Bankruptcy Court Must Defer to Arbitration for Noncore Claims

Sarah Hautzinger

St. John’s University School of Law

American Bankruptcy Institute Law Review Staff

            In In re McPherson, a Maryland bankruptcy court held that when a prepetition contract contains an arbitration clause, the bankruptcy court must defer to the arbitration as to the prepetition noncore claims.[1] John McDonnell McPherson (“Debtor”) entered into a Litigation Funding Agreement (“Funding Agreement”) with Camac Fund, L.P. (“Camac”),[2] pursuant to which Camac “extend[ed] financing to the Debtor in exchange for a percentage of the Debtor’s [recoveries from certain litigation].”[3] Eventually, the parties came to a dispute, and Camac invoked the arbitration clause in the Funding Agreement.[4] Thereafter, the Debtor filed a petition for relief under chapter 11 of title 11 of the United States Code (“Bankruptcy Code”), which automatically stayed all litigation against the Debtor, including the arbitration.[5] Camac filed a request to lift the automatic stay to allow the arbitration to proceed.[6] The Debtor opposed the request, arguing the dispute should be resolved in the bankruptcy court.[7]

         In this instance, the Maryland bankruptcy court concluded that a court must defer to the arbitration as to the noncore claims.[8] The constitutionally core claims that arose would remain subject to the automatic stay in connection with the chapter 11 case.[9] The court began by analyzing the tension between the Bankruptcy Code and the Federal Arbitration Act (“FAA”) in a chapter 11 case.[10] According to the court, the Bankruptcy Code provides a central “forum,” in the form of the bankruptcy court, to “consolidate[] the resolution” of the debtor’s matters.[11] Conversely, the FAA “creates a strong presumption in favor of arbitration” when an agreement contains an arbitration clause.[12] To determine if the claims should be arbitrated, the court noted that the Supreme Court previously stated in McMahon that “the FAA’s mandate may be overridden by a contrary congressional command.”[13] Therefore, a court must determine whether the claim is “constitutionally core” (i.e., “stems from the bankruptcy”) in determining whether the court should adjudicate the claim.[14]

            The Maryland bankruptcy court employed a four step “arbitrability analysis” to decide whether the claims were arbitrable.[15] The first two steps involved determining (i) whether the parties agreed to arbitrate, and (ii) the scope of the arbitration agreement.[16] The court found that the parties agreed to arbitrate and that the arbitration clause “does not by its plain language suggest a broad application.”[17] In the third step, the court split the parties’ claims into three categories (Bankruptcy Claims, FDCPA Claim, and Contract Claims) to consider whether Congress intended those claims to be non-arbitrable.[18] First, the court held that the Debtor’s Bankruptcy Claims arose under federal law and were constitutionally core claims because they stemmed from the bankruptcy.[19] Second, the court held that the Debtor’s FDCPA Claim was not constitutionally core because it sought to augment the Debtor’s estate as a vehicle for damages rather than a defense; therefore, it was subject to arbitration.[20] Third, the court held that the Contract Claims were “grounded in state law,” thus classifying them as non-core and subjecting them to arbitration.[21] In the fourth step, the court considered whether to stay the bankruptcy proceedings pending arbitration, simply because some of the claims were arbitrable, non-core claims.[22] The court explained that it was bound by the Fourth Circuit’s decision in Moses v. CashCall, Inc., which requires a bifurcation of constitutionally core and non-core claims.[23] Based on this bifurcation, the Contract Claims and FDCPA Claim would proceed under arbitration while the Bankruptcy Claims remained in bankruptcy court.[24]

            Here, according to the Maryland bankruptcy court, consolidation of the claims, not bifurcation, would have been the most “efficient and fair” resolution.[25] The dangers of bifurcation might include “overlap in facts, duplication in effort, and conflicting results.”[26] Indeed, the court noted that if it had been “writing on a clean slate,” it would have reached “a very different conclusion,” but it could not ignore binding precedent.[27] Accordingly, the court was bound to strike a balance between the Bankruptcy Code and the FAA.