How does a party’s insolvency impact pending arbitration proceedings?
Generally, the U.S. Bankruptcy Code mandates an automatic stay of all civil proceedings that have been brought against the debtor (11 U.S.C § 362(a)). This mandate may include a stay of claims against the debtor brought in arbitration.
However, an arbitration party that has brought a claim against the debtor can request the court to lift the stay “for cause” (11 U.S.C § 362(d)(1)). In determining whether to lift this automatic stay and permit arbitration to proceed against the debtor, the court undertakes a four-part inquiry: (i) whether the parties agreed to arbitrate; (ii) whether the dispute falls within the arbitration clause; (iii) if federal statutory claims are raised, whether Congress intended those claims to be arbitrable; and (iv) if the court concludes that some but not all of the claims are arbitrable, whether it should stay the non-arbitrable claims pending the conclusion of the arbitration (Kraken Inv. Ltd. v. Jacobs (In re Salander-O'Reilly Galleries, LLC), 475 B.R. 9, 21 (S.D.N.Y. 2012) - where the court determined that the issue raised did not arise out of the contract containing the arbitration clause and the party opposing the stay was not bound by the arbitration clause).
Importantly, the Federal Arbitration Act (the “FAA”) provides that “an agreement in writing to submit to arbitration an existing controversy arising out of such contract, transaction or refusal, shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract” (9 U.S.C. §2).
While courts must stay proceedings if an arbitration clause applies, the U.S. Supreme Court has acknowledged that “the [FAA’s] mandate may be overridden by a contrary congressional command [but the] burden is on the party opposing arbitration… to show that Congress intended to preclude waiver of judicial remedies for the statutory rights at issue.” (Shearson/American Express, Inc. v. McMahon, 482 U.S. 220, 226-227 (1987)). The U.S. Bankruptcy Code provides some of these overriding statutory rights.
Whether a bankruptcy court may deny a motion to compel arbitration depends on whether the proceeding at issue is “core” or “non-core” under the Bankruptcy Code (Kraken, 475 B.R. at 35). Under 28 U.S. Code § 1334, bankruptcy courts determine core proceedings, i.e. proceedings that arise under Bankruptcy Code, which include matters concerning the administration of estate, orders in respect to obtaining credit, and proceedings to determine, avoid or recover preferences, among others.
With respect to international agreements, courts have less discretion to deny motions to arbitrate. However, a court may still find that there is a “‘severe conflict’ between policies underlying arbitration agreements and the conduct of [the] bankruptcy proceeding” (Bethlehem Steel Corp. v. Moran Towing Corp. (In re Bethlehem Steel Corp.), 390 B.R. 784, 795 (Bankr. S.D.N.Y. 2008) - where the court found that even if the preference claims at issue were subject to the arbitration clauses, the court exercised its discretion to deny the motions to compel arbitration).
A bankruptcy case is initiated by filing a voluntary or involuntary petition with the bankruptcy court where the debtor has domicile. A creditor shall register its claim with the bankruptcy court by filing a proof of claim, but such registration of claim does not waive any applicable arbitration agreement.
There is currently no specific guidance from U.S. legislation or case law on whether claims in a pending arbitration must be amended when an insolvent party is replaced by an insolvency administrator. Since an insolvency administrator (or trustee) have the power to pursue claims on behalf of an insolvent party, such administrator could potentially replace the insolvent party in the arbitration as it had legally assumed such insolvent party’s obligations under the contract containing the arbitration agreement.
The most important responsibility of an insolvency trustee (or administrator) is that they must act to maximise the value of the estate for the creditors. In order to do that, trustees have the power to pursue claims against third parties on behalf of both the debtor and the creditors. Trustees may pursue any claim the debtor would have had in the absence of the bankruptcy, including any contract or tort claims, and claims under federal and state laws. A trustee will have to respect the procedural steps already taken by the company and continue with the arbitration as the insolvent party would have done (Hays and Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 885 F.2d 1149, 1155-57 (3d Cir. 1989)).
The Bankruptcy Code safeguards various ways to maximise value for the bankruptcy estate. In this regard, § 365 of the Bankruptcy Code permits a trustee to either assume or reject executory contracts (11 U.S.C. § 365(a)).
A rejection of an executory contract constitutes a breach of contract and is therefore subject to the Bankruptcy Court’s approval (11 U.S.C. § 365(g)). The decision whether to approve the rejection of an executory contract is subject to the business judgment rule (2 Collier on Bankruptcy § 365.03 (15th ed. 1990)). In applying this rule, a trustee may reject an executory contract if doing so would benefit the bankruptcy estate. Courts will usually defer to a trustee’s decision to reject an executory contract unless the decision was made in bad faith or was a gross abuse of discretion (Lubrizol Enters, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1046 (4th Cir. 1985)).
While the Bankruptcy Code does not define “executory contract”, courts have held that an executory contract is one “under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other” (Vern Countryman, Executory Contracts in Bankruptcy, Part I, 57 MINN. L. REV. 439, 460 (1963); see also Kimmelman v. Port Authority (In re Kiwi Int'l Air Lines Inc.), 344 F.3d 311, 318 (3d Cir. 2003); Kaler v. Craig (In re Craig), 144 F.3d 593, 596 (8th Cir. 1998)). Essentially, an executory contract is a contract in which neither party completed performance.
Whether an arbitration clause is considered an executory contract and whether the trustee is permitted to circumvent arbitration by rejecting the arbitration agreement itself and/or the pre-petition contract that contains the arbitration agreement in its entirety turns on the inquiry of whether an arbitration clause is deemed a separate executory contract and whether rejection terminates the arbitration clause. Arbitration provisions are rarely standalone agreements, and executory contracts must generally be assumed or rejected in their entirety (11 U.S.C. § 365; Thompkins v. Lil’ Joe Records Inc., 476 F.3d 1294 (11th Cir. 2007)).
However, “as a matter of substantive federal arbitration law, an arbitration provision is severable from the remainder of the contract,” and therefore, an arbitration clause may survive the rejection of the underlying contract (Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440, 445 (2006)). The filing of a bankruptcy petition by one of the parties to an arbitration agreement does not revoke a pre-petition arbitration agreement.
Bankruptcy law allows a trustee to reject an existing agreement which may also cancel the arbitration provision in that agreement. However, if a trustee chooses to proceed with arbitration, even after rejecting the contract, this operates as a waiver of any objection to arbitration (Societe Nationale Algerienne v. Distrigas Corp., 80 B.R. 606, 609 (D. Mass. 1987); In re Statewide Realty Co., 159 B.R. 719 (D.N.J. 1993)).
If an insolvency trustee chooses to assume an executory contract, then the trustee must perform the contract, including making payments out of the estate as administrative expenses. By contrast, if a trustee rejects the executory contract, then the other party to the contract may be entitled to damages.
A rejection of an executory contract cuts off any rights of the creditor to require the estate to perform the remaining provisions of the contract and limits the creditor’s recovery to a breach of contract claim (Univ. Med. Ctr. v. Sullivan, 973 F.2d 1065, 1075 (3d Cir. 1992)).
Therefore, because the rejection of an arbitration agreement is a breach of contract and not a revocation, courts have stated that the arbitration agreement survives the rejection and should be enforced, unless a countervailing federal statute preempts the FAA, also known as the McMahon test (Selby’s Mkt. Inc. v. PCT (In re Fleming Cos.), Civ. No. 05-749-SLR, 2007 WL 788921, at *4 (D. Del. Mar. 16, 2007); Shearson/American Express Inc. v. Mcmahon, 482 U.S. 220 (1987)).
A bankruptcy court’s power is limited to core proceedings that arise out of or are directly related to bankruptcy. As discussed above, a proceeding is core if it encompasses a substantive right under the Bankruptcy Code and arises only in the context of a bankruptcy filing (In re Gandy, 299 F.3d 489, 48).
In contrast, a non-core proceeding does not directly involve any right created by bankruptcy law but contains issues that will impact the bankruptcy case. If the underlying contract was entered into prior to the filing of the bankruptcy petition, or if the underlying issues are not a direct result of a bankruptcy reorganisation, the proceeding is non-core and the bankruptcy trustee stands in the shoes of the debtor. This means that if the debtor would have had to arbitrate the claim if no bankruptcy petition was filed, then the trustee would also be obligated to arbitrate (Hays and Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 885 F.2d at 1149).
However, in a core bankruptcy proceeding involving a bankruptcy trustee, a bankruptcy court can adjudicate it, subject to appeal. Under these circumstances, the court balances the Bankruptcy Code with the policies supporting arbitration in determining whether to require arbitration (In re FRG, 115 B.R. 72 (E.D. Pa. 1990)).
In the United States, if a company files for bankruptcy under Chapter 11 of the Bankruptcy Code and is seeking reorganisation, the company remains in control of the business and can continue to act in the arbitration proceedings. This is known as a debtor-in-possession. A debtor-in-possession maintains all the rights of a trustee, except for the right to be compensated (11 U.S.C. § 1107).
However, if a company files under Chapter 7 of the Bankruptcy Code and is seeking a liquidation, an administrator/trustee will be appointed to control the company and the trustee will represent it in any arbitration proceedings (11 U.S.C. §§ 701, 1104). The insolvency administrator will often succeed the insolvent party in the arbitral proceedings, depending on which Chapter bankruptcy was filed under, and replace it to continue with the arbitration as the insolvent party would have.
If the trustee is bringing a claim that derives from the debtor’s pre-petition estate, then the trustee is essentially stepping into the debtor’s shoes (Hays & Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 885 F.2d at 1149). In such a case, the trustee is subject to all defenses that can be raised against the debtor, including a demand for arbitration.
A trustee in bankruptcy stands in the shoes of the debtor of the purposes of enforceability of an arbitration agreement entered into by the debtor and is bound by the agreement to the same extent as the debtor (In re Cooker Restaurant Corp. 292 B.R. 308 (S.D. Ohio 2003)). In these cases, the trustee can be compelled to arbitrate because arbitration provisions in a contract are considered contractual rights as much as a right of payment (Tobin v. Plein, 301 F.2d 378 (2d Cir. 1962)).
However, if the trustee is bringing an action that stems from the Bankruptcy Code, such as a proceeding seeking damages for violation of the automatic stay, arbitration agreements should not apply. These kind of creditor claims are not arbitrable (Whiting-Turner Contracting Co. v. Elec. Mach. Enterprises, Inc. (In re Elec. Mach. Enterprises, Inc.), 479 F.3d 791 (11th Cir. 2007)).
A bankruptcy trustee stands in the shoes of an insolvent entity and has standing to bring any suit that the insolvent entity would be able to bring had it not filed for bankruptcy (Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114). Trustees are bound by arbitration agreements when the arbitral provision is found in a pre-petition contract that is not executory, and in those instances must step into arbitration proceedings (Hays and Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc. 885 F.2d at 1149).
Can arbitration proceedings be commenced by or against an insolvent entity?
Can one initiate arbitration against an insolvent entity?
The FAA provides that 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” (9 U.S.C. §2). Pursuant to this clear legislative intent, the federal courts have held that they “can no longer subscribe to a hierarchy of congressional concerns that places the bankruptcy law in a position of superiority over the Act” (Hays & Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 885 F.2d 1149, 1161 (3d Cir.1989)).
It has become practice for bankruptcy courts to “enforce [an arbitration clause] unless [it] would seriously jeopardise the objectives of the Code.” Id. In the bankruptcy context, the U.S. Supreme Court held that the “[FAA], standing alone… mandates enforcement of agreements to arbitrate statutory claims” (McMahon, 482 U.S. at 226 (1987)).
A plaintiff may demonstrate an exception to the FAA’s mandate by establishing Congressional intent by (i) reference to the statute’s text; (ii) examining the statute’s legislative history; or (iii) demonstrating “an inherent conflict between arbitration and the statutes’ underlying purposes” (Id at 227). Bankruptcy courts routinely delve into the third inquiry since the Bankruptcy Code’s text and legislative history do not contain exceptions to the FAA.
Bankruptcy courts have held that when a plain reading of the parties’ agreement displays an intent to arbitrate all disputes relating to the policy, the court must consider whether the dispute is “core” to the Bankruptcy Code, which matters include those concerning the administration of estate, orders in respect to obtaining credit, and proceedings to determine, avoid or recover preferences, among others.
A New York bankruptcy court for instance has held that arbitration was required when funds at issue were relatively small when compared to the entire context of the case, and the dispute itself related to the prior relationship of the parties before the proceedings began (MF Glob. Holdings Ltd. v. Allied World Assurance Co., 2017 U.S. Dist. LEXIS 19328 (S.D.N.Y. 2017)).
The third prong under the Supreme Court’s inquiry to determine which of the FAA or the Bankruptcy Code controls, guides the analysis. Importantly, while courts have demonstrated that in a non-core proceeding a bankruptcy court cannot deny enforcement of an arbitration proceeding, core proceedings will necessitate evaluation under the third prong.
Courts will most often deny enforcement of arbitration clauses when it adversely impacts the debtor’s ability to reorganise, with a court going so far as to say that an arbitration that took place in the UK “was inconsistent with the purpose of the bankruptcy laws to centralise disputes about a Chapter 11 debtor's legal obligations so that reorganisation can proceed efficiently” (Phillips v. Congelton, L.L.C. (In re White Mt. Mining Co., L.L.C.), 403 F.3d 164, 170 (4th Cir. 2005)).
Can an insolvent entity commence arbitration?
Under 11 U.S.C. § 362, nearly all legal claims relating to a debt to be collected are granted an automatic stay by the Bankruptcy Code. An insolvent party must disclose all civil lawsuits, assets and incomes that they currently have. The requirement to disclose civil lawsuits includes arbitration proceedings. In order to bring a claim in arbitration, the insolvent party would need to first provide notice to the Bankruptcy Court before commencing the proceeding.
Courts have also held that consequent administrators – such as a liquidator who may now take the place of an insolvent party – are bound by pre-insolvency arbitration agreements when attempting to enforce contractual rights of the insolvent issuer (Bennett v. Liberty Nat'l Fire Ins. Co., 968 F.2d 969, 972 (9th Cir. 1992)). While the Bankruptcy Code does not specify the precise mechanism, the respondent who may wish to bring a counterclaim against an insolvent claimant who brought a claim in arbitration would likely need to register its counterclaim against the insolvent claimant with the bankruptcy court where the bankruptcy proceedings against such insolvent claimant are pending.
What processes are available to raise the objection of pending arbitration proceedings against insolvency proceedings?
The initiation of insolvency proceedings in U.S. bankruptcy court results in an automatic stay of pending arbitration. The commencement or continuation of an arbitration as well as the enforceability of an arbitration agreement fall within the scope of the automatic stay and are subject to court determination. Generally, arbitration proceedings cannot resume unless the stay is lifted, or the insolvency proceedings are concluded or dismissed (11 U.S.C. § 362(c)-(d)).
A party may object to court adjudication, in favour of arbitration, of certain claims in insolvency proceedings. Irrespective of whether the claims will be ultimately resolved in arbitration or in bankruptcy court, a creditor must first register his or her claim by filing a proof of claim with the bankruptcy court (Fed. R. Bankr. P. 3002(a)) and then petition the court to seek relief from the stay (11 U.S.C. § 362(d)).
While the decision to lift the stay is at the discretion of the bankruptcy court, circuit courts have long held that a stay of an arbitration concerning arbitrable “non-core” claims (i.e., claims that do not invoke rights created by federal bankruptcy law or affect a bankruptcy function) generally must be lifted (see, e.g., Hays & Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 885 F.2d 1149, 1161 (3d Cir.1989)). Bankruptcy courts largely do not have discretion to refuse to compel arbitration of non-core claims or matters that are simply “related-to” bankruptcy cases because the presumption in favour of arbitration outweighs the interest of bankruptcy courts adjudicating non-core disputes (MBNA America Bank, N.A. v. Hill, 436 F.3d 104, 108 (2d Cir. 2006)).
How does insolvency affect recognition and enforcement of an arbitral award against an insolvent party?
In the United States, there is no distinction for whether the party challenging the award is insolvent. When the prevailing party in an arbitration moves to confirm the arbitral award, the other party may move to vacate or modify the award for reasons listed in Section 10 or Section 11 of the FAA in either U.S. bankruptcy court or in a district court (9 U.S.C. §§ 10-11 - see also 105 Am. Jur. Trials 125, 141: a party should give notice of a motion to vacate, modify, or correct an order served upon the adverse party within three months after the arbitral award is filed). This motion is available to whichever seeks to challenge the arbitral award.
There are four enumerated reasons in the FAA for which an arbitral award may be vacated – all of which focus on the corruption or misconduct by the arbitrators (9 U.S.C. § 10(a)). These reasons create “an extremely limited review of authority,” designed to preserve due process while preventing intrusion into private arbitration matters (see Berland v. Conclave, 2021 WL 461727, at *6 (S.D. Cal. Feb 9, 2021)).
Therefore, judicial review of an arbitral award on these grounds is “both limited and highly deferential” and the arbitration award may be vacated only when “completely irrational” or when it constitutes “manifest disregard of the law” (Comedy Club, Inc., v. Improv W. Assocs., 553 F.3d 1277, 1288 (9th Cir. 2009)).
In addition to the reasons under the FAA, parties seeking to challenge foreign arbitral awards governed by the New York Convention may rely on seven grounds in Article V of the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York, 1958) (the “New York Convention”), which are more expansive than the basis in the FAA and allow an award to be vacated in cases of improper jurisdiction, improper notice, or public policy grounds (see 9 U.S.C. § 207).
In terms of the effect insolvency has on the recognition and enforcement of an arbitral award, U.S. courts will unlikely recognise and enforce an award against an insolvent party, provided the award was rendered while the arbitration against the debtor was automatically stayed.
Generally, U.S. courts have little discretion to vacate or modify an arbitral award (Folkways Music Publishers, Inc. v. Weiss, 989 F.2d 108, 111 (2d Cir. 1993)). Courts may, however, refuse to enforce an award that violates public policy as embodied by federal law because the automatic stay provision “promotes a public policy sufficient to preclude enforcement of an award that violates its terms or interferes with its purposes” ‘ACandS, Inc. v. Travelers Cas. & Sur. Co., 435 F.3d 252, 258 (3d. Cir. 2006)).
Furthermore, courts may refuse to enforce such an award because insolvency laws are considered a part of the country’s public policy under the international comity principles and Article V(2)(b) of the New York Convention.
The party seeking to enforce the award must make a claim in the U.S. insolvency proceedings by filing a proof of claim with the U.S. bankruptcy court to receive a pro rata share of any distributions from the bankruptcy estate (see 11 U.S.C. § 501; Fed. R. Bankr. P. 3001-3002). The priority of the creditors, including the party seeking enforcement, is determined pursuant to the Bankruptcy Code and factors in secured claims, administrative expenses and priority claims, unsecured claims, subordinated claims, and equity interests (Fed. R. Bankr. P. 3003-3007).
The party seeking enforcement against the insolvent party may also request provisional or injunctive relief. Arbitral tribunals often grant interim relief such as ordering funds to be placed in escrow, attaching funds and property, and preventing liquidation or transfer of the insolvent party’s assets. U.S. courts consider themselves to have the authority to enforce the arbitral orders granting such relief, provided that the tribunal’s interim order is final and not contrary to the arbitration agreement.
Has a special insolvency regime been introduced in response to the SARS-CoV-2 / Covid-19 pandemic?
The Coronavirus Economic Stabilization Act (“CARES Act”), enacted in March 2020, contains insolvency provisions including revisions to the Bankruptcy Code, the majority of which expire after one year. These revisions to the Bankruptcy Code aid individual and small business debtors affected by the pandemic.
The Consolidated Appropriations Act (“CAA”), passed in December 2020, supplements the CARES Act. The CAA adds and modifies certain bankruptcy provisions that aim to expand coronavirus relief, protect debtors against discrimination, and prevent the termination of utility services during bankruptcy. One point of particular interest is the loan under the Paycheck Protection Program (“PPP”) for small business debtors. Presently, the Small Business Administration has excluded debtors who declared bankruptcy or are pending bankruptcy proceedings from accessing these PPP loans.