Adopting the Minority View, a Texas Bankruptcy Court Concludes that Arbitration Clauses are a Form of Executory Contract

The Federal Arbitration Act (FAA) codifies federal policy favoring the enforceability of contractual arbitration clauses.   Due to the FAA, courts will thus generally require parties to arbitrate a dispute if their contract so dictates.

This is no less true in bankruptcy court, at least in connection with contracts at issue in non-core proceedings.[1]  For example, in In re Fleming Companies[2], the Delaware bankruptcy court held that the debtor could enforce an arbitration clause even after the contract had been rejected.  Indeed, Fleming Companies described arbitration clauses as a negotiated method to resolve pre-petition disputes that would be rendered meaningless if they could be ignored post-rejection. 

In contrast, a bankruptcy court in Texas recently characterized the impact of an arbitration clause differently.  In Highland Cap.[3], an arbitration clause was described as a “classic form” of executory contract subject to rejection, after which no party can be compelled to arbitrate a contractual dispute.

In Highland Cap., the Chapter 11 Debtor (“Highland”) had extended loans memorialized by promissory notes.  Post-petition, Highland sought to enforce the notes by commencing an adversary complaint against the note obligors.  But the obligors claimed their loans had been forgiven pursuant to an agreement with one of Highland’s limited partners, an entity controlled by the “Dondero” family.  Upon learning of the purported loan forgiveness, Highland amended its complaint to sue the limited partner, its then former president, James Dondero, and others for causes of action arising out of Highland’s limited partnership agreement (LPA).

 This LPA contained an arbitration clause, which the newly added defendants moved to enforce.  In opposition, Highland argued that both the LPA and its arbitration clause had been rejected, such that arbitration could not be compelled.  The court sided with Highland.

Supporting its conclusion, the court cited to a recent Texas district court decision rendered in a federal receivership proceeding.[4]  Janvey had analyzed both the Bankruptcy Code and a law review article written by a bankruptcy law professor to conclude that arbitration clauses are a “classic” form of executory contract.  Based on Janvey, the Highland Cap. court concluded that the arbitration clause in the LPA was executory and had been rejected by Highland.  Hence, Highland could not be compelled to arbitrate the disputes arising out of the LPA.

Practice Pointer

Janvey explained that the executory nature of an arbitration clause is dependent on “the nature of the [clause] as well as arbitration caselaw regarding severability.”  This suggests that arbitration clauses will be treated as executory only if the underlying state law views the arbitration clause as an “independent contractual obligation of the parties” which, if not honored by a party, would constitute a material breach.  Highland Cap. concedes that treating an arbitration clause as an executory contract is a minority position not previously adopted by most courts.  Whether this line of reasoning eventually proves influential to other bankruptcy courts (whether in or outside Texas) remains to be seen. 

The enforceability of arbitration clauses may be of particular interest to those involved in the   construction industry, and its intersection with bankruptcy law. All manner of contracts with owners, developers, subcontractors, and surety companies may contain arbitration clauses, some of them quite specific.  Even though the majority of cases support the enforceability of those clauses, thereby preventing a bankruptcy court from deciding disputes absent the parties’ consent, the Highland Cap case may at least provide a good faith argument to the contrary.  Thus, counsel to parties in the construction space  should be aware of, and consider if it is appropriate to raise, the argument that an arbitration clause should not  be enforced in bankruptcy if the agreement (or ancillary documents) containing the clause is rejected.