A Bankruptcy Exception to the Federal Arbitration Act — In the U.S. Constitution

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Uniformity (photo by Marilyn Swanson)

By: Donald L Swanson

“The Congress shall have Power . . . To Establish . . . uniform Laws on the subject of Bankruptcies throughout the United States.”

–Bankruptcies Clause in the U.S. Constitution, Art. I, Sec. 8, Cl. 4.

Bankruptcy Exception to Arbitration — A Constitutional Argument

Try this argument on for size:

  • The Constitution’s Bankruptcies Clause requires that bankruptcy laws be “uniform . . . throughout the United States.”
  • The standard for review of an award under the Federal Arbitration Act is a rubber-stamp, under which a uniform application of bankruptcy laws throughout the United States cannot be assured.
  • So, the U.S. Constitution requires that bankruptcy issues be resolved by bankruptcy courts and their appellate overseers (not by arbitration) to assure uniformity.  (See this linked article.)

I think it works!  But I’ve never seen this argument used.

Instead, we get a mishmash of bankruptcy-exception theories with limited application to narrow sets of facts and issues — none of which start with a citation to the Bankruptcies Clause.

Fortunately, however, progress in the direction of a Constitution-focus is in the works.  Here’s how.

Arbitration Exceptions — Restricted

Starting at the top, with the U.S. Supreme Court, is an entrenched reluctance to find exceptions for arbitration requirements under the Federal Arbitration Act.

For example, on January 15, 2019, the U.S. Supreme Court issues an arbitration decision (New Prime Inc. v. Oliveira) described by Professor Ronald J. Mann as follows:

  • This opinion “rejects a claim for arbitration for the first time in a string of more than a dozen of Supreme Court cases stretching back more than a decade”; and
  • “Indeed, I doubt the court has rejected such a claim in any previous decision since the turn of the millennium.” [Fn. 1]

Arbitration of Bankruptcy Disputes

Accordingly, it is imperative that a bankruptcy exception to arbitration under the Federal Arbitration Act be based on the strongest-possible foundation.  And the Bankruptcies Clause provides that foundation.

Fortunately, bankruptcy courts and their appellate overseers have an opportunity to develop the bankruptcy exception. Back on October 1, 2018, the U.S. Supreme Court denied certiorari [Fn. 2] in a case that presented this bankruptcy / arbitration question:

“Whether an agreement that requires . . . arbitration is enforceable . . . , notwithstanding the provisions of the Bankruptcy Code providing for a . . . discharge of a debtor’s debts”?

And the courts have been making the most of this opportunity.

“Constitutionally Core” Claims — A Line of Cases

One line of cases finds a bankruptcy exception for “constitutionally core” claims.

Here’s a general analysis behind this exception:

  • A claim is constitutionally core when its issues would necessarily be resolved in ruling on an objection to a proof of claim;
  • Constitutionally core claims strike at the heart of the Bankruptcy Code, which is designed, (i) to promptly and effectually administer and settle the bankruptcy estate, and (ii) to centralize disputes over assets and obligations in one forum; and
  • Sending a constitutionally core claim to arbitration would inherently conflict with the purposes of the Bankruptcy Code.

A Recent “Constitutionally Core” Case

A recent “constitutionally core” opinion is dated October 22, 2019: Allied Title Lending, LLC v. Taylor,

  • Case No. 3:18 cv 845 in U.S. District Court for Eastern Virginia (Doc. 22), affirming Bankruptcy Court in Adv. No. 18-03003 (Doc. 115).

Here’s what happened.

–The Loan and Credit Agreement

In July 2016, Debtor obtains a $1,500 loan from Allied. Debtor signs a credit agreement and agrees to repay the loan with 0.75% per day interest (i.e., an annualized rate of 273.75%) and a $100 origination fee.

The Credit Agreement contains various arbitration provisions, including:

  • all Claims arising from or relating to this Agreement . . . must be resolved by binding arbitration.
  • You may not join or participate in a class action.
  • You give up your right to have a jury decide your Claim.

–Bankruptcy and Adversary Proceedings

On January 11, 2017, Debtor files a Chapter 13 bankruptcy, in which Allied files a proof of claim for $2,756.92. And the Court confirms Debtor’s Chapter 13 plan.

On January 15, 2018, Debtor initiates an adversary proceeding against Allied. Debtor’s complaint:

• objects to Allied’s proof of claim (Count I); and
• asserts usury claims under state law for herself and as a class action (Counts II & III).

In response, Allied files a motion to dismiss and seeks an order to compel arbitration of Counts II and III. Debtor objects.

Meanwhile, Virginia’s Attorney General asks to intervene, seeking (i) disallowance of Allied’s claim under Virginia’s consumer finance and usury laws, and (ii) restitution, civil penalties, attorney’s fees and injunctive relief against Allied. The Bankruptcy Court allows intervention over Allied’s objection.

–Bankruptcy Court’s Opinion

The Bankruptcy Court rules that Counts II and III are constitutionally core claims and should not be referred to arbitration, because a referral would:

  • conflict with the essential purpose of the Bankruptcy Code to quickly and efficiently resolve claims against Debtor’s estate in a single forum; and
  • undermine the Attorney General’s statutory prerogative to intervene. [Fn. 3]

–District Court’s Opinion on Appeal

On appeal, the U.S. District Court declares:

  • Arbitration of constitutionally core claims inherently conflicts with the purpose of the Bankruptcy Code, and a bankruptcy court is “generally well within its discretion to refuse arbitration.”
  • The Bankruptcy Code’s “animating purpose” is to efficiently reorganize a bankruptcy estate through the centralization of disputes concerning a debtor’s legal obligations.

The U.S. District Court, therefore, affirms the Bankruptcy Court:

  • Count II is constitutionally core because it presents a direct objection to Allied’s claims;
  • Count III is constitutionally core because its resolution will resolve the validity of the Credit Agreement and, if successful, directly reduce the amount of Allied’s claims; and
  • While the Attorney General’s intervention does not preclude arbitration, the Bankruptcy Court acted within its discretion to consider the intervention in deciding whether to arbitrate the constitutionally core claims.

Conclusion

Bankruptcy laws hold a special place within the U.S. Constitution via the Bankruptcies Clause.

When searching for a foundation upon which to base a bankruptcy exception to the Federal Arbitration Act, the Bankruptcies Clause, with its uniformity requirement, is the perfect place to start.

————————————-

Footnote 1: Ronald J. Mann, Opinion Analysis, Justices uphold arbitration exemption, Scotusblog, January 15, 2019.

Footnote 2: See Credit One Bank, N.A. v. Anderson, U.S. Supreme Court Case No. 17-1652.

Footnote 3: The Bankruptcy Court follows the Fourth Circuit’s analysis and rationale in the case of Moses v. CashCall, Inc., 781 F.3d 63 (4th Cir. 2015).

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