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Bankruptcy Court Trumps Federal Arbitration Clause

With $3.3 million in alleged damages against a Chapter 7 debtor at stake, in Ackerman v. Eber (In re Eber), 687 F.3d 1123 (9th Cir. 2012) the U. S. Court of Appeals for the Ninth Circuit ruled in favor of the debtor in denying a creditor's Motion to Compel Arbitration. This left the creditor with no right to prove its case in the arbitration proceeding. So, having lost its nondischargeability case in bankruptcy court earlier, the creditor received nothing.

The Setting

This is an important and interesting case, and helpful for debtors, because it affirms the jurisdiction of the bankruptcy court to decide whether debts should be the discharged or not, in spite of the Federal Arbitration Act which "establishes a federal policy favoring arbitration." Mandatory arbitration clauses are now standard in more and more creditors' contracts, with the consumer having no effective choice about it. So there is a huge practical and financial benefit for debtors not to be dragged out of bankruptcy court to defend arbitration proceedings on nondischargeability allegations all over the country.

The Facts

Jose Eber entered into a contract for the construction and operation of his hair solon in Las Vegas with Ackerman and Kuriloff. That contract had an arbitration clause, requiring that any disputes between them would be resolved through arbitration. Things did not go well and eventually Ackerman and Kuriloff ("A & K") started an arbitration proceeding in New York City against Eber, asking for damages for his alleged breach of contract, fraud, and breach of fiduciary duty.

A few weeks later, Eber filed a Chapter 7 bankruptcy case in Southern California. That stopped the arbitration, so A & K filed an adversary proceeding with a Complaint for Determination that Debts are Non-Dischargeable. A few months later they also filed a Motion for Relief from Automatic Stay to be allowed to proceed with the arbitration. While those two matters were pending, the Chapter 7 trustee determined that there were no assets to distribute through the bankruptcy case to creditors, and soon after Eber received a discharge of debts. The bankruptcy judge then denied the Motion for Relief from Automatic Stay, so A & K filed a Motion to Compel Arbitration, which the judge also denied.

A & K appealed the denial of their Motion to Compel Arbitration to the local U.S. District Court for the Central District of California. That court upheld the bankruptcy court's decision, so A & K filed an appeal to the Ninth Circuit.

While this appeal was pending, and against the objections of A & K, the adversary proceeding on their Complaint for Determination that Debts are Nondischargeable went to trial. After trial the bankruptcy judge determined that A & K failed to prove the elements for fraud or misrepresentation, fraud while acting in a fiduciary capacity, or willful and malicious injury, so their claims were discharged in full. That left A & K with their appeal of the denial of their Motion to Compel Arbitration.

The Decision

The appeal turned "on the tension between the Federal Arbitration Act . . . and the United States Bankruptcy Code . . . and more specifically, a bankruptcy court's jurisdiction to determine dischargeability pursuant to §§ 523(a)(2), (4), and (6)." (Those statutes refer to nondischargeability involving fraud or misrepresentation, fraud in a fiduciary capacity, and willful and malicious injury, respectively). The Ninth Circuit Court of Appeals held "that the district court did not abuse its discretion in denying [the] Motion to Compel Arbitration because granting the Motion would have 'conflict[ed] with the underlying purposes of the Bankruptcy Code.' "

The Federal Arbitration Act

The Federal Arbitration Act ("FAA"), found at 9 U.S.C. §§ 1 et seq., makes clear that arbitration clauses in contracts should generally be enforced, requiring disputes to be deciding by arbitration instead of in court.

Section 2 of the Act states that "an agreement in writing to submit to arbitration an existing controversy arising out of such a contract [involving commerce] . . . shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract." Section 3 states that "[i]f any . . . proceeding be brought in any of the courts of the United States upon any issue referable to arbitration under an agreement in writing for such arbitration, the court in which such suit is pending, upon being satisfied that the issue involved in such . . . proceeding is referable to arbitration under such an agreement, shall on application of one of the parties stay the trial of the action until such arbitration has been had in accordance with the terms of the agreement . . ."

So a contractual clause requiring arbitration is enforceable as long as the contract is not revocable. And a federal court must stop any court proceeding and allow an arbitration first to proceed if one of the litigants tells the court about the arbitration clause. That is, the court must do so if satisfied that the issue involved in the court proceeding "is referable to arbitration" under the contract. Apparently none of the three courts involved in this appeal believed that the nondischargeability issues were "referable to arbitration" in spite of "a federal policy of favoring arbitration." Why not? How would requiring arbitration here "conflict with the underlying purposes of the Bankruptcy Code"?

The Court's Rationale

The Ninth Circuit started by saying that "[w]hile the FAA establishes a federal policy of favoring arbitration, '[l]ike any statutory directive, the Arbitration Act's mandate may be overridden by a contrary congressional command.' "

But the Court admitted that no courts of appeal had found any "evidence in the text of the Bankruptcy Code or in the legislative history suggesting that Congress intended to create an exception to the FAA in the Bankruptcy Code." So the pertinent question was "whether there is an inherent conflict between arbitration and the underlying purposes of the Bankruptcy Code."

The heart of the Ninth Circuit's response to this question was that:

Courts must consider the Bankruptcy Code's objectives, including centralization of disputes concerning a debtor's legal obligations, and protection of debtors and creditors from piecemeal litigation. When a bankruptcy court considers conflicting policies as the bankruptcy court did here, we acknowledge its exercise of discretion and defer to its determinations that arbitration will jeopardize a core bankruptcy proceeding.

The Court had earlier acknowledged that core proceedings include "determinations as to the dischargeability of particular debts." It reasoned that

[a]lthough Ackerman and Kuriloff were attempting to designate their underlying state law breach of contract, fraud, and breach of fiduciary duty claims as non-core, arbitratable claims, in actuality, they were seeking to arbitrate dischargeability under §§

523(a)(2), (4) and (6), a core bankruptcy issue.

So the power of the bankruptcy trumped the FAA's policy favoring arbitration.

Crucial Practical Distinction

In making this decision favoring debtors in bankruptcy, the Ninth Circuit emphasized the all-important distinction between stopping an unresolved arbitration from going forward upon the filing of a bankruptcy case versus the enforceability of an arbitration decision already made before the bankruptcy case is filed.

Ackerman and Kuriloff were not attempting to enforce a prior arbitration judgment because one did not exist. The bankruptcy judge made a determination—prior to an arbitration beginning—that allowing an arbitrator to decide the issues related to dischargeability in this case would conflict with important bankruptcy principles. Our holding in no way extends beyond the particular facts of this case or to all cases in which a bankruptcy judge makes this determination prior to the commencement of an arbitration.

The Court acknowledged that the Ninth Circuit itself had held that if nondischargeability issues are "actually litigated and necessarily decided on the merits in the confirmed final arbitration award" then that determination resolves the matter. The debtor is stuck with that arbitration decision and the debt would not be discharged in the subsequent bankruptcy.

A Word to the Wise

What this distinction makes abundantly clear is how dangerous it is to allow an arbitration proceeding, or a conventional lawsuit, to proceed against you without getting immediate legal advice and, where appropriate, stopping that proceeding by filing bankruptcy.

In the court opinion presented here, Jose Eber, the debtor, did not file his Chapter 7 case until 26 days AFTER the arbitration proceeding was commenced. The Ninth Circuit was in fact a bit disingenuous in the quotations above, skirting the fact that the arbitration proceeding WAS indeed commenced before the bankruptcy was filed—the arbitration simply hadn't gotten very far before the bankruptcy filing stopped it, and the bankruptcy judge refused to allow it to continue. Eber was very lucky. Had the arbitration process gotten much further, so that "an arbitrator was already familiar with the facts," "judicial economy" would have likely yielded an opposite result. The arbitration would have continued, 3,000 miles away from where he filed his bankruptcy case, in a forum that was likely less favorable to him, and he could have been left owing a few million dollars instead of nothing.

If you wait to file bankruptcy until after an arbitration proceeding has been started and the arbitrator has gotten involved, there's a good chance that your bankruptcy judge WILL rule in favor of your creditor's Motion to Compel Arbitration. Prevent that from happening by seeing a competent attorney preferably BEFORE an arbitration or lawsuit is filed against you, or certainly immediately after.

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