Thursday, March 10, 2022

Trustee Who Sought Turnover of Contract Receivable Bound by Arbitration Clause

A trustee who sought "turnover" of amounts owed under a construction contract had an arbitration clause in that contract enforced against him. The Bankruptcy Court found that the bankruptcy exception to enforcement of an arbitration clause was narrow and did not apply to a construction dispute. Satija v.  Kella (In re Davila General Contractors, LLC), Adv. No. 21-1047 (Bankr. W.D. Tex. 3/9/22). The order can be found on CM/ECF at Docket #23.

What Happened

Davila General Contractors, LLC entered into an AIA Contract with Higginbotham Concepts, LLC to construct improvements for a Sun Auto Store. The contract contained an arbitration clause. Disputes arose between the parties and  Higginbotham sought to terminate the contract. Immediately prior to bankruptcy, Davila brought suit against Higginbotham seeking to recover over $158,000.

After Davila filed, the Trustee filed suit against Higginbotham for "turnover" of the contract receivable under 11 U.S.C. Sec. 542. Higginbotham filed a Motion to Abate Proceedings and Compel Arbitration. The Trustee responded that arbitration should not be compelled in a core proceeding and that the contract was no longer enforceable because it had been terminated and/or rejected. 

The Court's Ruling

The Court granted the Motion. The Court noted that in the Fifth Circuit, there is a two-part test for determining whether to allow arbitration.

First, the underlying nature of the proceeding must derive exclusively from the provisions of the Bankruptcy Code.  Second, requiring arbitration must conflict with the purposes of the Bankruptcy Code.

Order, p. 2. 

The Court found that labeling a cause of action as one for turnover was not sufficient since "Congress intended section 542 to apply to claims for tangible property and money due to the debtor without dispute which are fully matured and payable on demand, not to liquidate disputed contract claims." Order, p. 2 (cleaned up). Finally, the Court found that ordering arbitration would not conflict with the purposes of the Bankruptcy Code. "This is a chapter 7 case the goal of which is to liquidate assets and resolve claims. Both functions can be accomplished by arbitration." Order, p. 3. 

Finally, the Court found that terminating or rejecting the contract would not affect the arbitration clause. The Court noted that a party should not be able to escape the reach of an arbitration clause merely by breaching a contract (which is what rejection entails).  The Court also cited Nolde Bros. v. Loc. No. 358, Bakery & Confectionery Workers Union, AFL-CIO 8, 430 U.S. 243, 253-255 (1977) which holds that parties' obligations under an arbitration clause "survive contract termination when the dispute is over an obligation created by the expired agreement." Order, pp. 3-4.

Judge Davis declined to follow a contrary ruling by his Texas colleague Judge Stacy Jernigan.  The Trustee had relied upon Highland Capital Management v. Dondero (In re Highland Capital Management), 2021 Bankr. LEXIS 3314 (Bankr. N.D. Tex. 2021), which in turn had relied on Janvey v. Alguire, 2014 U.S. Dist. LEXIS 193394 (N.D. Tex. 2014). Judge Jernigan had denied arbitration based upon two grounds. The first was that the arbitration clause was contained within an executory contract which had been rejected. When an executory contract has been rejected, it can no longer be enforced through specific performance but rather the contract counterparty has a claim for damages. This ruling was grounded on a U.S. District Court opinion in the Stanford Ponzi Scheme litigation and an article by the renowned Prof. Jay Westbrook. Judge Davis found that when the Fifth Circuit affirmed the Janvey v. Alguire decision on other grounds it cautioned against relying on the broad rationale used by the District Court.  In his oral ruling, Judge Davis stated that while he was reluctant to disagree with Judge Jernigan and Prof. Westbrook, he had worked on the Stanford cases as a practitioner and federal equity receiverships were considerably different than bankruptcy cases. 

Judge Jernigan also had an alternative rationale that the parties had waited too long to request arbitration. That was not a factor in Judge Davis's case.

What Does It Mean?

Many contracts have arbitration clauses. Many bankruptcy lawyers (myself included) have little experience with arbitration. Nevertheless, arbitration is one of the items in a defendant's toolkit to move a dispute to a different tribunal. The Trustee's suit for turnover was essentially a suit for breach of a contract containing an arbitration clause. The Trustee could not simultaneously seek damages under the contract and disavow the part of the contract containing the arbitration clause.

I have three final thoughts here. 

First, when parties want to argue for or against arbitration in Texas bankruptcy courts, they now have opposing opinions from two well-respected Bankruptcy Judges. While the Davis opinion is considerably shorter than Judge Jernigan's ruling, it packs a lot of substance into a few pages.

Second, the arbitration clause was included in an AIA form contract which was presumably prepared by the Debtor. The pre-petition Debtor must have thought that arbitration would give it some benefit, although it later ignored the clause and filed suit in state court. Including an arbitration clause in a contract benefits both the party that put it there and the counterparty, either of whom can choose or enforce or ignore it. 

Finally, calling something an action for turnover does not transform a breach of contract claim into a core proceeding. I remember when bankruptcy lawyers would routinely sue to recover on accounts receivable and call the suit a turnover action. However, as aptly pointed out by Judge Davis, turnover only applies to tangible property, such as a car, liquidated, undisputed amounts. Labels are not magic and breach of contract suits are still non-core proceedings.

 (Author's note: Readers may be curious as to why I chose to write about an unpublished order containing little more than two pages of text. I was in Judge Davis's court for another matter and heard his oral ruling on this case and it sounded interesting so I decided to look it up.). 

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