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Bankruptcy Court Denies Creditors Request for Relief from Automatic Stay to Arbitrate its Claims and Progress Setoff and Recoupment Rights

One of the primary reasons that most debtors seek bankruptcy relief is the automatic stay, which prevents creditors from pursuing collection efforts outside of the bankruptcy proceedings. Creditors can, however, seek relief from the automatic stay from the bankruptcy court under certain circumstances.

The United States Bankruptcy Court for the Western District of Michigan, in the Chapter 11 case of In re Patriot Solar Group, LLC, recently considered, and denied, a creditor’s request for relief from the automatic stay to arbitrate its claim and effectuate rights of setoff and recoupment against a corporate debtor. The case involved a debtor, Patriot Solar Group, LLC (the “Debtor”), and its customer, Vanguard Energy Partners, LLC (the “Creditor”). The Debtor was a supplier to the Creditor pursuant to various subcontractor agreements which the Creditor alleged that the Debtor breached. The Debtor also alleged that the Creditor was in breach. The subcontractor agreements contained arbitration clauses where the parties agreed to submit any claims arising from the agreement to binding arbitration.

Prior to the bankruptcy filing, the Creditor filed a demand for arbitration, and the Debtor commenced a civil action in the state court of Massachusetts. Shortly thereafter the Debtor filed for bankruptcy.

The Creditor then sought relief from the automatic stay, a request that the bankruptcy court denied.

Relief from the automatic stay can be granted for “cause,” which is granted on a case by case basis. The bankruptcy court explained that the Federal Arbitration Act “is entitled to great deference when relief from the automatic stay is sought in order to enforce an agreement to arbitrate.” The bankruptcy court’s analysis of whether the automatic stay should be lifted in this case to allow the parties to arbitrate boiled down to whether “an inherent conflict exists between arbitration and the underlying purposes of the Bankruptcy Code" and, if so, whether the court should exercise its discretion by declining to enforce the parties’ agreements to arbitrate.

The first step in this analysis is determining whether the dispute that would be subject to arbitration is a core or non-core proceeding, because a non-core proceeding generally leaves the court without discretion to preclude enforcement of an arbitration provision. A core proceeding is generally one that “either invokes a substantive right created by federal bankruptcy law or one which could not exist outside of the bankruptcy.” The bankruptcy court determined that the liquidation of the Creditor’s claims against the Debtor “would clearly be a core proceeding.”

Resolving the core vs. non-core distinction is not the end of the story, however. The bankruptcy court next had to consider whether the enforcement of the arbitration provision in the subcontractor agreements would conflict with the underlying purposes of the Bankruptcy Code.

In this case, the bankruptcy court found that lifting the automatic stay to allow for the enforcement of the arbitration provision would conflict with the purposes of the Bankruptcy Code for several reasons, including that it could lead to the depletion of cash necessary to fund the Debtor’s reorganization, potentially prevent other creditors of the opportunity to participate in the claims resolution process, and deprive the debtor of a breathing spell during which to develop a strategy for its exit from bankruptcy.

The bankruptcy court then turned to whether relief from the automatic stay should be granted to allow the Creditor to exercise its right of setoff and assert the defense of recoupment. For a number of reasons, including the fact that the Creditor failed to adequately explain why such relief is appropriate under the circumstances of this case, the bankruptcy court denied the Creditor’s requested relief.

If you have any questions about this case, or about bankruptcy issues in general, please contact Patricia Scott at pscott@fosterswift.com or 517-371-8132.

Categories: Chapter 11, Western District of Michigan

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