Bankruptcy Court Declares Arbitration Clause Unenforceable When Underlying Contract Dismisses Pursuant to Section 365 of the Bankruptcy Code | Kramer Levin Naftalis & Frankel LLP

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Overview

In Highland Capital Management. v. Dondero (In re Highland Capital Mgmt.), Case No. 21-03007-sgj (Bankr. ND Tex. 2021), the U.S. Bankruptcy Court for the Northern District of Texas ruled that a debtor could not be compelled to honor an arbitration clause in an agreement that had been dismissed under Article 365 of the Bankruptcy Code.

Fund

Plaintiff Highland Capital Management LP (“mountains”) originally filed four adversarial proceedings to recover large promissory notes owed to him (collectively, the “Note Contradictory procedures“” of the various debtors under the notes (the “Note Debtor defendants”). Each Obligor Defendant was closely associated with former Highland Chairman James Dondero and collectively borrowed tens of millions of dollars from Highland’s pre-petition.

Subsequently, Highland amended its original complaints in each of the adversarial note proceedings to add one of its principal limited partners, Dugaboy Investment Trust (“Dugaboy”), which is a family trust of Dondero, whose trustee is his sister Nancy Dondero (collectively, the “Defendants“), and to add new counts alleging, among other things, a declaratory judgment as to certain provisions of the Highland Limited Partnership Agreement (the “PLA“), breach of fiduciary duty and complicity in breach of fiduciary duty (collectively, the “Amended Complaints”).

Invoking a mandatory arbitration clause (the “Arbitration Clause”) in the Highland LPA, the Defendants sought to compel arbitration of the Amended Claims and to fully suspend litigation in the Adversarial Ticket Proceedings pending arbitration. Notably, the LPA was an enforceable contract that Highland had rejected under Section 365 of the Bankruptcy Code. Thus, Highland argued that it was no longer bound by the provisions of the PCPA which impose specific performance its obligations – such as the arbitration clause – and can only be liable for pecuniary damages.

Opinion

The court agreed with Highland, finding “that the APL was an enforceable contract duly rejected in its confirmed Chapter 11 plan, and that the arbitration clause should also be considered a separate enforceable agreement that was rejected” . ID. at 9. Therefore, as the court explained, “Highland cannot be compelled to perform specifically under the arbitration clause or the LPA by compulsorily participating in the arbitration of [the Amended Complaints].” ID.

In reaching its decision, the court relied on the opinion of a district court for the Northern District of Texas and a law review article written by Professor Jay L. Westbrook. See Janvey v. Alguire, 2014 US Dist. LEXIS 193394 (ND Tex. July 20, 2014), aff’d for different motives at 847 F.3d 231 (5th Cir. 2017) (stating that the court could not require specific performance from the trustee, i.e., compel arbitration, pursuant to a rejected arbitration agreement); Jay Westbrook, The upcoming meeting: international arbitration and Bankruptcy, 67 Univ. of Minn. L.Rev. 595 (1983) (“an arbitration agreement is like any other enforceable contract which the trustee may reject”). The court singled out a contrary ruling from the Georgia bankruptcy laws court.

Why this case is interesting

Notably, although not the direct basis for its opinion, the court also concluded that to require arbitration would impose an undue and unjustified burden and expense on the parties to the detriment of Highland’s creditors. This decision is significant because it preserves the protection given to debtors under Section 365 of the Bankruptcy Code by allowing debtors to opt out of arbitration provisions when it is in the best interests of the estate. The court did not address the impact, if any, of the most recent U.S. Supreme Court decision regarding enforceable contracts in mission products. Interestingly, the court also added that the defendants waived any right to invoke the arbitration clause due to their delay in raising the issue after months of litigation.

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