In Bethlehem Steel Corp. v. Moran Towing Corp. (In re Bethlehem Steel Corp.),1 the United States Bankruptcy Court for the Southern District of New York held that preferential transfer claims were not arbitrable. The Court reasoned that because the avoidance powers did not belong to the debtor, but rather were creditor claims that could only be brought by a trustee or debtor-in-possession, they were not subject to the arbitration clauses in contracts to which the creditors were not parties.

The Dispute and the Arbitration Clauses

Bethlehem Steel Corporation and its subsidiaries (the “Debtors”) filed petitions for relief under chapter 11 of the Bankruptcy Code on October 15, 2001. On the petition date, the Debtors were parties to four transport contracts (the “Contracts”) with various counterparties (the “Defendants”). The Debtors made payments under the Contracts shortly before they filed for bankruptcy relief. Pursuant to the terms of each of the Contracts, any and all disputes arising under the Contracts were to be subject to mandatory arbitration.

The Debtors proposed a liquidating plan that was confirmed by the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”). The plan established a liquidating trust, the Bethlehem Steel Corporation Liquidating Trust (the “Liquidating Trust”) which, among other things, was responsible for prosecuting and settling claims of the Debtors as well as attending to additional matters involving the distribution of the Debtors’ assets.

Prior to confirming its plan and establishing the Liquidating Trust, the Debtors commenced various adversary proceedings against the Defendants pursuant to sections 547 and 550 of the Bankruptcy Code to recover, as preferential transfers, the payments made under the Contracts. Section 547 of the Bankruptcy Code provides that a trustee or debtor-in-possession2 may avoid, for the benefit of the estate, certain transfers made to creditors during a period of time shortly before the debtor files for bankruptcy (90 days for a non-insider, one year for an insider).3 Section 550, in turn, provides that the trustee may recover either the property transferred or, if the court so orders, the value of that property, from either an initial or subsequent transferee.4

In response to the avoidance actions, the Defendants contended that the Contract dispute was subject to arbitration. The Liquidating Trust disagreed and continued to prosecute the four adversary proceedings on the Debtors’ behalf post-confirmation. The Defendants then moved to compel arbitration, arguing that the arbitration clauses covered any and all possible disputes, including potentially preferential transfers. The Defendants further contended that, although the United States Court of Appeals for the Second Circuit had decided in Allegaert v. Perot 5 that fraudulent transfer claims were exempt from arbitration, this precedent no longer applied because the case had also prohibited arbitrating securities claims, which have since become arbitrable. Moreover, the Defendants argued that because Allegaert was decided under the former bankruptcy laws, the Bankruptcy Act, the rule of Allegaert was not controlling in the Bethlehem Steel case, which was governed by the Bankruptcy Code.

Court’s Analysis

The Bankruptcy Court found that the Contract claims were not subject to arbitration. The Court began by explaining the four factors used to determine whether a claim should be subject to arbitration: (i) whether the parties agreed to arbitrate; (ii) whether the scope of the arbitration clause is broad or narrow; (iii) whether, if federal statutory claims are asserted, Congress intended such claims to be nonarbitrable; and (iv) whether all claims in the action, as opposed to certain claims, should be arbitrated.6 Because it was undisputed that the Debtors had intended to arbitrate claims under the Contract, the Bankruptcy Court began its analysis with the second requirement. The Bankruptcy Court pointed out that, in enforcing arbitration clauses, courts generally distinguish “between ‘broad’ [arbitration] clauses that purport to refer all disputes arising out of a contract to arbitration and ‘narrow’ clauses that limit arbitration to specific types of disputes.”7

Because the arbitration clause in Bethlehem Steel was broad, it was presumed that the preferential transfers at issue were covered by its language. The Bankruptcy Court noted, however, that even with broad arbitration clauses, “if the claims present ‘no questions in respect of the parties’ rights and obligations under [the agreements]’, they are outside the purview of the arbitration clause and are not arbitrable.”8 The Bankruptcy Court thus turned to the question of whether Congress had intended for such statutory claims to be nonarbitrable. The Bankruptcy Court found that Congress did not intend preference actions to be subject to arbitration because they are statutory claims of creditors that can only be pursued by the debtor-in-possession or the trustee. The Bankruptcy Court explained:

Avoidance claims are not derivative of the debtor’s rights; rather, they are statutory claims created in favor of creditors that can only be prosecuted by a trustee or debtor in possession, or as in this case, by the Liquidating Trust as assignee under Debtor’s confirmed chapter 11 plan. Claims that are derivative of a debtor’s rights may be subject to arbitration. Claims that belong exclusively to a trustee or debtor in possession belong to creditors who were not parties to the arbitration agreement and, therefore, are not subject to arbitration.9

The Court further determined that it would apply the rule of Allegaert, that fraudulent transfer claims cannot be arbitrated, to the preference claims at issue. The Court found that Allegaert, although decided under the Bankruptcy Act, still controlled because the Defendants were unable to point to any differences between the Bankruptcy Act and the Bankruptcy Code that would suggest otherwise. The Bankruptcy Court explained that, although it recognized that after Allegaert was decided, the United States Supreme Court and the Second Circuit have enforced arbitration clauses in a wide range of situations (including securities claims, antitrust claims, and post-discharge stay-violation claims), it would not expand these decisions to include preference avoidance actions. The Bankruptcy Court thus rejected the argument of the Defendants that Allegaert was obsolete. The Court observed that the Third Circuit had followed Allegaert’s holding after the enactment of the Bankruptcy Code in refusing to find that fraudulent transfer claims were subject to arbitration, as did the Bankruptcy Court for the Southern District of New York several years earlier.10

The Bankruptcy Court further explained that, even if it had found that the preference claims were covered by the arbitration clauses, it would, in any event, exercise its discretion to deny arbitration. The Federal Arbitration Act provides that “an agreement in writing to submit to arbitration an existing controversy arising out of such a contract, transaction, or refusal, shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.”11 The Bankruptcy Court noted that the Second Circuit has cautioned that a dispute implicating the Bankruptcy Code could create such grounds.12 The Bethlehem Steel Court reasoned that the risk of conflict between the Bankruptcy Code13 and the Federal Arbitration Act is especially inherent in the case of a core proceeding, which arises out of, and exists solely because of, the Bankruptcy Code. Because preferential transfer claims are statutorily delineated core proceedings, the Bankruptcy Court concluded that even if the preference claims were subject to arbitration, it would have utilized its equitable powers to prevent having a core proceeding determined in arbitration.14

Finally, the Court acknowledged that refusing to compel arbitration as to one foreign Defendant presented a closer question, because that Defendant’s Contract was international and thus implicated comity. In such situations, a court “has less discretion to deny motions to arbitrate than it does with respect to domestic agreements.”15 The Bankruptcy Court decided that it would nevertheless exercise its discretion to deny arbitration of the dispute. The Court explained that it would override the policy favoring arbitration due to a severe conflict between the Bankruptcy Code and the Federal Arbitration Act.16

Conclusion

The holding of Bethlehem Steel provides solid reasoning for denying the right to arbitrate in the context of a preference action. While the Bankruptcy Court emphasized the fact that the claim at issue was not derivative of the debtors’ right, and was instead the right of a creditor that could be pursued by a trustee or debtor-inpossession, it is difficult to imagine a bankruptcy court allowing arbitration in other core matters, even those involving claims “derivative” of the debtors, if this reasoning is followed. For example, when deciding whether an asset is property of the estate, the rights of the debtor and debtor-in-possession are not so easily delineated. In this context, it would be difficult for a court to conclude that the debtor-in-possession is not subject to the pre-petition agreement binding it to arbitrate. Under these circumstances, a court may side-step the issue of who possesses the action—the debtor or the debtor-in-possession—and use its equitable powers to find that such a core proceeding should not be arbitrated. As a result, the finding of Bethlehem Steel may be as important for its discussion of the court’s tendency to avoid arbitration in core proceedings as it is for its decision to decline to compel arbitration of a creditor-derived claim.