”11 The Court recognized that the FAA’s mandate may be overridden only if the party opposing arbitration can show that Congress intended to preclude arbitration of the statutory rights at issue.12 This congressional intent can be deduced from the statute’s text or legislative history, or from “an inherent conflict between arbitration and the statute’s underlying purposes.”13

Reacting to McMahon’s affirmation of the arbitration mandate and Congress’ 1984 amendments to the Bankruptcy Code,14 in 1989 the Third Circuit abandoned Zimmerman’s “sound discretion” standard. Applying McMahon to the context of the conflict between the FAA and the Bankruptcy Code, in Hays and Co. v. Merrill Lynch, Pierce, Fenner & Smith the court held that an agreement to arbitrate must be enforced unless the party seeking to arbitrate shows that “the text, legislative history, or purpose of the Bankruptcy Code conflicts with the enforcement of an arbitration clause.”15 Because the court found no evidence of such intent in either the legislative history or the statutory text of the Bankruptcy Code, it held the relevant determination is whether there is an “inherent conflict” between arbitration and the objectives of the Bankruptcy Code.16 If a severe conflict is found, then the court can properly conclude that, with respect to the particular Code provision involved, Congress intended to override the FAA’s general policy favoring the enforcement of arbitration agreements. Considering the claims before it, the court concluded that an adversary proceeding involving non-core matters would not “seriously jeopardize the objectives of the Code” and the court therefore did not have discretion to refuse to compel arbitration.17

Following Hays, for purposes of determining whether Congress intended to carve out an exception to the FAA’s mandate (and accordingly that a bankruptcy court has discretion to deny the enforcement of a valid arbitration clause), many courts have found useful the core/non-core distinction mentioned in Hays. While the Bankruptcy Code does not offer a definition of a core proceeding, it can be defined as a proceeding involving a right created by federal bankruptcy law which would only arise in bankruptcy and that affects the adjustment of the debtor-creditor relationship.18 Claims that “arise under” the Bankruptcy Code or “arise in” a bankruptcy case are “core” matters; claims that “relate to” a bankruptcy case are “non-core.”19 28 U.S.C. 157(b)(2) contains a non-exclusive list of fifteen “core proceedings.”20 A bankruptcy
judge may hear and determine any “core” proceeding. All other proceedings related to a bankruptcy case are “noncore” and are those that could have been brought in a federal or state court in the absence of a bankruptcy petition. The determination of whether a bankruptcy proceeding is core or noncore is a question of law.21

The Hays holding with regard to non-core matters makes “eminent sense” and has been “universally accepted.”22 Thus, where a non-core proceeding is at issue, the majority of federal courts conclude that “the presumption in favor of arbitration usually trumps the lesser interest of bankruptcy courts in adjudicating non-core proceedings.”23 Thus, the “inquiry ends and the bankruptcy court lacks [the] discretion to refuse arbitration.”24

The law is less clear with regard to core proceedings, where the bankruptcy court’s interest is greater. Some courts have found the core/non-core distinction determinative of the bankruptcy court’s authority when core proceedings are at issue, holding that “as to core proceedings,…[the] court may exercise its full panoply of discretion…in determining whether to refer a proceeding before it to arbitration.”25 However, the majority position is that, while compelling arbitration of core proceedings is more likely to interfere with the objectives of the Code than compelling arbitration of non-core proceedings, the fact that a claim is “core” does not end the inquiry.26 In other words, that a proceeding is deemed to be core does not automatically give the Bankruptcy Court the discretion to deny arbitration. Instead, if a core proceeding is at issue, the bankruptcy court still must determine whether the McMahon standard is satisfied—whether arbitration of the proceeding would conflict with the purposes of the Code.27

Courts that have refused to find that core claims categorically vest bankruptcy judges with discretion to deny arbitration have done so because the category of core claims is too broad, such that it cannot be assumed that all core proceedings are premised on provisions of the Code that inherently conflict with the FAA. Instead, to determine whether arbitration would conflict with the Code, these courts focus on why a claim is core—specifically, whether their “coreness” is procedural or substantive. Many proceedings are procedurally core—“they are garden variety pre-petition contract disputes dubbed core because of how the dispute arises or gets resolved.”28 The arbitration of a procedurally core dispute rarely conflicts with any policy of the Bankruptcy Code.29 Other proceedings are substantively core —they are not based on the parties’ pre-petition relationship, and involve rights created under the Bankruptcy Code.30 It is more likely that arbitration of these claims will conflict with the policy of the Bankruptcy Code, and thus the bankruptcy court is granted much greater discretion to refuse to compel arbitration.31 Accordingly, for many courts, it is the underlying nature of the proceeding, not the label “core,” that determines whether arbitration would conflict with the purposes of the Code.

Conclusion
Where an otherwise applicable arbitration clause exists, a bankruptcy court likely lacks the discretion to deny its enforcement, unless the party opposing arbitration can establish congressional intent, under the McMahon standard, to preclude waiver of judicial remedies for the statutory rights at issue. In some jurisdictions the core/non-core distinction will determine the authority of the bankruptcy judge to refuse to enforce an arbitration agreement. In others, the core/non-core analysis serves merely as a useful starting point, and if the claim is core, a deeper analysis is required. In either event, parties seeking to compel arbitration should take comfort in the knowledge that a bankruptcy court’s refusal to stay an adversary proceeding pending arbitration, though interlocutory in nature, is nevertheless appealable.32

Deborah Karakowsky, a 2008 graduate of the University of Texas School of Law, is an associate with the Houston office of Yetter, Warden, & Coleman LLP. Her practice encompasses a variety of complex business disputes..

Endnotes
1. M9 U.S.C. § 2. 2. Moses H. Cone Mem’l Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 23 (1983). 3. Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S. 614, 631 (1985); Safer v. Nelson Fin. Group, Inc., 422 F.3d 289, 294 (5th Cir. 2005) (“The Fifth Circuit has repeatedly emphasized the strong federal policy in favor of arbitration.”). 4. AT&T Tech., Inc. v. Commc’ns. Workers of Am., 475 U.S. 643, 650 (1986) (emph. added). 5. McCartney v. Integra Nat. Bank North, 106 F.3d 506, 512 (3rd Cir. 1997). 6. Id. 7. However, as the stay is designed to protect the debtor, if the debtor is the party seeking arbitration, he may waive the stay’s protection and pursue arbitration without court approval. 8. Zimmerman v. Continental Airlines, Inc., 712 F.2d 55 (3d Cir. 1983). 9. Id. at 56. 10. 482 U.S. 220 (1987). 11. Id. at 226. 12. Id. at 227. 13. Id. 14. The 1984 Amendments undermined the goal of centralizing disputes before a single bankruptcy judge by granting the district court original but non-exclusive jurisdiction over actions and proceedings in bankruptcy. 28 U.S.C. §1334(b). 15. 885 F.2d 1149, 1157 (3d Cir. 1989). 16. The objectives of the Code that are relevant to this determination include the goal of centralized resolution of purely bankruptcy issues, the need to protect creditors and reorganizing debtors from piecemeal litigation, and the power of the bankruptcy court to enforce its own orders. Nat’l Gypsum, 118 F.3d at 1069. 17. Hays, 885 F.2d at 1160-61. 18. See Nat’l Gypsum Co. v. NGC Settlement Trust & Asbestos Claims Management Corp., 118 F.3d 1056, 1063 (5th Cir. 1997). 19. WRT Creditors Liquidation Trust v. C.I.B.C. Oppenheimer Corp., 75 F.Supp.2d 596, 606 (S.D. Tex. 1999). 20. The list includes: administration of the estate, allowance of claims against the estate, counterclaims by the estate, orders regarding obtaining credit, orders to turn over property of the estate, avoidance of preferences, motions to lift the automatic stay, avoidance of fraudulent conveyance, dischargeability of debts, objections to discharges, determination of priorities, confirmation of plans, orders regarding the use of property, orders approving the sale of property, proceedings affecting the liquidation of assets, and the recognition of foreign proceedings. 28 U.S.C. s. 157(b)(2). 21. In re Mintze, 434 F.3d 222, 228 (3d Cir. 2006). 22. Nat’l Gypsum, 118 F.3d at 1066. 23. MBNA Am. Bank, N.A. v. Hill, 436 F.3d 104, 108 (2d Cir. 2006). 24. In re Hagerstown, 277 B.R. 181, 202 (S.D. NY 2002). 25. In re Sacred Heart Hosp., 181 B.R. 195, 202 (Bankr. E.D. Pa. 1995). See also Selcke v. New England Ins. Co., 995 F.2d 688, 691 (7th Cir. 1993); In re Spectrum Info. Techs., Inc., 183 B.R. 360, 363 (Bankr. E.D.Pa. 1995); In re Am. Freight Sys., Inc., 164 B.R. 341, 347 (D. Kan. 1994); In re Glen Eagle Square, Inc., 1991 WL 71782 (Bankr. E.D. Pa. 1991). 26. Several courts have compelled arbitration of core issues. See In re Statewide Realty Co., 159 B.R. 719, 722 (Bankr. D.N.J. 1993); In re Chorus Data Systems, Inc., 122 B.R. 845 (Bankr. D.N.H. 1990); In re Bi-coastal Corp., 111 B.R. 999 (Bankr. M.D. Fla. 1990). 27. Selcke v. New England Ins. Co., 995 F.2d 688, 691 (7th Cir. 1993); In re Mintze, 434 F.3d at 231; Nat’l Gypsum, 118 F.3d at 1067; United States Lines, Inc. v. Am. S.S. Owners Mut. Prot. & Indem. Ass’n. Inc., 197 F.3d 631 (2d Cir. 1999); Pardo v. Akai Elec. Co., 2001 WL 984678 (S.D.N.Y. 2001); Cibro Petroleum Prods., Inc. v. City of Albany, 270 B.R. 108 (S.D.N.Y. 2001). 28. Hagerstown, 277 B.R. at 203. 29. Id. 30. Id. 31. Id. 32. Section 16 of the Federal Arbitration Act provides that an appeal may be taken from an order “refusing a stay of any action under section 3” and permits interlocutory appeals of orders favoring litigation over arbitration. See also McDermott Int’l, Inc. v. Underwriters at Lloyds Subscribing to Memorandum of Ins. No. 104207, 981 F.2d 744, 746-47 (5th Cir. 1993); Am. Cas. Co. of Reading, Pa. v. L-J Inc., 35 F.3d 133, 135 (4th Cir. 1994).