Bankruptcy Court May Refrain from Enforcing a Valid Arbitration Clause

Bankruptcy Court May Refrain from Enforcing a Valid Arbitration Clause

By: Laila Rizk

St. John’s University School of Law

American Bankruptcy Institute Law Review Staff

            Generally, a court will enforce an arbitration clause in a contract, but may refrain from doing so under certain circumstances.[1] In In re Acis Capital Mgmt., L.P., the United States Bankruptcy Court for the Northern District of Texas did not enforce an arbitration clause, finding that (1) a valid arbitration agreement would be applied to the dispute[2] and (2) it had discretion under Fifth Circuit authority to decline to order arbitration because enforcing arbitration would conflict with the purposes of Title 11 of the United States Code (the “Bankruptcy Code”).[3]

            Acis Capital Management, L.P. (“Acis LP”) is a Delaware limited partnership investment adviser and collateralized loan obligation (“CLO”) manager.[4] Highland Capital Management L.P. (“Highland”) was an insider of Acis and provided management to services to Acis pursuant to a Shared Services Agreement.[5] Acis was named as an alleged debtor in an involuntary petition for relief under chapter 11 of the Bankruptcy Code.[6] Thereafter, the court entered an order for relief against Acis and appointed a trustee.[7]  The Acis trustee rejected the Shared Services Agreement, which as amended on March 17, 2017, did not contain an arbitration clause.[8] Highland filed a complaint against the Acis trustee for injunctive relief, arguing that the trustee was interfering with its business rights and decisions. [9] In response, the trustee objected to the claims and asserted numerous counterclaims against Highland.[10]  Highland filed a motion to compel arbitration of several of the counterclaims and claims objections because they implicated conduct prior to the March 17, 2017 amendment during which the Shared Services Agreement contained a valid arbitration provision. [11]

            Pursuant to the terms of a confirmed chapter 11 plan, Acis LP was vested with the trustee’s claims against Highland.[12] Consequently, it was Acis LP and not the trustee that opposed Highland’s motion for arbitration, arguing that there was no arbitration provision, but “if there are applicable arbitration clauses, the court [] should exercise discretion and decline to order arbitration, since . . . arbitration would conflict with the purposes of the Bankruptcy Code.”[13] The court found that the arbitration clause was valid, but that it had discretion as to whether or not to enforce it.[14] In order to determine whether to grant the motion to compel arbitration, the court applied the Fifth Circuit’s test that incorporates two threshold questions “(1) whether an arbitration agreement is valid; and (2) whether the dispute falls within the scope of the agreement.”[15] The court applied Texas state law to answer the first question.[16] The court determined there was a valid arbitration agreement that applied, as the sub-set of claims Highland wanted to send to arbitration “involve[d] conduct prior to March 17, 2017 . . . [and] f[e]ll within the scope of the arbitration agreements in the Sub-Advisory Agreement and Shared Services Agreement.”[17]

            Next, the court had to decide whether to use its discretion since “these disputes arose in a proceeding that involve[d] mostly, if not entirely, ‘core’ matters.”[18] Generally, the bankruptcy system seems to be “dropp[ing] the overall hostility that once characterized its view of alternative dispute resolution.”[19] However, the debate still remains as to whether there should be a distinction between core and non-core matters when deciding to enforce valid arbitration agreements.[20] The court relied on the Fifth Circuit case In re Gandy, in which the court chose not to enforce the arbitration agreement because it conflicted with one of the central purposes of the Bankruptcy Code -- expeditious and equitable distribution of the assets of a debtor’s estate.[21] Here, the court noted that the counterclaims were seeking avoidance of actual and constructive fraudulent transfers, along with turnover of property of the estate for unauthorized overpayments.[22] The court mentioned that the avoidance theory is derived from sections 542, 547, 548, 550, and the “strong arm” powers of 544(a) of the Bankruptcy Code.[23] Therefore, the court used its discretion under the Fifth Circuit test and declined to order arbitration.[24]

            The Supreme Court in Dean Witter Reynolds, Inc. v. Byrd stated that the purpose of the Federal Arbitration Act was to honor privately-made agreements to arbitrate and not to promote expeditious resolution of claims.[25] However, the goals of enforcing arbitration clauses and expedition can be compatible under the Federal Arbitration Act.[26] The court in In re Acis Capital Mgmt., L.P. chose to distinguish incompatibility and provided the determination proofs of claim, avoidance of fraudulent transfers, and turnover of property of the estate for unauthorized overpayments, some of the bankruptcy court’s quintessential duties, as the primary reason why.[27] The Fifth Circuit did not utilize the test provided by the Supreme Court: determining whether the risk of error in arbitration is “unacceptable.” [28]