Arbitration Clause As Executory Contract: Rejecting In Bankruptcy To Forestall Arbitration? (Highland Capital v. Dondero)

An outlier (photo by Marilyn Swanson)

By: Donald L Swanson

Bankruptcy Court denies a motion to compel arbitration, because the arbitration agreement is a rejected executory contract. This appears to be a new and outlying theory for denying arbitration of bankruptcy disputes.

The opinion is Highland Capital Management, L.P. v. Dondero et al., A.P. No. 21-03003, Northern Texas Bankruptcy Court (issued 12/3/2021, Doc. 118).  What follows is an attempt to summarize this opinion

Background

Adversary proceedings are filed post-confirmation, in a Chapter 11 case, by the Reorganized Debtor to collect on promissory notes executed and delivered by various insiders.

Long story short: defendants assert, (i) various defenses based on an oral agreement, and (ii) a right to compel arbitration of those defenses, based on a mandatory arbitration clause in Debtor’s Limited Partnership Agreement.

The arbitration clause in question is “typical” for partnership agreements and provides:

  • “In the event there is an unresolved legal dispute between the parties and/or any of their respective officers, directors, partners, employees, agents, affiliates or other representatives that involves legal rights or remedies arising from this Agreement, the parties agree to submit their dispute to binding arbitration under the authority of the Federal Arbitration Act.”

However, Debtor’s Limited Partnership Agreement is an executory contract rejected under Debtor’s confirmed plan.

Defendants argue that defenses based on the oral agreement are subject to mandatory arbitration. Debtor counters that:

  • Rejection of the Limited Partnership Agreement and its arbitration clause excuses Debtor from being forced into arbitration; and
  • Defendants have waived arbitration by failing to invoke it in a timely manner.

Rejection of Executory Contract

Federal case law dictates a strong federal policy favoring arbitration under the Federal Arbitration Act.

The Act supports private parties’ agreements to resolve disputes through arbitration.  It provides:

  • “A written provision in … a contract … to settle by arbitration a controversy thereafter arising out of such contract … shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.”  9 U.S.C. § 2.

Thus:

  • Under the Act, arbitration is entirely a matter of contract;
  • Where parties have a contract to submit future disputes to arbitration, such provisions are to be enforced; and
  • The Act directs a court to order parties into arbitration, upon request by a party entitled by written contract to demand it.

Some courts suggest that an arbitration clause is “less mandatory” in bankruptcy than in other cases.  That’s because bankruptcy cases, unlike other lawsuits, are multi-faceted, multi-party, and fast-moving.

Some courts suggest that bankruptcy courts may decline to order arbitration of “core” disputes (i.e., those deriving from the Bankruptcy Code).  The theory and practice go like this:

  • Congress—in enacting the Bankruptcy Code—intended to preclude arbitration, when such intent is apparent from (1) a statute’s text; (2) its legislative history; or (3) “an inherent conflict between arbitration and the statute’s underlying purposes”; and
  • Thus, courts—when dealing with a “core” dispute—often “plow down a complicated trail” on whether an “inherent conflict” between arbitration and the Bankruptcy Code exists for that dispute.

The Fifth Circuit identifies these two elements for plowing that complicated trail and denying arbitration:

  1. the matter is “core” or derives from rights under the Bankruptcy Code; and
  2. enforcement of arbitration would irreconcilably conflict with the purposes or goals of the Bankruptcy Code.

A Slightly Different Argument

Debtor, in Highland Capital, presents a “slightly different argument” that “very few courts have addressed.”  The argument goes:

  • The Limited Partnership Agreement and its arbitration clause are executory contracts and are rejected in Debtor’s confirmed Chapter 11 plan;
  • So, Debtor is no longer bound by the arbitration clause in that Agreement; and
  • A counterparty to a rejected executory contract can only seek monetary damages—not specific performance.

Federal Receivership Analogy

Supporting Debtor’s argument is the “lengthy and well-reasoned opinion” of Janvey v. Alguire [fn. 1], which makes analogies between federal receiverships and bankruptcy.

Janvey involves a federal receivership filed by the SEC in response a massive Ponzi scheme. Ralph S. Janvey, as Receiver, takes possession of all debtor’s assets and records, then files suit against former employees.  He alleges that those employees received fraudulent transfers or were unjustly enriched at the expense of creditors.

Some of the Janvey defendants file motions to compel arbitration, based on arbitration clauses in (1) promissory notes, (2) broker-dealer forms submitted to FINRA when registering those employees as brokers; (3) FINRA’s internal rules on disputes between brokers and their employers, and (4) the company’s employee benefits plan.

The arbitration clauses require that “any controversy arising out of or relating to” this contract “shall be submitted to and settled by arbitration.”

The Janvey Court declines to order arbitration because, (i) the Receiver had not adopted the arbitration agreements, and (ii) arbitration of the Receiver’s claims would frustrate a central purpose of federal equity receiverships. In doing so, the the Court looks almost entirely to bankruptcy law for reaching its ruling.

The operative question in Janvey is this:

  • whether the arbitration agreements are contracts that the Receiver can reject?

That question is significant because:

  • the right to reject contracts is held by both federal receivers and bankruptcy trustees;
  • such right has “deep historical roots” and continues to be “an important tool for both”; and
  • an agreement to arbitrate is a classic executory contract, since neither side has substantially performed it at the time enforcement is sought.

Further, the appropriate remedy for a rejected contract “cannot be for the Court to require specific performance” by the trustee or receiver—i.e., to compel arbitration.  That would greatly burden and deplete the bankruptcy / receivership estate—an unjust and inequitable result.

The Fifth Circuit affirms the Janvey Court’s decision—but on different grounds.  One different ground is waiver: a defendant had waived the right to arbitrate “by substantially invoking the judicial process” in (i) filing a motion to dismiss and an answer, and (ii) by serving and answering written discovery. 

On the direct Janvey issue, however, the Fifth Circuit punts, saying: “we are wary of endorsing these broad policy arguments in the absence of specific direction from the Supreme Court.”

Following Janvey

The  Highland Capital court says:

  • “This court finds Janvey to be persuasive (and possibly binding)”; and
  • just as a federal receiver is analogous to a bankruptcy trustee, a debtor-in-possession is statutorily the same as a bankruptcy trustee under § 1107.

The operative bankruptcy rules are:

  • when a bankruptcy trustee rejects an executory contract, the rejection constitutes a breach of the contract and subjects the estate to a pre-petition claim for money damages;
  • the injured party cannot insist on specific performance by the trustee; and
  • an arbitration clause is a classic executory contract, since neither party has fully performed.

In summary, this court accepts Debtor’s argument that the Limited Partnership Agreement and its arbitration clause are executory contracts duly rejected under section 365.

Accordingly, Debtor cannot be forced to specifically perform—i.e., cannot be compelled to arbitrate.

Further, the court finds that defendants waived any right to invoke arbitration by:

  • answering and pleading affirmative defenses;
  • seeking a withdrawal of the District Court’s reference of the case to Bankruptcy Court (and causing the expenditure of substantial judicial resources thereon);  
  • pursuing extensive discovery; and
  • first mentioning arbitration more than seven months after the litigation began.

Conclusion

It will be interesting to see if and how other practitioners and courts pick up on and attempt to apply the contract rejection argument from Highland Capital to forestall arbitration of bankruptcy disputes

————————–

Footnote 1.  Janvey v. Alguire, 2014 U.S. Dist. LEXIS 193394 (N.D. Tex., Jul. 20, 2014), aff’d on different grounds at 847 F.3d 231 (5th Cir. 2017).

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