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Arbitration Clauses as Separate Executory Contracts

This term, Supreme Court Justice Elena Kagan has authored a pair of opinions related to arbitration. The first of these decisions, Badgerow v. Walters, 20-1143, 142 S. Ct. 1310 (2022) came down on March 31, 2022, where Justice Kagan, writing for the 8/1 majority, held that a court must have an independent basis of federal jurisdiction to undertake a petition to confirm or vacate an arbitration award.

Under Section 4 of the Federal Arbitration Act (“FAA”), a district court may use a “look-through” approach to determine whether it has jurisdiction over the underlying substantive controversy when considering a petition to compel arbitration, as adopted in Vaden v. Discover Bank, 556 U.S. 49 (2009). But the same approach is not available for parties seeking to confirm an arbitral award under Sections 9 and 10 of the FAA. Under these Sections, the court’s review must be limited to the application itself.

In Badgerow, the parties presented a petition to confirm an arbitral award, which was confirmed by the district court and affirmed by the Fifth Circuit Court of Appeals. Here, the arbitration was conducted prior to any federal lawsuit in which a party sought to compel arbitration under Section 4.  The Supreme Court reversed the lower courts, finding that the text of Sections 9 and 10 did not provide the same jurisdictional look-through provisions as when a district court is presented with an application to confirm an award for which it had previously compelled arbitration. Where there is no prior federal lawsuit in which arbitration was compelled, the application itself must meet jurisdictional requirements in order for a district court to take it up: diversity jurisdiction, a federal question regarding confirmation of the award itself, or another cause for establishing jurisdiction.

Then, on May 23, 2022, Justice Kagan, writing this time for a unanimous court in Morgan v. Sundance, Inc., 21-328, --- S. Ct. ---- (U.S. May 23, 2022), held that the long-held majority rule specific to arbitration that a party can waive its arbitration rights by litigating only when its conduct has prejudiced the other side was improper. The Court found that, outside of arbitration, a “federal court assessing waiver does not generally ask about prejudice. Waiver, we have said, is the intentional relinquishment or abandonment of a known right.” Id. at 5 (quoting United States v. Olano, 507 U.S. 725, 733 (1993)).

And while the Court recognized that for many years there has been a general policy consensus among the Circuits favoring arbitration, that “does not authorize federal courts to invent special, arbitration-preferring procedural rules.” Id. at 6. Instead, the Court clarified, “[t]he policy is to make arbitration agreements as enforceable as other contracts, but not more so.” Id. (quoting Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395, 404 n.12 (1967)). “Accordingly, a court must hold a party to its arbitration contract just as the court would to any other kind. But a court may not devise novel rules to favor arbitration over litigation.” Id.

Kagan continues, “Section 6 of the FAA provides that any application under the statute . . . shall be made and heard in the manner provided by law [meaning] to apply the usual federal procedural rules [and] a bar on using custom-made rules.” Id. at 7. A court should not and must not apply a novel or arbitration-favoring analysis when considering a motion to compel arbitration.

Justice Kagan’s arbitration focused opinions have pushed back on long standing policy and procedure favoring arbitration over litigation in federal district courts and demands a return to strict compliance with the text of the FAA.

For bankruptcy practitioners, arbitration clauses present a unique inquiry.  Bankruptcy is unique in that it permits a debtor to assume or reject an executory contract under Section 365 of the Bankruptcy Code. That includes any contract containing an arbitration clause, as found in Highland Capital Mgmt v. Dondero (In re Highland Capital Mgmt.), No. 19034054, 2021 WL 5769320 (Bankr. N.D. Tex. Dec. 3, 2021). In that case, the court found that the debtor’s rejection of a limited partnership agreement containing an arbitration clause was, in effect, the rejection of two executory contracts: the partnership agreement and, separately, the arbitration agreement. Id. at *7.

The court’s analysis led to the conclusion that an arbitration clause within another agreement creates an executory contract separate and apart from the parent agreement. See id. at *6-7. While arbitration may survive breach of a contract in general contract law, in bankruptcy, rejection of a contract precludes specific performance—including arbitration—against the trustee. Id.

The Supreme Court makes clear that the enforcement of an arbitration agreement is limited to contractual interpretation and not an overarching policy favoring arbitration over litigation. In bankruptcy, debtors are left with the unique ability to reject executory contracts, including separate arbitration agreements contained within other agreements. It follows then, that bankruptcy courts must consider favorably a debtor’s rejection of an arbitration agreement as an executory contract when determining whether to compel a matter to arbitration. 

Copyright ©2023 Nelson Mullins Riley & Scarborough LLPNational Law Review, Volume XII, Number 157
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About this Author

Woods Drinkwater Bankruptcy Associate Attorney Nashville Tennessee Commercial Litigation Nelson Mullins Riley & Scarborough LLP
Associate

Woods focuses his practice in the areas of bankruptcy, creditors’ rights and restructuring, bankruptcy and insolvency-related litigation, and general commercial litigation.

615-664-5307
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