Arbitration vs. Bankruptcy

Posted by NCBRC - August 13, 2012

The Ninth Circuit found that the creditor’s motion to compel arbitration was properly denied where arbitration would have resolved the core bankruptcy issue of dischargeability and, therefore, the Federal Arbitration Act conflicted with the underlying purposes of the Bankruptcy Code. In re Eber, No. 11-55341 (9th Cir. July 9, 2012). Specifically, the creditors sought arbitration to determine whether the debtor had committed fraud, breach of fiduciary duty, and willful injury, with respect to a contract for construction and operation of a hair salon. The bankruptcy court denied the motion on the basis that findings on these issues would essentially decide the issue of whether the debts were nondischargeable under sections 523(a)(2), (4) and (6) of the Bankruptcy Code.

Guided by its decision earlier this year in the chapter 11 case of In re Thorpe Insulation Co., 671 F.3d 1011 (9th Cir.), petition for cert. filed, Continental Insurance Co. v. Thorpe Insulation Co., No. 11-1310 (Apr. 30, 2012), the court resolved the issue under the construct set forth in the Supreme Court case of Shearson/Am. Express, Inc. v. McMahon, 482 U.S. 220, 226 (1987), which listed three considerations for determining whether the FAA conflicts with another federal law: “(1) the text of the statute; (2) its legislative history; and (3) whether an inherent conflict between arbitration and the underlying purposes of the statute exist.” The court began with the finding that there was no textual or historical basis for creating a broad exception to the FAA in the bankruptcy context, and went on to consider whether there was an inherent conflict between the FAA and the Bankruptcy Code when it came to dischargeability under sections 523(a)(2), (4) and (6). The court noted thata bankruptcy court generally does not have discretion to deny arbitration in non-core matters. It went on to find that the core/non-core distinction is not, by itself, dispositive, however. Once it is found that the issue involves a core matter, the McMahon framework must still be applied. Weighing the objectives of the Code including centralization of disputes and avoidance of piecemeal litigation, against the FAA policy favoring arbitration, the court found that the lower court had not abused its discretion in finding that allowing the arbitrator to decide whether the debtor had committed fraud was so closely intertwined with the issue of dischargeability that it would conflict with the “underlying purposes of the Bankruptcy Code” and jeopardize a core bankruptcy proceeding.

Circuit courts are generally in agreement with this method of analysis. See, In re Electric Machinery Enterprises, Inc., 479 F.3d 791 (11th Cir. 2007); In re Mintze, 434 F.3d 222 (3d Cir. 2005); In re White Mountain Mining Co., 403 F.3d 164 (4th Cir. 2005); In re Gandy, 299 F.3d 489 (5th Cir. 2002).

 Eber opinion


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