Arbitration: Second Circuit Holds an Arbitration Provision as Separable from the Contract (Web)

The Court of Appeals for the Second Circuit reversed a district court order and compelled arbitration on a consulting agreement.  The District Court found the agreement mutually fraudulent and therefore the arbitration clause unenforceable. 
 
The plaintiffs, a class that includes individual investors and investment companies, allege that they were recruited by accounting firms aided and abetted by law firms and a multi-national bank to participate in an allegedly illegal tax scheme where the participants realize substantial capital gains from certain stock holdings then offset those gains by forming partnerships to engage in certain option transactions. 
 
All of the defendants moved to compel arbitration based on a consulting agreement between the accounting firm and some of the plaintiffs.  The District Court found that the consulting agreement was structured to conceal the nature of the services rendered and held that it was mutually fraudulent and the clause unenforceable.
 
The Second Circuit wholly rejected the district court’s holding that the arbitration provision is automatically void in an unenforceable agreement.  The Second Circuit referred to Prima Paint which indicates that “arbitration clauses as a matter of federal law are separable from the contracts in which they are embedded” so that “a broad arbitration clause will be held to encompass arbitration of the claim that the contract itself was induced by fraud.” Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967). 
 
On the issue of fraud, the Court held that the record showed that only the plaintiff’s counsel acquiesced to the court’s description of parties’ conduct as a “cover.”  Therefore, the District Court’s finding that both parties’ intentions were mutually fraudulent was clearly erroneous.  
 
The Court was clear to point out that the “extraordinarily vague language” in the contract identifying the type of services being provided was insufficient to support a finding of mutual fraud. Further, the Circuit Court rejected the district court’s holding that stand-alone language of the services being provided does not support the conclusion that the contractual provisions by their terms are fraudulent. 
 
The Circuit Court remanded the merits of the claim to the district court to determine if the defendant bank, the non-signatory, was sufficiently intertwined with the obligations of the consulting agreements.  The court relied on JLM Industries v. Stolt-Nielson SA, the Second Circuit decision that held that where a party is so “intimately founded in” or “intertwined with” the underlying obligations of the agreement, that party may compel arbitration. JLM Industries v. Stolt-Nielson SA, 387 F.3d 163, 178 (2d Cir. 2004).