United States: Bankruptcy Court Finds Arbitration Clause In Consumer Loan Contract To Be Sufficient Cause To Grant Relief From Automatic Stay

Last Updated: October 19 2018
Article by Jonah Wacholder and Daniel A. Lowenthal

When a bankruptcy petition is filed, an automatic stay comes into effect staying proceedings against the debtor or the debtor's property. 11 U.S.C. § 362(a). The stay centralizes litigation regarding the debtor and its property in the debtor's bankruptcy case. When contract entered into pre-bankruptcy contains an arbitration clause, a bankruptcy court will consider if the stay should be enforced or if the parties can resolve the matter in arbitration. In In re Argon Credit, LLC, No. 16-39654 (Bankr. N.D. Ill. Sept. 21, 2018), a bankruptcy court considered this question in a dispute between  two non-debtor parties concerning the validity of loans issued by the debtor and part of the debtor's estate. The bankruptcy court ruled that the arbitration clause was binding and ordered the stay lifted to permit arbitration to go forward.

The debtors, Argon Credit and Argon X ("Argon"), had made small consumer loans and financed its lending via a revolving line of credit agreement with Fintech. To guarantee repayment, Argon gave Fintech a security interest in Argon's receivables portfolio generated from its consumer loans. This security interest was ultimately assigned to Fund Recovery Services ("FRS").  Argon filed a chapter 11 petition in December 2016, and the case was later converted to chapter 7. FRS sought and was granted relief from the automatic stay to collect the receivables it was entitled to given its security interest, with FRS retaining the proceeds collected on the receivables up to the amount of its allowed claim against Argon, and the consumer loan contracts remaining property of the estate.

Some small California borrowers brought arbitration proceedings against FRS and First Associates, Argon's loan servicer, arguing that the loans they entered into are invalid because they didn't comply with California lending law. The loan contracts the borrowers had signed with Argon included broad mandatory arbitration clauses. The bankruptcy court had earlier concluded that these arbitration proceedings were covered by the automatic stay even though Argon itself was not a defendant, because the loan contracts were property of the estate and the borrowers sought declarations that the contracts were invalid. (The bankruptcy court noted some uncertainty as to whether such declarations would bind Argon, a non-party to the arbitrations, but concluded that there was some possibility that they would.)  The borrowers thus sought relief from the automatic stay to permit them to pursue the arbitration proceedings.

An applicant for relief from the automatic stay must show "cause." 11 U.S.C. § 362(d)(1). Relying on prior case law involving the application of the automatic stay to arbitration agreements, the bankruptcy court ruled that an otherwise-binding arbitration agreement is sufficient cause to lift the automatic stay as to a particular issue if the issue is a "non-core" issue, while such cause may not exist if the issue is a "core" issue. The court reasoned that since there is a strong federal interest in enforcing arbitration agreements, there must be a strong countervailing federal bankruptcy interest to overcome the arbitration agreement. Non-core proceedings, the court held, do not ordinarily implicate such strong federal bankruptcy interests.

Bankruptcy law divides proceedings between core proceedings and non-core proceedings. 28 U.S.C. § 157. The origin of this statutory distinction is the constitutional limits on the scope of a bankruptcy court's jurisdiction. Because the statutory definition is supposed to track the constitutional definition, the court first considered whether the issue regarding the loan contracts' validity was "core" as a matter of constitutional law. Relying on Stern v. Marshall, 564 U.S. 462, 499 (2011), the court held that an issue is constitutionally core if it "stems from the bankruptcy itself or would necessarily be resolved in claims allowance process." Because the invalidity claims did not stem from the bankruptcy nor sought relief from the debtor, but rather were state-law claims between third parties, the court concluded that they were not core as a matter of constitutional law.

The court noted that nonetheless the claims arguably fell within the statutory definition in section 157 of the Bankruptcy Code because they could be understood as "matters concerning the administration of the estate" or "other proceedings affecting the liquidation of the assets of the estate," since the loan contracts and their receivables were the estate's main assets. However, the court read these provisions narrowly to preserve a meaningful core/non-core distinction. It reasoned that because the contracts had been formed before the bankruptcy case was filed, and because the bankruptcy case was now a chapter 7 liquidation rather than a chapter 11 reorganization, adjudication of the validity of the contracts was not sufficiently entangled in the bankruptcy case to count as a core proceeding.

Because the court concluded that the invalidity claims were not core issues, the court granted the borrowers' motion for relief from the stay.

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