The Eastern District of Pennsylvania Bankruptcy Conference (“EDPABC”) is a nonprofit organization that was formed in 1988 to promote the education and interests of its members and the citizens of the Commonwealth of Pennsylvania residing in the ten counties within the United States District Court for the Eastern District of Pennsylvania. Members include lawyers, other professionals, and paraprofessionals who specialize in the practice of Bankruptcy and Creditors’ Rights law in the Eastern District of Pennsylvania. Please visit EDPABC’s website, www.pabankruptcy.org, for more information or to join the organization.
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Each year, the EDPABC’s Education Committee formulates challenging hypotheticals based on recent case law. At the EDPABC’s Annual Forum, typically held in late March/early April each year, professors from local law schools facilitate lively discussions among EDPABC members about the hypotheticals in small-group breakout sessions. The hypotheticals are always engaging—and sometimes deliberately ambiguous—to mirror the complexity of everyday practice and foster debate among even the most seasoned bankruptcy professionals.
The hypotheticals are accompanied by summaries of the underlying case law and other relevant authorities inspiring the fact patterns. The summaries are intended to give readers insights into how similar issues have been argued before and decided by the courts and to inform their answers to the questions presented in the hypotheticals.
This hypothetical from a previous Forum, titled “The Greasy Spoon,” describes the fictional bankruptcy of a small restaurant chain in the wake of the COVID-19 pandemic. The hypothetical raises questions around the intersection of adversary proceedings in bankruptcy court and mandatory arbitration provisions, as well as the enforceability of prepetition guarantees in connection with postpetition liabilities.
The Greasy Spoon: Case Problem
The Greasy Spoon, LLC (“Company”) is a Pennsylvania limited liability company based in Montgomery County, Pennsylvania, that has two members, Bob and Brian Greasy, a father and his son. Through the Company, the Greasys owned and operated three restaurants in and around Norristown, Pennsylvania.
When the COVID-19 pandemic hit in March of 2020, the Company was initially able to weather the storm, obtaining Paycheck Protection Program (“PPP”) loans, dipping into savings, and hanging on through the initial wave of shutdowns. However, as the pandemic wore on, the Company found itself in an ever more precarious financial situation due to a decided lack of outdoor seating at its three locations as well as limited takeout operations. As the pandemic headed into its second year, the Company’s losses ballooned, and the Greasys wondered how much longer they could hang on. Finally, on June 15, 2021, a fire broke out in the East Norriton restaurant, the Company’s most popular location, severely damaging the kitchen and necessitating a closing so that repairs could be made. In addition, the Company found it increasingly difficult to retain and hire new staff because of COVID-related staffing shortages. As a result of the loss of revenues and staffing difficulties, the Company decided that it could no longer continue; and on July 7, 2021, the Company shuttered the two remaining locations and filed for protection under Chapter 11 of the Bankruptcy Code in the U.S. Bankruptcy Court for the Eastern District of Pennsylvania. As of the petition date, the Company had a number of long-standing contracts with vendors providing goods and/or services to their restaurants.
Problem #1
Several years earlier, in an effort to manage costs and ensure twenty-four-hour service coverage, the Company entered into an agreement (“Services Agreement”) with Hot Air HVAC Company, a Delaware limited liability company operating out of Laurel Hill, New Jersey. Pursuant to the Hot Air Services Agreement, the Company would pay a monthly subscription fee of $1,000. In exchange, Hot Air would manage all of the Company’s heating, ventilation, and air-conditioning (“HVAC”) needs, which included maintenance of the Company’s oven vents as well as its heating and air-conditioning systems. Whenever a maintenance issue would arise, the Company would contact Hot Air, which contracted with local HVAC repairmen and would send a repairman out to immediately assess and begin making any necessary repairs. The Services Agreement contained the following provision:
In the event of a dispute between the Company and the Customer (the “Parties”) that arises from this Agreement or the services provided hereunder including, but not limited to, a payment dispute, the Parties agree to submit their dispute to binding arbitration under the authority of the Federal Arbitration Act and in accordance with the Commercial Arbitration Rules of the American Arbitration Association.
In the year preceding the bankruptcy, the Company had fallen behind on any number of payables. Among other things, the Company failed to timely make its monthly service payments under the Services Agreement with Hot Air. As of June 2021, the Company was approximately four months in arrears. On June 12, the oven vent at the East Norriton location suddenly stopped working during the busy Saturday morning breakfast lunch. Frantic to keep its most profitable location operating on its busiest day, Brian called Hot Air with a service request—but Hot Air informed Brian that until the Company paid its past-due service fees, Hot Air would not send anyone out to the location. As a result, over the phone, Brian paid the $4,000 for the four months of past-due invoices. Within a couple of hours, Hot Air sent out one of its subcontractors, who inspected and repaired the oven vent in time to salvage the Saturday evening dinner rush.
After the Company filed for bankruptcy protection, it quickly filed a number of motions seeking to reject executory contracts that were no longer needed now that the restaurants had closed. Among others, the Company filed a motion to reject the Hot Air Services Agreement, which the bankruptcy court granted as unopposed.
A couple of months after filing for bankruptcy protection, the Company learned that the subcontractor sent out by Hot Air had failed to properly wire a replacement fan in the oven vent, which was the cause of the devastating fire that had occurred just several days later. After considering its options, the Company filed an adversary complaint in the bankruptcy court against Hot Air, asserting claims for negligence and breach of contract and damages in the amount of $20,000. In addition, the Company asserted a preference claim under section 547 of the Bankruptcy Code, seeking to recover the $4,000 paid to Hot Air on June 12.
Hot Air timely filed a motion to dismiss for failure to state a claim, which was denied. After the motion to dismiss was denied and approximately three months after the complaint was filed, Hot Air filed an answer with affirmative defenses; the parties then engaged in some initial discovery, serving interrogatories, requests for documents, and requests for admissions. Thereafter, Hot Air served initial responses to the Company’s discovery requests and filed a motion to compel discovery after the Company failed to serve any responses.
Two months after filing its answer and shortly after it served discovery responses and filed its motion to compel discovery, Hot Air filed a motion to compel arbitration and to stay the adversary proceeding based on the arbitration clause. Hot Air argued that there is a strong federal policy favoring the enforcement of arbitration clauses. It further noted that it had not filed a proof of claim in the bankruptcy.
The Company argued that the arbitration clause was no longer enforceable because the Company had rejected the Services Agreement and a party cannot pursue specific performance from a trustee or debtor in possession. Accordingly, the Company asserted, Hot Air could not compel arbitration. Further, the Company argued, the adversary complaint also included a preference claim against Hot Air that is a core matter under the Bankruptcy Code. Accordingly, the Company reasoned that the bankruptcy court clearly had jurisdiction over Hot Air with respect to the preference claim and that the dispute should not be bifurcated, with some claims subject to arbitration and others remaining before the bankruptcy court. Such bifurcation, the Company asserted, would be inefficient and unduly burdensome to the bankruptcy estate. The Company also argued that to the extent that the arbitration clause could still be invoked, Hot Air had waived arbitration by failing to object to the rejection of the Services Agreement, filing an answer that failed to raise arbitration as a defense, engaging in discovery, and not raising the arbitration issue at all for several months.
Hot Air countered that whether or not the preference claim was “core” was immaterial because the claim had its genesis in a payment made by the Company to Hot Air under the Services Agreement, and any payment disputes under the Services Agreement are subject to arbitration. Accordingly, Hot Air argued, the claims did not need to be bifurcated at all, and the bankruptcy court should order that they all be arbitrated.
Questions for Problem #1
- Taking into account the parties’ arguments and relevant case law, should the bankruptcy court grant the motion to compel arbitration and order the parties to arbitration, notwithstanding the fact that the Company rejected the Services Agreement? Does it matter whether it is the debtor or the counterparty to a rejected contract that is seeking to compel arbitration?
- Putting aside the rejection of the Services Agreement, did Hot Air waive its rights under the arbitration clause by answering the complaint, participating in discovery, and waiting several months to file the motion to compel arbitration?
- Assume that Hot Air is also owed money for unpaid service charges and that, upon rejection of the Services Agreement, Hot Air filed a proof of claim for the service charges as well as liquidated rejection damages. Does Hot Air’s filing a proof of claim change the analysis on whether or not the court should compel arbitration?
- If the court orders the parties to arbitration, should the arbitration be limited to the negligence and breach of contract claims, or should it include the preference claim? If the court bifurcates the claims, should it stay the preference action until conclusion of the arbitration?
Summary of Legal Authorities for Problem #1
Highland Capital Management, L.P. v. Dondero (In re Highland Capital Management, L.P.)[1]
Background
The debtor, Highland Capital Management, L.P., commenced four separate adversary proceedings to collect tens of millions of dollars owed to it under certain promissory notes (collectively, “Note Adversary Proceedings”). Each note obligor was closely related to Highland’s former president, who himself was an obligor on three of the notes. The Note Adversary Proceedings were originally brought as breach of contract actions, but after the defendants raised certain affirmative defenses, the debtor amended its complaints to add claims for fraudulent transfers, declaratory judgments as to certain provisions of the debtor’s limited partnership agreement, breach of fiduciary duties, and aiding and abetting said breaches of fiduciary duties.
Thereafter, the former president, his wife, and a family trust that was one of the debtor’s largest partners (collectively, “Movants”) filed motions to compel arbitration relying on a mandatory arbitration provision in the limited partnership agreement, which also restricted the scope of discovery. They also sought to stay the litigation with respect to concededly nonarbitrable claims pending the completion of arbitration.
The debtor had previously rejected the limited partnership agreement under section 365 of the Bankruptcy Code. The debtor asserted, among other things, that (i) the rejection of the limited partnership agreement excused the debtor from mandatory arbitration, and (ii) the Movants had waived the right to arbitration by not invoking it earlier in the litigation. The debtor further argued that arbitration of some, but not all, of the debtor’s claims would be inefficient and a waste of resources.
Analysis
The court acknowledged the “wealth of federal case law dictating the strong federal policy undergirding the Federal Arbitration Act (“FAA”).”[2] The court noted that “the FAA reflects a liberal federal policy favoring arbitration and requires arbitration agreements to be rigorously enforced according to their terms.”[3] However, noting that other courts have wrestled with whether bankruptcy courts can treat arbitration provisions as “less mandatory” than other courts, the court observed that “bankruptcy cases are not like other lawsuits; they are multi-faceted, multi-party, and fast-moving.”[4] The court also explained that one of the primary purposes of bankruptcy is to provide a centralized forum for a debtor and creditors to resolve their claims in an orderly fashion.
The court pointed out that some courts, in determining whether to enforce arbitration provisions, apply a “core versus noncore” analysis. Those courts, when presented with a noncore dispute, find that they generally must enforce mandatory arbitration provisions. In contrast, when presented with a core dispute, they employ a test derived from the U.S. Supreme Court’s decision in Shearson/American Express, Inc. v. McMahon.[5] Under that test, a party seeking to avoid arbitration must show in enacting the relevant statute that Congress intended to preclude arbitration. Such a showing must be made based on (i) the statute’s text, (ii) its legislative history, or (iii) an inherent conflict and the underlying purpose of the statute.
However, the primary issue presented by the debtor was one that, according to the court, few other courts have addressed—namely, whether a contract counterparty can force a debtor to engage in arbitration where the underlying contract has been rejected. Relying primarily on a U.S. Court of Appeals for the Fifth Circuit decision involving a federal receivership, Janvey v. Alguire (discussed below),[6] the court concluded that the debtor could not be compelled to engage in arbitration under the rejected limited partnership agreement. According to the Janvey court, an arbitration provision is a classic executory contract with performance due on both sides since neither party has performed an arbitration provision when one party seeks to enforce it. Looking to bankruptcy jurisprudence, the Janvey court determined that it could not order arbitration under a rejected contract because injured parties under a rejected contract cannot insist on specific performance by a trustee.
The court noted that although Janvey involved a federal receivership and not a bankruptcy case, the Fifth Circuit looked almost exclusively to bankruptcy law. The court found the Fifth Circuit’s analysis in Janvey persuasive and potentially binding. The court noted that under section 365, “if a bankruptcy trustee rejects an executory contract, the rejection, of course, constitutes a breach of the contract and subjects the estate to a claim for money damages on behalf of the injured party.”[7] However, the court also concluded that the injured party cannot insist on specific performance by the trustee. “Instead, the injured party is treated as having a prepetition claim for damages arising as if the breach occurred immediately before the filing of the bankruptcy petition.”[8]
The question then becomes whether such prepetition claim must be liquidated through arbitration. According to the court, most courts dealing with arbitration provisions do not analyze them as classic executory contracts even though, in the view of Professor Westbrook, that’s exactly what they are.[9] Although arbitration provisions generally survive a contract, executory obligations may be avoided by a trustee under section 365; and, accordingly, because specific performance is not available against a trustee, arbitration provisions remain subject to rejection.
In following the Janvey court’s reasoning, the Highland Capital court rejected the reasoning of the bankruptcy court in In re Fleming Cos. (discussed below), which held that rejection does not prevent a party from enforcing an arbitration provision in the rejected contract.[10] The court noted that in Fleming, it was the debtor demanding arbitration, which the court found to be a significant distinction.
With respect to the debtor’s argument that the Movants had waived arbitration, the court noted that the Note Adversary Proceedings were filed in January 2021 and that, thereafter, the Movants had engaged in the litigation for eight or nine months before moving to enforce the arbitration provisions. Among other things, they had filed answers with affirmative defenses, moved to withdraw the reference, and attended hearings—all without ever raising the issue of arbitration. Moreover, they had served significant discovery far outside the scope permitted by the arbitration provisions. The court concluded that although courts in the Fifth Circuit often impose a presumption against waiving the right to arbitration, under the circumstances, the Movants’ belated attempt to enforce arbitration was prejudicial to the debtor.
Madison Foods, Inc. v. Fleming Cos. (In re Fleming Cos.)[11]
Background
The debtor filed a motion to compel arbitration and stay any related nonarbitrable claims. The debtor was a nationwide wholesale supplier of food and grocery products. The plaintiff had purchased a grocery store from the debtor prepetition. In connection with the sale, the plaintiff and the debtor entered into a facility standby agreement (“FSA”) containing an arbitration clause, as well as a number of related agreements and promissory notes. The debtor soon after filed a voluntary Chapter 11 petition and sought authority from the bankruptcy court to sell substantially all of its assets, including the notes, to a third-party buyer (“Buyer”). The debtor also rejected the FSA pursuant to section 365 of the Bankruptcy Code.
Thereafter, the plaintiff filed an adversary complaint against the debtor and the Buyer requesting various forms of relief, alleging that the notes were unenforceable due to fraud, breach of contract, and promissory estoppel. In response, the debtor moved to compel arbitration under the FSA, which provided that “[a]ll disputes . . . including any matter relating to this Agreement, shall be resolved by final binding arbitration in accordance with the Commercial Arbitration Rules of the American Arbitration Association.”[12] Both the Buyer and the plaintiff opposed arbitration.
The Buyer and the plaintiff asserted, among other things, that (1) the debtor waived arbitration by previously seeking a determination on an issue involving the FSA, and (2) the debtor breached the agreement by rejecting it pursuant to section 365.
Analysis
The court rejected the plaintiff and Buyer’s argument that arbitration had been waived. Although the debtor, in connection with the sale of its assets, had previously requested a determination of the enforceability of the consequential damages provision of the FSA, the court had refused to make such a determination, finding that the debtor was seeking an advisory opinion. Accordingly, the court determined that the plaintiff and the Buyer had failed to demonstrate any prejudice, which the U.S. Court of Appeals for the Third Circuit has established “is the touchstone for determining whether the right to arbitration has been waived.”[13]
On the issue of whether rejection of the FSA barred any effort by the debtor to compel arbitration, the court found that it did not. The court distinguished a case relied upon by the plaintiff and the Buyer that held that a debtor who rejected a contract could not thereafter sue for breach of contract under the agreement but could maintain a suit in equity for the return of funds that had not been earned by the defendant. In contrast, the court concluded, the debtor in Fleming was not seeking to compel payment or any substantive performance under the FSA but was only seeking to compel arbitration under the terms of the FSA.
The court looked to other decisions holding that a party can compel arbitration despite a rejection or breach of the underlying agreement, including the decision in Southeastern Pennsylvania Transportation Authority v. AWS Remediation, Inc. (discussed below).[14] The court found that rejection of a contract will not void an arbitration clause, in part because “[a]ny different conclusion would allow a party to avoid arbitration at will simply by breaching the contract.”[15] In addition, the court rejected an argument that resolution of the issue should turn on whether it is the nonbreaching party who is seeking to compel arbitration, observing that “[b]oth parties agreed to the method of dispute resolution and both parties should be able to take advantage of it.”[16] Accordingly, the court granted the debtor’s motion to compel arbitration and also stayed the nonarbitrable claims on grounds of judicial economy and to avoid inconsistent rulings.
Mintze v. American Financial Services, Inc. (In re Mintze)[17]
Background
In a Chapter 13 case, after a lender filed a proof of claim, the debtor brought an adversary proceeding to enforce a purported prepetition rescission of a loan agreement. The underlying loan agreement contained an arbitration clause that covered all claims and disputes arising out of or related to the loan. The creditor moved to compel arbitration. The parties stipulated that the matter was a “core” proceeding, and the bankruptcy court had found that because it was a core matter, it had discretion to deny arbitration. The district court affirmed.
Analysis
On appeal, the Third Circuit reversed, holding that the core versus noncore distinction has no bearing on whether a bankruptcy court has discretion to deny enforcement of an arbitration agreement. Rather, under McMahon, regardless of whether a dispute is core or noncore, the party opposing enforcement of the arbitration agreement has the burden of demonstrating congressional intent to preclude arbitration for the statutory rights at issue through (1) the statute’s text, (2) the statute’s legislative history, or (3) an inherent conflict between arbitration and the statute’s underlying purposes. The Third Circuit noted the strong federal policy in favor of arbitration. The court observed that the McMahon test establishes a high burden for the party opposing arbitration.
The court rejected the debtor’s argument that its decision in Hays & Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc.[18] stood for the proposition that a bankruptcy court lacks discretion to deny arbitration only in noncore matters. In Hays, the Third Circuit considered whether the Bankruptcy Code conflicts with the FAA “‘in such a way as to bestow upon a district court discretion to decline to enforce an arbitration agreement’ with respect to a trustee’s claims.”[19] The Third Circuit in Mintze noted that it held in Hays that “where a party seeks to enforce a debtor-derivative pre-petition contract claim, a court does not have the discretion to deny enforcement of an otherwise applicable arbitration clause.”[20] In Mintze, the Third Circuit clarified that the decision in Hays did not rest on the distinction between core and noncore proceedings, but rather “sought to distinguish between causes of action derived from the debtor and bankruptcy actions that the Bankruptcy Code created for the benefit of the creditors of the estate.”[21] Accordingly, the standard adopted in Hays and derived from the McMahon decision does not turn on the core versus noncore distinction.
The Third Circuit then went on to consider whether the debtor had satisfied her burden of establishing congressional intent to preclude arbitration. Finding no such intent in the statutory text or legislative history of the Bankruptcy Code, the Third Circuit analyzed whether there was an inherent conflict between arbitration and the Bankruptcy Code. The bankruptcy court had found that resolution of the debtor’s contract rescission claim would have an effect on the rights of other creditors that was sufficient to create an inherent conflict, but the Third Circuit disagreed. The debtor’s claims did not arise under the Bankruptcy Code, and, accordingly, with no bankruptcy issue to be decided by the bankruptcy court, there could be no conflict between arbitration and the Bankruptcy Code. In sum, the Third Circuit concluded that the bankruptcy court lacked discretion to deny arbitration. “The FAA mandates enforcement of arbitration when applicable unless Congressional intent to the contrary is established.”[22] Having failed to demonstrate such intent, the debtor’s attempt to avoid arbitration was denied.
Janvey v. Alguire[23]
Background
The Janvey decision, relied upon heavily by the bankruptcy court in Highland Capital (summarized above), arose in the context of an SEC-imposed receivership over several related entities. As part of the receivership, the receiver initiated suits against certain former employees asserting claims for fraudulent transfer and unjust enrichment. The employees then filed motions to compel arbitration. The motions were litigated up to the Fifth Circuit twice on issues related to the arbitration agreements before again being remanded to the district court to determine “whether the Receiver is bound by the arbitration clauses.”[24]
Analysis
Acknowledging the broad federal policy in favor of arbitration and the Supreme Court’s holding in McMahon, the court noted that there was little case law regarding the FAA and federal equity receiverships. The court examined the historical relationship between federal equity receiverships and bankruptcy law and determined that “because equity receivership law and bankruptcy law share similar roots regarding their successor rights, the Court will supplement the sparse equity receivership law by also examining relevant bankruptcy law.”[25]
The court then determined that the receiver could be bound by the arbitration agreements and considered whether the receiver had the right to reject the arbitration agreements. Analogizing to bankruptcy law, the court adopted the Countryman material breach test for determining whether a contract is an executory contract that may be rejected. Under that test, a contract is executory if either party’s failure to complete performance would constitute a material breach. The court concluded that “arbitration agreements must be analyzed as separate executory contracts, based on the nature of the agreement as well as arbitration caselaw regarding severability.”[26] The court, again relying on bankruptcy case law, found that upon rejection of an executory contract, the injured party cannot compel specific performance by a trustee. Finding that the receiver could and did reject the arbitration provisions, the court opined that forcing the receiver to adopt the arbitration provisions would be an unjust result, imposing a financial burden on the estate and valuing arbitration agreements above other contracts.
In light of the dearth of case law analyzing federal equity receiverships and arbitration agreements, the court looked to bankruptcy jurisprudence to determine whether arbitration of the receiver’s claims would conflict with the federal equity receivership statutory scheme. The court then discussed the Third Circuit’s analysis in Hays, noting that the Fifth Circuit had previously adopted the reasoning in Hays in determining that “where a core proceeding involves adjudication of federal bankruptcy rights wholly divorced from inherited contractual claims, the importance of the federal bankruptcy forum provided by the Code is at its zenith.”[27] Thus, the Fifth Circuit held that where a cause of action is not derivative of prepetition legal rights possessed by a debtor, the bankruptcy courts have discretion to determine whether arbitration is inconsistent with the Bankruptcy Code.
After examining the statutory history of federal equity receiverships, the court explained that the objectives of the receivership were equivalent to the objectives of the Bankruptcy Code—that is, “to marshal assets, preserve value, equitably distribute to creditors, and, either reorganize, if possible, or orderly liquidate.”[28] The court determined that “[f]or a bankruptcy court to be afforded discretion in refusing to enforce an arbitration clause, there must be a specific conflict with a central purpose of the Bankruptcy Code in arbitrating the particular claims at issue.”[29] The court held that there was a conflict because, among other things, the fraudulent transfer claims (i) would allow the receiver to protect creditors, (ii) were brought pursuant to federal statutes that gave the receiver special jurisdictional authorization, and (iii) were likely not viable outside of the receivership. Thus, the court determined that it had significant discretion and denied arbitration as contrary to the purposes of the receivership.
Camac Fund, L.P. v. McPherson (In re McPherson)[30]
Background
A creditor moved for stay relief to arbitrate claims against the Chapter 11 debtor pursuant to an arbitration clause in a prepetition funding agreement. Prepetition, the creditor had invoked the arbitration clause. The debtor filed a response disputing the enforceability of the arbitration clause before filing for Chapter 11 relief. The debtor then brought an adversary proceeding against the creditor, and the creditor requested that the bankruptcy court abstain from or stay the adversary proceeding in favor of the pending prepetition arbitration. The debtor asserted that all of the issues in the litigation overlapped with his reorganizational efforts such that the bankruptcy court should resolve the entire dispute between the parties. The creditor asserted that the arbitrator could resolve most, if not all, of the issues, and the bankruptcy court could then resolve the administration of any resulting claims.
Analysis
The court acknowledged that there was some merit to the debtor’s position that the Bankruptcy Code is intended “to facilitate a timely, cost-effective resolution of all claims asserted against a debtor,” which would be undermined by arbitration.[31] Nevertheless, although the court noted that it might be a “suboptimal” outcome, the court held that applicable law required bifurcation of the claims between the bankruptcy case and the prepetition arbitration matter.[32]
In considering the interplay between the FAA and the Bankruptcy Code, the court explained that “[t]he FAA and the Code both are grounded in important policy considerations concerning efficiency and fairness.”[33] On the one hand, the FAA reflects a strong federal policy in favor of arbitration that “reflects the reality that, at least in contracts subject to negotiation, the arbitration clause may be a critical piece of the parties’ bargain and integral to their cost-benefit analysis of the contract itself.”[34] On the other hand, the Bankruptcy Code “is not party- or contract-specific but seeks to balance the rights of many parties with many different contracts, rights, and interests involving a single debtor.”[35]
The court then acknowledged the applicability of the McMahon analysis and noted that some courts start the analysis by first determining whether the dispute involves core or noncore claims. However, the court also recognized that the core/noncore distinction is “not mechanically dispositive” and that matters involving a mix of core and noncore issues require additional analysis.[36] The court agreed with the line of cases holding that where a core claim is involved, bankruptcy courts have wider discretion to deny arbitration.
Finding that the dispute at hand involved both core and noncore claims, the court bifurcated the core and noncore claims, ordering the noncore claims to arbitration. Although the court expressed concerns that arbitration of the noncore claims carried the risk of interfering with the debtor’s reorganization efforts and could result in conflicting results, the court concluded that it was bound by U.S. Court of Appeals for the Fourth Circuit precedent strongly favoring arbitration. The court noted that had the bankruptcy been filed prior to the initiation of arbitration, the court might have come to a different conclusion.
Hoxworth v. Blinder, Robinson & Co.[37]
Background
In Hoxworth, the Third Circuit articulated standards for determining when a party has waived arbitration. Among other things, the court considered whether the defendants had waived their right to compel arbitration by actively litigating the case for almost a year prior to filing their motion to compel arbitration. Citing Gavlik Construction Co. v. H.F. Campbell Co., the Third Circuit noted that “prejudice is the touchstone for determining whether the right to arbitrate has been waived.”[38] The court observed that other courts have found that prejudice exists where a party substantially invokes “the litigation machinery” before pursuing arbitration.[39] Relevant factors include the timeliness or lack thereof of a motion to arbitrate, the degree to which the party seeking arbitration has contested the merits of its opponents’ claims, whether that party has informed its adversary of its intention to seek arbitration, the extent of its nonmerits motion practice, its assent to the district court’s pretrial orders, and the extent to which both parties have engaged in discovery.
Analysis
In Hoxworth, the Third Circuit affirmed the district court’s denial of arbitration on waiver grounds where the defendants had participated in numerous pretrial proceedings over more than eleven months; moved to dismiss the complaint for failure to state a claim; filed a motion to disqualify the plaintiff’s counsel; took depositions of the plaintiffs that would not have been available in arbitration; inadequately answered discovery requests, prompting additional motion practice; objected to a motion for class certification; and only moved to compel arbitration after their motion to dismiss was denied and the plaintiff’s motion to compel discovery was granted.
Nova Hut A.S. v. Kaiser Group International Inc. (In re Kaiser Group International, Inc.)[40]
Background
The appellant purchaser (“Nova”), who was sued by appellee debtors (collectively, “Kaiser”) in an adversary proceeding, appealed from the orders of the bankruptcy court denying its motions to stay the proceedings, to compel arbitration, and to dismiss the debtors’ third amended complaint. The bankruptcy court had denied arbitration on the basis that by filing a proof of claim in the bankruptcy case and pursuing litigation against a nondebtor affiliate in the Netherlands, Nova had waived arbitration. Nova filed a proof of claim but only invoked arbitration after the debtor objected to the proof of claim.
Analysis
The court reversed the bankruptcy court’s denial of arbitration, noting that “[t]he Third Circuit has recognized that prejudice is ‘the touchstone for determining whether the right to arbitrate has been waived.’”[41] The court found that in denying the arbitration, the bankruptcy court had not addressed whether Kaiser had established prejudice. Here, although Nova filed a proof of claim and did not seek arbitration until Kaiser filed an adversary proceeding, Nova never answered the complaint and moved for arbitration each time Kaiser amended its complaint. In addition, Kaiser did not demonstrate that any delay in pursuing arbitration was unreasonable or resulted in prejudice. Similarly, although Nova had initiated litigation against a nondebtor affiliate in the Netherlands, Kaiser failed to make any showing of actual prejudice, and it appeared that there was no discovery or litigation advantage for Nova.
Southeastern Pennsylvania Transportation Authority v. AWS Remediation, Inc.[42]
Background
On cross-motions for summary judgment, where the plaintiff had requested a declaratory judgment that a contract dispute between the parties was not subject to arbitration and the defendant sought to enforce a mandatory arbitration clause, the district court found in favor of the defendant and ordered arbitration.
Here, Amtrack and Southeastern Pennsylvania Transportation Authority (“Rail Companies”) had entered into a contract for environmental consulting with the debtor, a nonparty to the litigation, which subcontracted with the defendant to provide labor and materials. The defendant was not a party to the agreement, which contained a mandatory arbitration clause. In January 2002, the Rail Companies terminated the contract with the debtor, which then filed for bankruptcy relief. The bankruptcy court granted the debtor’s motion to reject the agreement. However, the bankruptcy court also approved the debtor’s sale of the accounts receivable owed to it by the Rail Companies under the contract to the defendant, which then filed a demand for arbitration in order to collect the receivables, leading to the filing of the adversary proceeding.
Analysis
After first determining that the debtor’s arbitration rights had been assigned to the defendant, the court turned to whether the Rail Companies’ prepetition termination of the agreement and the debtor’s postpetition rejection of the contract barred enforcement of the arbitration provisions. The court rejected the Rail Companies’ argument that an arbitration provision dies with the underlying contract. “While a rejection or termination of an agreement may affect the arbitrability of events that occur after the date of termination or rejection, it cannot change the remedial limitations applied to pre-rejection events.”[43] The court concluded that allowing a party to avoid arbitration by terminating a contract would render mandatory arbitration provisions illusory and that the same rationale applies to a debtor’s rejection of a contract in bankruptcy. The court also noted that the Rail Companies had undermined their own arguments by previously seeking a modification of the asset purchase agreement to allow them to pursue set-asides arising under the agreement, finding that it would be unfair to allow the Rail Companies to pursue set-asides under the agreement but bar the defendant from invoking its arbitration provisions.
Problem #2
Since 2010, the Company had contracted with Cream of the Crop Dairy (“Cream of the Crop”) for the provision of all of the Company’s dairy needs, including both dairy products and various refrigerator units for storing the Company’s dairy inventory. In 2012, at Cream of the Crop’s request, Bob signed an “Unconditional and Continuing Guaranty,” which provided thus:
Guarantor, for and in consideration of [Cream of the Crop’s] extension of credit to [the Company], hereby personally guarantees prompt payment of any and all obligations of the Company to Seller whether now existing or hereinafter incurred. Guarantor expressly binds himself to pay on demand any sum that is due from the Company to Seller whenever Company fails timely to pay the same. Guarantor expressly acknowledges and agrees that this guaranty shall be an absolute, continuing and irrevocable guaranty for such indebtedness to the Company.
In 2017, Bob filed a no-asset Chapter 7 bankruptcy case in order to address significant outstanding credit card debt. Although Bob had some assets, including his interest in the Company, all of his assets were either exempt or represented collateral for debts. As a result, shortly after the Chapter 7 case was filed and Bob’s 341 meeting concluded, Bob received a discharge, the Chapter 7 trustee filed a report of no distribution, and the Chapter 7 case was closed. However, Bob never scheduled his guaranty obligation to Cream of the Crop, believing it was unnecessary because at the time there were no outstanding amounts due from the Company to Cream of the Crop. Accordingly, Cream of the Crop never received formal notice of the Chapter 7 case.
In the several months preceding the Company’s Chapter 11 filing, the Company had received several shipments of dairy products for which it had not tendered payment, as well as several sliding-door dairy refrigerators to replace aging units at each of its locations. As a result, when the Company filed the Chapter 11 case, the Company held outstanding invoices from Cream of the Crop reflecting approximately $26,000 due and owing to Cream of the Crop. It was only after the Company filed for Chapter 11 protection and Cream of the Crop received notice as a creditor of the Company that Cream of the Crop undertook its own investigation and discovered Bob’s Chapter 7 case from several years prior.
Realizing that it was unlikely that its unsecured claim would be paid in full in the Company’s Chapter 11 case, Cream of the Crop moved to reopen Bob’s Chapter 7 case and then filed an adversary complaint seeking (i) a declaration that the postpetition invoices for goods provided to the Company created fresh liabilities under the guaranty that were not discharged in Bob’s Chapter 7 case (“Count I”) and (ii) a judgment against Bob for the debts incurred by the Company (“Count II”). Cream of the Crop took the position that Bob’s Chapter 7 discharge did not extinguish his liability for the postpetition extensions because such liabilities arose postpetition.
Bob objected to Cream of the Crop’s attempt to impose liability, asserting that all debts arising under the guaranty, whether matured or contingent, were discharged in 2017. Bob also asserted that, notwithstanding his failure to schedule Cream of the Crop in his Chapter 7 schedules, at some point Cream of the Crop became aware of the bankruptcy: the Company’s general manager was aware and informed the Company’s vendors, and many of the vendors requested new payment terms after the Chapter 7 case concluded. Cream of the Crop insisted that it had no knowledge of the Chapter 7 case until 2021, after the Company filed the Chapter 11 case. It asserted that debt owing to Cream of the Crop was nondischargeable under section 523(a)(3) of the Bankruptcy Code and, therefore, was not discharged under section 727(b) of the Bankruptcy Code. Cream of the Crop moved for summary judgment.
Questions for Problem #2
- Did Cream of the Crop’s claim against Bob arise prior to or after his Chapter 7 case?
- Why is or is not the debt giving rise to Cream of the Crop’s claim against Bob nondischargeable pursuant to section 523(a)(3) of the Bankruptcy Code?
- Was the debt discharged under section 727(b) of the Bankruptcy Code?
- Assume the court finds that Cream of the Crop’s claims arose prior to the Chapter 7 case and thus were dischargeable. Given the dispute over whether Cream of the Crop had notice of the Chapter 7 case, can the court grant summary judgment in favor of either party?
- Does the bankruptcy court have jurisdiction over Count II?
Summary of Legal Authorities for Problem #2
Jeld-Wen, Inc. v. Van Brunt (In re Grossman’s Inc.)[44]
Background
The successor in interest to a reorganized Chapter 11 debtor brought an adversary proceeding to enjoin the prosecution of asbestos-related claims asserted against it as well as a determination that its liability for such claims had been discharged. In 1977, the appellee remodeled her home using products containing asbestos, which were purchased from a home improvement retailer called Grossman’s (“debtor”). In 1997, the debtor filed for protection under Chapter 11. The debtor provided notice of its claims bar date by publication, but there was no specific reference to potential future asbestos liability. The debtor’s Chapter 11 plan was confirmed in December 1997. The appellee did not file a proof of claim because she was unaware that she had any claim. It was not until she was diagnosed with mesothelioma in 2007 that she filed an action against the debtor’s successor. The successor moved to reopen the Chapter 11 case for a determination that its liability on the claims had been discharged.
Relying on Third Circuit precedent, the bankruptcy court held that the debtor’s confirmed Chapter 11 plan did not discharge the claims because they arose after the petition date. In Avellino & Bienes v. M. Frenville Co. (In re M. Frenville Co.),[45] the Third Circuit had held that a “claim,” as defined by the Bankruptcy Code, arises when the underlying state law cause of action accrues. Because applicable New York law provides that an asbestos-related personal injury cause of action does not accrue until the injury manifests itself, the appellee’s claim did not accrue until after the debtor’s bankruptcy had been filed. The district court affirmed.
Analysis
On appeal in Grossman’s, the Third Circuit reexamined its decision in Frenville, which involved a litigation brought by four banks against the debtor’s former accountants, alleging that the accountants had recklessly prepared the debtor’s prepetition financial statements and seeking damages for the resulting losses. The accounting firm then filed an adversary complaint in the bankruptcy court seeking relief from the automatic stay to implead the debtor as a third-party defendant in order to seek indemnification. In Frenville, the bankruptcy court and the district court both found that the automatic stay barred the adversary proceeding, but the Third Circuit reversed on appeal. It held that the automatic stay, which applies only to prepetition claims, was inapplicable to the action because, under New York law, the accounting firm’s claim for indemnification did not arise until after the banks filed suit. In Frenville, the Third Circuit established the “accrual test” for determining when a “claim” arises under the Bankruptcy Code. Under the accrual test, the existence of a claim depends on (1) whether the claimant possesses a right to payment and (2) when that right arose, as determined by reference to applicable nonbankruptcy law.
In Grossman’s, the Third Circuit acknowledged that both the bankruptcy court and the district court had correctly applied the accrual test to determine that the appellee’s claims arose postpetition when she became ill, not prepetition when she purchased the offending products. However, the Third Circuit concluded that it should abandon the accrual test. The court noted that the other courts of appeal had uniformly declined to follow Frenville, which had been described as “one of the most criticized and least followed precedents decided under the current Bankruptcy Code.”[46] Those courts criticized Frenville for its conflict with the Bankruptcy Code’s “expansive” treatment of the definition of claim, noting that both congressional reports and the U.S. Supreme Court have indicated that the term should be afforded the broadest possible scope.[47] The Third Circuit agreed that “[t]he accrual test in Frenville does not account for the fact that a ‘claim’ can exist under the Code before a right to payment exists under state law.”[48]
Considering the implications of when a claim arises under the Bankruptcy Code—including the effect that such a determination has on both the automatic stay and dischargeability of claims—and noting, in particular, the significant due process issues at play, the Third Circuit looked to the reasoning of other courts and explained that there are generally two lines of cases on the issue. The first line of cases applies the “conduct test,” under which a claim arises when the acts or conduct giving rise to the claim occur, not when the injury caused by the conduct manifests itself. The second line of cases applies the “prepetition relationship test,” under which a claim arises from a debtor’s prepetition conduct, but only where there is also some prepetition relationship. The prepetition relationship test is intended to allay due process concerns—namely, that under the conduct test, a claim could be discharged without the creditor ever receiving notice.
After examining the various approaches taken by courts on the issue, the Third Circuit noted that “there seems to be something approaching a consensus among the courts that a prerequisite for recognizing a ‘claim’ is that the claimant’s exposure to a product giving rise to the ‘claim’ occurred pre-petition.”[49] The Third Circuit then held that “a ‘claim’ arises when an individual is exposed pre-petition to a product or other conduct giving rise to an injury, which underlies a ‘right to payment’ under the Bankruptcy Code.”[50]
Reinhart FoodService L.L.C. v. Schlundt (In re Schlundt)[51]
Background
In 2003, the debtor signed a personal guaranty in favor of Reinhart FoodService L.L.C. (“Reinhart”), guarantying his business’s debts under a supply agreement with Reinhart. The guaranty contained the following language:
I, David Schlundt, for and in consideration of your extending credit at my request to The Refuge, LLC personally guarantee prompt payment of any obligation of the Company to Reinhart FoodService, Inc. (“Seller”), whether now existing or hereinafter incurred, and I further agree to bind myself to pay on demand any sum which is due by the Company to Seller whenever the Company fails to pay same. It is understood that this guaranty shall be an absolute, continuing and irrevocable guaranty for such indebtedness of the Company.[52]
In 2014, the debtor and his wife filed for protection under Chapter 7 of the Bankruptcy Code. The Chapter 7 case was a no-asset case, no bar date was ever set, and the debtor received a discharge. The debtor never scheduled Reinhart as a creditor. The debtor asserted that Reinhart must have learned of the bankruptcy while it was pending or shortly after. Reinhart asserted that it did not learn of the bankruptcy until 2018 and that had it known earlier it would have required new security.
In 2018, the debtor’s business obtained additional goods and services from Reinhart but shuttered its operations without ever paying its approximately $36,000 debt to Reinhart. Reinhart sought to reopen the debtor’s Chapter 7 case to obtain a declaratory judgment that the credit advances constituted a fresh liability under the guaranty such that the debtor’s liability was not discharged in the prior Chapter 7 case. Reinhart moved for summary judgment, and the debtor objected, asserting that all amounts due under the personal guaranty, whether matured or contingent, were discharged in 2014.
Reinhart initially sought a declaration that the debt was nondischargeable pursuant to section 523(a)(3) but thereafter adjusted its argument, relying solely on section 727(b). In sum, Reinhart asserted that the debtor’s liability for the 2018 invoices instead arose at the time Reinhart extended credit. The debtor argued that the 2014 discharge extinguished any and all personal liability to Reinhart and, in the alternative, that there were genuine issues of material fact regarding Reinhart’s lack of notice.
Analysis
The court noted that two views have developed on this issue regarding prepetition guaranties. The first view holds that a debtor’s discharge does not extinguish personal liability for postpetition credit extensions. The second view holds that all debts, including postpetition liabilities, arising under a prepetition guaranty are contingent claims that may be discharged in bankruptcy.
The court noted that the U.S. Court of Appeals for the Seventh Circuit has adopted the “conduct test” for determining whether a claim arose prepetition or postpetition.[53] Under that test, the date that the claim arose is determined by looking to the conduct that gave rise to the claim. The court determined that under Seventh Circuit precedent, the conduct that gives rise to a claim under a contract is generally the signing of the contract; and, therefore, liability arises on the date that a contract is signed. The court found that this is most consistent with the Bankruptcy Code’s definitions of claim and debt and that, “under most circumstances, finding that a claim arose ‘at the earliest point possible’ will best serve the policy goals underlying the bankruptcy process.”[54] Although some courts also require a prepetition relationship in order to address due process concerns, the Seventh Circuit has not determined whether such relationship is always required.
In this case, the court found that even under the relationship inquiry, Reinhart’s claim arose prepetition because he had a prepetition relationship with the debtor. In distinguishing cases relied upon by Reinhart, the court noted that in each of those cases the court relied primarily on state law and that, although not necessarily identified by name, those courts utilized the accrual theory instead of the conduct test. The court, “mindful that the bankruptcy discharge is meant to afford debtors a fresh start,” concluded that the earliest conduct between the debtor and Reinhart was the signing of the guaranty and, accordingly, the debt was dischargeable in 2014.[55]
With respect to notice, the court determined that it did not need to make any factual determination. Reinhart could not state a claim for relief because under the plain language of section 523(a)(3), in a no-asset, no-bar-date bankruptcy case, “garden variety debts” do not fall within the scope of section 523(a)(3).[56]
Russo v. HD Supply Electrical, Ltd. (In re Russo)[57]
Background
In June 2011, the debtor’s company (“Company”) executed a credit application with the defendant (“HD Supply”), and the debtor executed a “Continuing Personal Guaranty.” In November 2011, the debtor filed for relief under Chapter 7 of the Bankruptcy Code. The debtor scheduled HD Supply as a general unsecured creditor, although he never formally revoked his guaranty and there was some dispute over whether HD Supply received notice of the bankruptcy. In March 2012, the debtor obtained his discharge. Thereafter, HD Supply delivered over $20,000 in products to the Company. After the Company failed to pay for the products, HD Supply sent a collection letter to the Company demanding payment and stating that the debtor was personally liable. The debtor filed an adversary complaint alleging that HD Supply violated the discharge injunction by sending the demand letters, and both parties moved for summary judgment. HD Supply argued that the continuing nature of the guaranty encompassed all future transactions and that because the debtor never revoked the guaranty in writing, he remained liable for post-discharge obligations incurred by the Company.
Analysis
The court noted that “[c]ourts have recognized that a personal guaranty is the classic example of a contingent liability because the guarantor’s liability is triggered only if the principal obligor has failed to satisfy its debt.”[58] Accordingly, the court found that on the date that the debtor filed for bankruptcy, HD Supply held a contingent claim against the debtor for any future indebtedness that the Company might incur but fail to pay. Even though the future indebtedness had not been incurred at the time of the bankruptcy case, the claim itself existed by virtue of the debtor’s prepetition execution of the guaranty. The court observed that other courts have come to the same conclusion, including one that stated that courts “universally recognize that claims are contingent as to liability if the debt is one which the debtor will be called upon to pay only upon the occurrence or happening of a future event.”[59] The future events that triggered the debtor’s liability were HD Supply’s postpetition extensions of credit and the Company’s failure to pay. Upon notice of the bankruptcy, HD Supply could have demanded a new personal guaranty. The court rejected any assertion that a debtor’s liability under a guaranty does not arise until the credit to the principal obligor is actually extended, finding that such an interpretation would “conflict[] with the broad definition of ‘claim’ [in the Bankruptcy Code] and is contrary to the very notion of a continuing guaranty.”[60]
However, although the court granted summary judgment in favor of the debtor as to whether HD Supply’s claim was subject to discharge, the court denied summary judgment in favor of the debtor as to whether HD Supply had actual notice of the bankruptcy. The court concluded that HD Supply’s alleged lack of notice was relevant to the issue of whether the claim was actually discharged under 11 U.S.C. § 523(a)(3).
In re Lipa[61]
Background
The debtor and his wife filed for Chapter 7 relief in December 2004 and received a discharge in March 2005. In 1997, the debtor had signed a personal guaranty with a building supply company pursuant to which he guaranteed the debts of his drywall company. Five years after the bankruptcy, the supplier filed suit against the debtor to enforce the guaranty. A couple of months later, the debtor moved to reopen the Chapter 7 case and sought damages for violation of the discharge injunction. The court granted the motion, and the supplier moved for reconsideration.
Analysis
The court noted that Congress gave the terms debt and claim “the broadest possible definitions so as to enable the debtor to deal with all legal obligations in a bankruptcy case.”[62] Although “[t]he term ‘contingent’ is not defined in the Bankruptcy Code, . . . courts have concluded that contingent claims are those in which a debtor will be required to pay only upon the occurrence of a future event triggering the debtor’s liability.”[63] Accordingly, because claim is defined to include “contingent” claims under the Bankruptcy Code, “a right to payment that is not yet enforceable under non-bankruptcy law at the time of the bankruptcy filing may still constitute a claim that is dischargeable in the bankruptcy case.”[64]
Quoting In re Pennypacker,[65] the court observed that “[g]enerally, ‘[t]he classic example of a contingent debt is a guaranty because the guarantor has no liability unless and until the principal defaults.’”[66] Looking to other cases, the court explained that “a broad definition of claim allows a bankruptcy court to deal fairly and comprehensively with all creditors in the case and, without which, a debtor’s ability to reorganize would be seriously threatened by the survival of lingering remote claims and potential litigation rooted in the debtor’s prepetition conduct.”[67]
Relying primarily on the broad definitions of debt and claim in the Bankruptcy Code, the court rejected other courts’ analysis to the contrary and held that the debtor’s liability under the guaranty, including for postpetition extensions of credit, had been discharged in the Chapter 7 case.
Republic Bank of California v. Getzoff (In re Getzoff)[68]
Background
In November 1991, the accounting firm (“Firm”) owned by the debtor signed a promissory note and obtained a loan for $250,000 from the Republic Bank of California (“Bank”). On the same day, the debtor signed a continuing guaranty of the Firm’s obligations under the note. Under the guaranty, the debtor promised to pay any and all indebtedness owing from the Firm to the Bank, including
any and all advances, debts, obligations and liabilities of Borrowers or any one or more of them, heretofore, now, or hereafter made, incurred or created, whether voluntary or involuntary and however arising, whether direct or acquired by Bank, by assignment or succession, whether due or not due, absolute or contingent, liquidated or unliquidated, determined or undetermined . . . .[69]
In April 1992, the debtor and his wife filed for protection under Chapter 7 of the Bankruptcy Code. In May 1992, the Bank and the Firm entered into an agreement pursuant to which the indebtedness under the original note was reduced to $213,000 and the loan was extended. On the same date, the parties entered into a new note, and the debtor executed a new guaranty identical in form to the original guaranty. In December 1992, the Bank asked the debtor to execute a reaffirmation agreement, but the debtor did not comply. The Firm made payments on the new note until July 1993. In January 1994, the Firm and the Bank agreed to stipulate to a judgment allowing the Firm to extend the date for repayment until April 1998. However, after the documents were prepared, the debtor asserted that his personal guaranty had been discharged, so the Bank filed an adversary complaint seeking a declaration from the bankruptcy court that the second guaranty was a postpetition obligation that had not been discharged. Both parties filed motions for summary judgment.
The bankruptcy court granted summary judgment in favor of the debtor. The bankruptcy court concluded that the Bank had given additional consideration in exchange for the second guaranty. However, the court held that execution of the second guaranty was an improper attempt to reaffirm discharged debt without following the requirements of section 524(c) and (d) of the Bankruptcy Code.
Analysis
On appeal, the U.S. Court of Appeals for the Ninth Circuit Bankruptcy Appellate Panel (“BAP”) noted that a debtor may voluntarily repay a discharged debt and may also enter into an agreement with a creditor to reaffirm an otherwise dischargeable debt. However, in order for such agreement to be enforceable, it must be made in compliance with section 524(c) and (d) of the Bankruptcy Code, which encompasses five requirements:
- the agreement must be made prior to discharge;
- the agreement must advise the debtor that the reaffirmation may be rescinded up to sixty days after it is filed;
- the agreement must be filed with the court;
- the debtor cannot already have rescinded the agreement within the proper time frame; and
- the agreement must be in the best interest of the debtor.[70]
The purpose of these requirements is to protect debtors from creditor coercion, and reaffirmation agreements are not favored by the courts. Accordingly, any reaffirmation agreement that does not comply fully with section 524 is void and unenforceable.
Here, the Bank acknowledged that it had not complied with section 524. However, the Bank argued that the second guaranty was not a promise to repay a discharged debt. Instead, it was a new promise in consideration for the Bank’s promise to extend the terms of the loan to the debtor’s Firm. According to the Bank, since section 727 only discharges prepetition debt, the second guaranty was not discharged because it arose after the debtor’s bankruptcy was filed.
The BAP disagreed, noting not only the broadness of the definition of debt under the Bankruptcy Code but also the broadness of the scope of debts covered by the first guaranty itself. In other words, prepetition, the first guaranty made the debtor contingently liable for any obligation “now or hereafter made” to the Bank; and, accordingly, such debt was discharged.[71] Further, the second note was merely a continuation of the first note; and by executing the second guaranty, the debtor effectively assumed the continuing guaranty obligation that had been discharged in his Chapter 7 case. Because he could not do so without following the requirements of section 524, the Bank could not recover that discharged debt.
Although the bankruptcy court here found that there was new consideration, the BAP found that under section 524(c), if the debtor’s consideration is based in whole or in part on a discharged debt, then a reaffirmation agreement must be filed with the court. The fact that the Bank gave new consideration was immaterial where the debtor’s new consideration was a promise to pay discharged debt.
Orlandi v. Leavitt Family Ltd. Partnership (In re Orlandi)[72]
Background
The debtor owned an entity called Studio 26 Salon, Inc. (“Studio 26”), which in September 2005 entered into a commercial lease with the defendant (“Landlord”). The debtor also executed a personal guaranty of the lease. In July 2008, the debtor and his wife filed for protection under Chapter 7 of the Bankruptcy Code, and they received a discharge in November 2008. In March 2011, after exercising a five-year extension option under the lease, Studio 26 vacated the space prior to the expiration of the lease, and the Landlord sued the debtor in state court for almost $25,000 in unpaid rent. The debtor answered in state court, asserting his bankruptcy discharge as an affirmative defense. Thereafter, the debtor filed a motion to reopen his bankruptcy case, which was granted in November 2016, resulting in a stay of the state court litigation. In January 2017, the debtor filed an adversary complaint against the Landlord, asserting that his guaranty had been discharged and that the Landlord had violated the discharge injunction.
The Landlord filed a motion for summary judgment asserting that the lease extension renewed the personal guaranty and that the lease extension contained a survivability clause that superseded the bankruptcy filing and discharge. The bankruptcy court denied the motion for summary judgment and, following trial, entered judgment in favor of the debtor.
Analysis
On appeal, the U.S. Court of Appeals for the Sixth Circuit BAP agreed with the bankruptcy court. Like other courts considering the issue, the BAP stated that whether the personal guaranty was discharged turned on whether it constituted a prepetition debt under the Bankruptcy Code. The BAP also noted that there are two lines of cases on the issue, with some courts concluding that absent some affirmative action by a debtor to revoke a guaranty, a guaranty may be enforced as to obligations incurred postpetition, and with other courts concluding that a prepetition guaranty is a contingent claim that is discharged in bankruptcy. The BAP agreed with the latter line of cases, noting that the terms debt and claim, as defined in the Bankruptcy Code, are afforded the broadest interpretations available in order to ensure the promise of a fresh start.
One distinguishing feature of this case is that, unlike many other similar cases, there was no dispute that the debtor had scheduled the guaranty in his bankruptcy case and that the Landlord had notice of the bankruptcy. The BAP opined that when the lease extension was executed, the Landlord should have requested that the debtor reaffirm the guaranty or execute a new guaranty. The BAP did not address whether a newly executed guaranty would run afoul of section 524(c).
In re Shaffer[73]
Background
David Osbourn and Michael Shaffer (together, “Debtors”) were part owners of St. James Electric, LLC (“St. James”). In 2011, St. James submitted a credit application to plaintiff Dulles Electric (“Dulles”) to obtain credit for future purchases. The Debtors each signed a personal guaranty pursuant to which they guaranteed the debts owed by St. James to Dulles. In November 2013, each of the Debtors filed a petition for relief under Chapter 7 of the Bankruptcy Code. They each obtained a discharge in February 2014. Neither expressly revoked their personal guaranties. Thereafter, St. James continued to operate, and Dulles continued to supply materials on credit. In March 2015, St. James filed a petition for relief under Chapter 7 of the Bankruptcy Code, scheduling a debt owed to Dulles in the amount of $20,000. No assets were available, and the case was closed in May 2015. Thereafter, Dulles reopened the Debtors’ Chapter 7 cases and filed adversary complaints against each of the Debtors, seeking declaratory judgments that their personal guaranties were not discharged.
Analysis
The bankruptcy court first noted that the Fourth Circuit follows the conduct test for determining when a debt arises—namely, that a debt arises when the conduct giving rise to the debt occurs. However, the court explained that “[a]lthough the existence of a claim is determined by the Bankruptcy Code, the timing of the creation of the liability is determined by nonbankruptcy law.”[74]
The court discussed the distinction between a “restricted guaranty” and a “continuing guaranty” under Virginia law, noting that the distinction is important in bankruptcy cases.[75] The court concluded that under a continuing guaranty, each transaction is considered a separate, unilateral contract; and, accordingly, the contingent liability arises when the loan is made, not when the guaranty is executed. “Logically, the conduct which gives rise to the contractual obligation can only occur if credit is extended and a default occurs.”[76] Therefore, the signing of a guaranty by itself does not obligate a guarantor if credit is never extended. “Under a continuing guaranty, it is unknown what future extensions may be made and thus the liability as of the signing of the guaranty is not ascertainable.”[77] Accordingly, the court held that the debts at issue did not arise until the credit was extended and therefore had not been discharged.
National Lumber Co. v. Reardon (In re Reardon)[78]
Background
In December 2009, the debtors, James and Jeanine Reardon (together, “Debtors”) filed a joint petition for relief under Chapter 7 of the Bankruptcy Code. The Chapter 7 trustee filed a report of no distribution, and the case was closed in July 2010. In September 2015, the Debtors moved to reopen their case to amend their schedules to add previously omitted creditors—namely, National Lumber Company (“National”)—and the motion was granted. Thereafter, National filed an adversary complaint alleging that in 2007 the Debtors delivered two personal guaranties with respect to extensions of credit by National to Beechwood Village Realty Trust (“Trust”). The complaint further alleged that the Debtors had never revoked the guaranties, did not schedule National as a creditor, and did not provide notice to National of the bankruptcy; and that in reliance on the personal guaranties, National had extended postpetition credit to the Trust in the amount of $775,000, of which $56,000 remained outstanding.
In March 2007, the Trust, as borrower, had entered into a construction loan agreement with National, as lender, in the principal amount of $230,000, in order to complete a model home at a development owned by the Trust. The Debtors signed a guaranty for the loan. It was undisputed that the construction loan had been paid in full. It was also undisputed that following the filing of the Debtors’ bankruptcy, National had sold goods to the Trust for which there remained a balance of $56,000. National sought (i) a declaration that the Debtors’ liability for the postpetition advances was not discharged and (ii) a money judgment against the Debtors for the amount due.
The Debtors admitted to executing the guaranty. They further admitted that they did not schedule National as a creditor, asserting that the omission was inadvertent. The Debtors alleged that National nevertheless had notice of the bankruptcy and denied that National had relied on the guaranty in extending additional credit to Beechwood. The Debtors also asserted the affirmative defense that the bankruptcy discharged any liability that they had under the continuing guaranty.
Analysis
Following a trial, the bankruptcy court determined that it did not have jurisdiction over National’s request for a money judgment but found that it did have jurisdiction to determine whether the Debtors’ obligations under the guaranty were extinguished by their discharge. The court summarized the primary issue thus: “With respect to a debtor’s liability under a prepetition guaranty for a postpetition extension of credit, the question is whether the debt arose when the guaranty was executed or when credit was later extended to the principal obligor.”[79] The court agreed with the reasoning of In re Jordan[80] that the question of when a debt arises is one of federal law, but its determination is informed by state law. The court found that under Massachusetts law, a continuing guaranty is seen as “giving rise to a divisible series of individual transactions, with liability for each extension of credit arising at the time of its extension.”[81] However, the court concluded that based on its terms, the guaranty at issue was actually a restricted guaranty that was limited to amounts due under the construction loan.
Weeks v. Isabella Bank Corp. (In re Weeks)[82]
Background
The debtor filed an adversary complaint against Isabella Bank Corp. (“Bank”) alleging that the Bank violated his discharge injunction. The Bank moved for summary judgment. The debtor owned a family medical practice (“Practice”). The Practice had a lending relationship with the Bank going back to 2002, with the debtor guarantying all indebtedness owing from the Practice to the Bank. The debtor and his wife filed for relief under Chapter 7 in February 2005. At the time, the Practice’s indebtedness to the Bank consisted of a $50,000 term loan and a $100,000 line of credit. In June 2005, the Bank renewed the line of credit when it came due and required the debtor to execute a new guaranty, only days after he had received his discharge. The term loan would not come due until 2009.
Fifteen months after the renewal, the line of credit had expired, and the Practice was unable to pay it down. As a result, the Bank consolidated the line of credit and the term loan into a new term note with a maturity date of September 2011. At the same time, the Bank required the debtor to execute a new guaranty. A few weeks later, the Practice ceased operations; and, thereafter, the debtor made seventeen regular payments before advising the Bank that he would no longer make any more payments. The Bank then began demanding payment, which the debtor contended violated his discharge injunction.
Analysis
The court began by pointing out that although section 727(b) of the Bankruptcy Code generally discharges all prepetition debt, a debtor may nonetheless enter into an agreement to pay such debt provided such agreement satisfies the requirements of section 524(c) of the Bankruptcy Code. The debtor asserted that his discharge relieved him of any liability under his prepetition guaranties and that the two postpetition guaranties that he executed were unenforceable because they were reaffirmation agreements that failed to comply with the requirements of section 524(c). The Bank contended that the postpetition guaranties were not reaffirmation agreements because they did not and could not have complied with section 524(c); furthermore, the Bank contended that the postpetition guaranties were enforceable because the Bank had provided new consideration in the form of extending the terms of the loans.
The court noted that section 524(c) is “not artfully drafted” and, “[i]ndeed, it would appear that a comma and an ‘and’ are missing.”[83] However, the court determined that section 524(c) nonetheless clearly prohibits connecting postpetition agreements with previously discharged debt other than as permitted therein. In other words, although a lender is free to enter into a lending relationship with a newly discharged debtor, section 524(c) strictly prohibits creditors from using a new loan to leverage payment of a previously discharged debt. The court observed that the parties had focused on whether the postpetition guaranties were subject to the requirements of section 524(c), but the court explained that it first needed to determine the implications of the prepetition guaranties because whether the postpetition guaranties were unenforceable reaffirmation agreements would be totally irrelevant if the discharge did not extinguish the debtor’s liability under the prepetition guaranties for the Bank’s alleged extension of postpetition credit.
The court rejected the reasoning of the Ninth Circuit BAP in Getzoff that the broad definition of claim in the Bankruptcy Code means that a debtor’s discharge extends to postpetition advances of credit under a prepetition guaranty. The court described such reasoning as “problematic” because it would permit the debtor to guaranty a hypothetical new equipment loan had he never previously guaranteed any obligations but render unenforceable any guaranty for such new equipment had the Bank had the “unfortunate foresight” to include future indebtedness under the prepetition guaranties.[84] According to the court, since a reaffirmation agreement must be entered into prior to discharge, the Bank would have had to have realized during the relatively short time frame of the debtor’s bankruptcy that it would need a reaffirmation agreement if it ever intended to extend additional credit postpetition. From the court’s perspective, the more practical resolution would be to require a debtor to affirmatively revoke a continuing guaranty in order to escape liability for future advances. Thus, the debtor had a choice to make—postpetition, he simply could revoke the guaranty and risk the possibility that the Bank would not extend new credit to the Practice.
However, the court also concluded that the Bank never made a new loan with respect to the prepetition term loan but simply modified the loan when it consolidated the unmatured term loan with the extended line of credit. Since the debtor’s obligation on the term loan arose prepetition and had not been reaffirmed pursuant to section 524(c), the court denied summary judgment and allowed the debtor to proceed with his claims with respect to the term loan.
11 U.S.C. § 101(12)
The term “debt” means liability on a claim.
11 U.S.C. § 101(5)
The term “claim” means—
- right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured; or
- right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured.
11 U.S.C. § 523(a)(3)
A discharge under section 727, 1141, 1192, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt—
. . .
(3) neither listed nor scheduled under section 521(a)(1) of this title, with the name, if known to the debtor, of the creditor to whom such debt is owed, in time to permit—
- if such debt is not of a kind specified in paragraph (2), (4), or (6) of this subsection, timely filing a proof of claim, unless such creditor had notice or actual knowledge of the case in time for such timely filing; or
- if such debt is of a kind specified in paragraph (2), (4), or (6) of this subsection, timely filing of a proof of claim and timely request for a determination of dischargeability of such debt under one of such paragraphs, unless such creditor had notice or actual knowledge of the case in time for such timely filing and request[.]
11 U.S.C. § 727(b)
Except as provided in section 523 of this title, a discharge under subsection (a) of this section discharges the debtor from all debts that arose before the date of the order for relief under this chapter, and any liability on a claim that is determined under section 502 of this title as if such claim had arisen before the commencement of the case, whether or not a proof of claim based on any such debt or liability is filed under section 501 of this title, and whether or not a claim based on any such debt or liability is allowed under section 502 of this title.
11 U.S.C. § 524(c) and (d)
(c) An agreement between a holder of a claim and the debtor, the consideration for which, in whole or in part, is based on a debt that is dischargeable in a case under this title is enforceable only to any extent enforceable under applicable nonbankruptcy law, whether or not discharge of such debt is waived, only if—
- such agreement was made before the granting of the discharge under section 727, 1141, 1192, 1228, or 1328 of this title;
- the debtor received the disclosures described in subsection (k) at or before the time at which the debtor signed the agreement;
- such agreement has been filed with the court and, if applicable, accompanied by a declaration or an affidavit of the attorney that represented the debtor during the course of negotiating an agreement under this subsection, which states that—
- such agreement represents a fully informed and voluntary agreement by the debtor;
- such agreement does not impose an undue hardship on the debtor or a dependent of the debtor; and
- the attorney fully advised the debtor of the legal effect and consequences of—
- an agreement of the kind specified in this subsection; and
- any default under such an agreement;
- the debtor has not rescinded such agreement at any time prior to discharge or within sixty days after such agreement is filed with the court, whichever occurs later, by giving notice of rescission to the holder of such claim;
- the provisions of subsection (d) of this section have been complied with; and
- in a case concerning an individual who was not represented by an attorney during the course of negotiating an agreement under this subsection, the court approves such agreement as—
- not imposing an undue hardship on the debtor or a dependent of the debtor; and
- in the best interest of the debtor.
- Subparagraph (A) shall not apply to the extent that such debt is a consumer debt secured by real property.
- in a case concerning an individual who was not represented by an attorney during the course of negotiating an agreement under this subsection, the court approves such agreement as—
(d) In a case concerning an individual, when the court has determined whether to grant or not to grant a discharge under section 727, 1141, 1192, 1228, or 1328 of this title, the court may hold a hearing at which the debtor shall appear in person. At any such hearing, the court shall inform the debtor that a discharge has been granted or the reason why a discharge has not been granted. If a discharge has been granted and if the debtor desires to make an agreement of the kind specified in subsection (c) of this section and was not represented by an attorney during the course of negotiating such agreement, then the court shall hold a hearing at which the debtor shall appear in person and at such hearing the court shall—
- inform the debtor—
- that such an agreement is not required under this title, under nonbankruptcy law, or under any agreement not made in accordance with the provisions of subsection (c) of this section; and
- of the legal effect and consequences of—
- an agreement of the kind specified in subsection (c) of this section; and
- a default under such an agreement; and
- determine whether the agreement that the debtor desires to make complies with the requirements of subsection (c)(6) of this section, if the consideration for such agreement is based in whole or in part on a consumer debt that is not secured by real property of the debtor.
No. 19-34054-sgj11, Adv. No. 21-03003-sgi, 2021 WL 5769320 (Bankr. N.D. Tex. Dec. 3, 2021) (memorandum opinion and order denying arbitration request and related relief). ↑
Id. at *4. ↑
Id. ↑
Id. ↑
482 U.S. 220 (1987). ↑
847 F.3d 231 (5th Cir. 2017). ↑
Highland Capital, Adv. No. 21-03003-sgi, at *8. ↑
Id. ↑
Jay Westbrook, The Coming Encounter: International Arbitration and Bankruptcy, 67 Univ. of Minn. Law School 595, 623 (1983). ↑
Fleming, 325 B.R. 687 (Bankr. D. Del. 2005). ↑
Id. ↑
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Id. at 691 (quoting Hoxworth v. Blinder, Robinson & Co., 980 F.2d 912, 925 (3d Cir. 1992)). ↑
No. 03-695, 2003 WL 21994811 (E.D. Pa. Aug. 18, 2003). ↑
Fleming, 325 B.R. at 694. ↑
Id. ↑
434 F.3d 222 (3d Cir. 2006). ↑
885 F.2d 1149 (3d Cir. 1989). ↑
Mintze, 434 F.3d at 230 (quoting Hays, 885 F.2d at 1150). ↑
Id. at 229 (citing Hays, 885 F.2d at 1161). ↑
Id. at 230. ↑
Id. at 233. ↑
No. 3:09-CV-0724-N, 2014 WL 12654910 (N.D. Tex. July 30, 2014). ↑
Id. at *2. ↑
Id. at *5. ↑
Id. at *9. ↑
Id. at *13 (quoting In re Nat’l Gypsum Co., 118 F.3d 1056, 1068 (5th Cir. 1997)). ↑
Id. at *17. ↑
Id. at *19. ↑
630 B.R. 160 (Bankr. D. Md. 2021). ↑
Id. at 166. ↑
Id. ↑
Id. at 166–67. ↑
Id. at 167. ↑
Id. ↑
Id. at 168. ↑
980 F.2d 912 (3d Cir. 1992). ↑
Id. at 925 (citing Gavlik Constr. Co. v. H.F. Campbell Co., 526 F.2d 777, 784 (3d Cir. 1975)). ↑
Id. at 926. ↑
307 B.R. 449 (D. Del. 2004). ↑
Id. at 454 (quoting Hoxworth, 980 F.2d at 925). ↑
No. 03-695, 2003 WL 21994811 (E.D. Pa. Aug. 18, 2003). ↑
Id. at *3. ↑
607 F.3d 114 (3d Cir. 2010). ↑
744 F.2d 332 (3d Cir. 1984). ↑
Grossman’s, 607 F.3d at 120. ↑
Id. at 121. ↑
Id. ↑
Id. at 125. ↑
Id. ↑
No. 14-20454-beh, Adv. No. 20-02091, 2021 WL 3700401 (Bankr. E.D. Wis. Aug. 19, 2021). ↑
Id. at *1. ↑
Id. at *4. ↑
Id. ↑
Id. at *5. ↑
Id. ↑
494 B.R. 562 (Bankr. M.D. Fla. 2013). ↑
Id. at 566. ↑
Id. at 567 (quoting In re Stillwell, 2012 WL 441193, at *3 (Bankr. D. Neb. Feb. 10, 2012)). ↑
Id. at 568. ↑
433 B.R. 668 (Bankr. E.D. Mich. 2010). ↑
Id. at 669–70. ↑
Id. at 670. ↑
Id. ↑
115 B.R. 504 (E.D. Pa. 1990). ↑
Lipa, 433 B.R. at 670 (quoting Pennypacker, 115 B.R. at 507). ↑
Id. (quoting In re Baldwin-United Corp., 55 B.R. 885, 898 (Bankr. S.D. Ohio 1985)). ↑
180 B.R. 572 (9th Cir. BAP 1995). ↑
Id. at 573. ↑
Id. at 574. ↑
Id. ↑
612 B.R. 372 (6th Cir. BAP 2020). ↑
585 B.R. 224 (Bankr. W.D. Va. 2018). ↑
Id. at 227. ↑
Id. at 228. ↑
Id. at 229–30. ↑
Id. at 230. ↑
566 B.R. 119 (Bankr. D. Mass. 2017). ↑
Id. at 127. ↑
2006 WL 1999117 (Bankr. M.D. Ala. 2006). ↑
Reardon, 566 B.R. at 128. ↑
400 B.R. 117 (Bankr. W.D. Mich. 2009). ↑
Id. at 122. ↑
Id. at 123–24. ↑
