Fourth Circuit Rules Need to Determine Whether Principal's Loan Was Debt or Equity (Web)

In re: White Mountain Mining Company, 2005 WL 736803 (4th Cir.(W.Va.), 4/1/05)): Fourth Circuit says bankruptcy court may refuse to enforce international arbitration agreements in core proceedings.

          On April 1, the Fourth Circuit Court of Appeals held that a bankruptcy court did not abuse its discretion by refusing to enforce an international arbitration agreement between an investor and a principal of a Chapter 11 debtor, where the principal brought an adversary proceeding against the investor involving a core issue and staying of the adversary proceeding would have substantially interfered with the debtor’s efforts to reorganize.
 
          In earlier proceedings, the principal of a corporate Chapter 11 debtor brought an adversary proceeding against a debtor and investor seeking a determination as to whether certain pre-petition cash advances were debt or equity. The bankruptcy court denied the investor's motion to compel arbitration, reasoning that because the principal’s complaint sought "a determination that [he] is owed money by the Debtor," it entailed a core proceeding under 28 U.S.C. § 157(b)(2)(B) and that the proceeding presented issues "critical to [the debtor company’s] ability to formulate a Plan of Reorganization." The arbitration, that court said, "clearly [would have sought] a determination of claims against [the debtor company] as well as a determination of the extent of equity holders in the entity." Thus, the core proceeding trumped the arbitration agreement, according to the bankruptcy court
 
          The investor appealed to the district court, the bankruptcy court's order denying arbitration, and both courts denied motions for a stay pending appeal. The bankruptcy court held a trial in the adversary proceeding and determined that the principal’s advance of $10.6 million to the debtor company was a loan and the principal was not obligated to make further advances. The district court affirmed the bankruptcy court. The investor appealed, arguing that the bankruptcy and district courts erred in failing to enforce the arbitration agreement, the bankruptcy court was divested of jurisdiction to try the adversary proceeding once the investor appealed the denial of arbitration to the district court, and an injunction against the arbitration was invalid because it was overly broad. The Court of Appeals reviewed de novo the conclusions of law reached by the lower courts, and reviewed the bankruptcy court's findings of fact for clear error.

          The Investor argued that the bankruptcy and district courts erred in failing to enforce the international arbitration agreement between the parties, noting the strong federal policy in favor of arbitration and the obligations of courts to uphold arbitration agreements under the New York Convention. The Court, however, held that in the bankruptcy setting, congressional intent to permit a bankruptcy court to enjoin arbitration is sufficiently clear to override even international arbitration agreements. In explaining this determination, the Court cited 28 U.S.C. § 157(b)(1): "Bankruptcy judges may hear and determine ... all core proceedings arising under title 11 ... and may enter appropriate orders and judgments, subject to review under section 158 of [title 28]." 
 
          The Court said these “core proceedings” included, for example, "matters concerning the administration of the estate" and "allowance or disallowance of claims against the estate," and found that the principal's complaint against the debtor, seeking determination that pre-petition cash advances from principal to corporation were loans "due and owing" from the corporation to the principal, was a core proceeding.
 
          Recognizing that the litigation involved a core proceeding, the court noted that a bankruptcy court is acting within its discretion to deny enforcement of an international arbitration agreement if congressional intent to allow such a denial pursuant to the  Bankruptcy Code is deducible "from an inherent conflict between arbitration and the statute's underlying purposes." The Court found that an inherent conflict existed between arbitration and the underlying purposes of the bankruptcy laws, to modify the rights of debtors and creditors. The Court found that congress intended to centralize disputes about a debtor's assets and legal obligations in the bankruptcy courts, and arbitration is inconsistent with centralized decision-making because permitting an arbitrator to decide a core issue would make debtor-creditor rights "contingent upon an arbitrator's ruling" rather than the ruling of the bankruptcy judge assigned to hear the debtor's case.
 
          The Court noted that the inherent conflict between arbitration and the purposes of the Bankruptcy Code was revealed clearly in this case. In affirming the District Court’s decision, the Court of Appeals said that the Bankruptcy Court was not clearly erroneous in finding that because resolution of the debt-equity issue was critical to the debtor's ability to formulate a plan of reorganization, the court would resolve the adversary proceeding on an expedited basis and that allowing the adversary proceeding to go forward would "allow all creditors, owners and parties in interest to participate [in a centralized proceeding] at a minimum of cost."

          The Court found that the issue of whether a stay of the entire action was required pending appeal of the order denying the motion to compel arbitration or whether the filing of an interlocutory appeal divested the bankruptcy court of jurisdiction was moot, since judgment had been entered in adversary proceeding and the Court of Appeals held that bankruptcy court was correct in denying motion to compel arbitration and in refusing to stay adversary proceeding pending arbitration.
 
          The Court also held that modification of the injunction on appeal was not warranted on the basis that the injunction against arbitration was too broad, since there was no ground for vacating the injunction in its entirety, no request had been made for alternative relief and no suggestion had been made of what other relief might have been appropriate.