Arbitration: Fourth Circuit, Limits on Nonsignatory's Attempts to Invoke Clause (Web)
May 2, 2006
In Wachovia Bank, N.A. v. Schmidt, No. 03-2061, 2006 WL 1073390 (4th Cir. April 25, 2006) (available at http://pacer.ca4.uscourts.gov/opinion.pdf/032061A.P.pdf), the Fourth U.S. Circuit Court of Appeals held that a nonsignatory to an arbitration agreement was not entitled to compel a signatory-plaintiff to arbitrate its claims when the contract terms containing the arbitration provision “are only tangentially related to the heart of the…claims."
The dispute centered around fraud-related allegations by plaintiff Daniel G. Schmidt III, and companies he controlled, against his financial advisers,Wachovia; his accountants, KPMG LLP; and an investment firm, QA Investments LLC, part of Seattle-based Quellos Group. Schmidt had sold a business, and Wachovia, representing the other original defendants, approached Schmidt with “a potentially advantageous investment strategy,” according to the unanimous Fourth Circuit opinion.
The “slam dunk” strategy, wrote Circuit Judge Robert B. King for the panel, was a “Foreign Leveraged Investment Program, . . . involv[ing] highly leveraged investments in stock of the United Bank of Switzerland.”
The strategy’s purpose was to “provide a so-called ‘basis shift,’ which would serve to shelter from federal taxation the capital gains Schmidt had made in the sale of his businesses.” It would generate tax losses to offset the gains.
The opinion states that the defendants “assured” Schmidt that the strategy “strictly complied with the rules and regulations of the Internal Revenue Service.”
But after the IRS audited Schmidt's returns and invalidated the losses generated by the strategy, Schmidt--facing more than $3 million in IRS tax liabilities, plus interest and penalties--brought South Carolina state-law claims against the defendants, asking for restitution and damages. He claimed that the defendants knew the strategy to be unsound at the time they marketed it to him.
Schmidt’s claims boiled down to one factual premise: Whether the defense parties, as his paid financial advisers, wrongfully induced Schmidt to participate in this strategy.
Wachovia Bank is significant because the court established boundaries regarding the U.S. Supreme Court's strong federal policy favoring the enforcement of arbitration agreements.
A number of contracts were at issue in this case. First, Schmidt signed a Financial Services Advisory Contract with Wachovia, under which he paid$100,000 for services.
Second, as part of the investment strategy, Schmidt signed a warrant with Quadra to purchase foreign stock. The warrant contained an arbitration provision.
And third, once the strategy’s mechanics were in motion, Wachovia loaned Schmidt $3.5 million, and he signed a note with Wachovia containing a broad arbitration provision.
According to the Wachovia suit brought in federal court, these arbitration provisions compelled Schmidt to arbitrate his disputes pursuant to the Federal Arbitration Act.
A South Carolina federal district disagreed and held that Schmidt was not required to arbitrate his claims with Wachovia based on either of these arbitration provisions. Schmidt and his companies’ state court claims “bore no significant relationship” to the note, and Wachovia, as a nonsignatory, couldn’t enforce the warrant’s arbitration clause.
In its first crack at the matter, the Fourth U.S., in a divided panel opinion, remanded the matter to be dismissed for lack of subject matter jurisdiction.
But Wachovia’s certiorari petition was accepted by the U.S. Supreme Court, which reversed the jurisdictional ruling and remanded the case to the Fourth Circuit.
In its second opinion on April 25, the Fourth Circuit assessed the merits of Wachovia’s contentions that the Schmidt state court claims against the bank should be arbitrated.
The panel again backed the district court’s decision, and refused to compel arbitration.
1. The Note.
The note contained an arbitration clause that permitted "either party to compel arbitration 'of any claim or controversy arising out of or relating to' the Note." Id. at *3. According to Wachovia, Schmidt's state-court claims were significantly related to the note because the tax strategy and the note were part of a "single, integrated course of dealing."
The Fourth Circuit rejected this argument in light of the fact that Schmidt's claims don’t require an inquiry into the note’s terms or validity. The opinion also points out that the note was paid in full by 1999--more than three years before Schmidt's suit against Wachovia. Id. at *4.
The panel was careful to distinguish Wachovia's two roles in the strategy. On the one hand, the bank acted as paid adviser to Schmidt, and on the other hand, it acted as a lender. Since Schmidt's claims were based on Wachovia's role as financial adviser, which was governed by the Financial Services Advisory Contract, the court was hesitant to compel arbitration based on the note’s arbitration provision.
Moreover, the Court stated that "although the loan evidenced by the Note enabled [Schmidt] to participate in the [tax strategy], we would be speculating to assert that the loan was a necessary condition of Schmidt's participation. . . . [T]hat is, we are unable to say that Schmidt would have abstained from participating in the [strategy] without the loan from Wachovia." Id. at *4. Schmidt didn’t allege that the loan was fraudulent.
The appellate panel also distinguished the note’s arbitration clause language from the language in Cara's Notions Inc. v. Hallmark Cards Inc.,140 F.3d 566 (4th Cir. 1998). In Cara's Notions, the arbitration clause at issue "embraced all claims 'arising out of or relating to … any aspects of the relationship between' the parties (including those aspects not created or governed by the agreement containing the arbitration clause)." Accordingly, the Court reasoned that the language in the Wachovia Bank note was not broad enough to extend to claims arising from Wachovia's role as Schmidt's paid financial adviser.
2. The Warrant.
Wachovia also argued that it was entitled to compel arbitration based on the warrant’s arbitration clause. Although Schmidt signed the warrant with Quadra Investments--not Wachovia--the bank argued that principles of equitable estoppel required Schmidt to arbitrate its claims against it, too.
The Fourth Circuit explained that "where a signatory relies on the terms of, and seeks benefits from, a contract in a suit against a nonsignatory, the signatory is estopped from asserting that the nonsignatory is precluded from enforcing the contract's arbitration clause." Id. at *5 (citing Long v. Silver, 248 F.3d 309 (4th Cir. 2001)).
That situation, however, was not present in this case. Wachovia argued that equitable estoppel applied due to the "close factual connection" between the claims and the contract. Hence, this connection estopped Schmidt from avoiding arbitration pursuant to the contract.
The Fourth Circuit rejected this argument, stating that the warrant is only tangentially related to the strategy since the "meat" of Schmidt's claims was that Wachovia knew or should have known that the strategy would be found invalid. Since the warrant was a mechanical part of that strategy, its terms really had little to do with Schmidt's claims themselves. Id. at *6.
Indeed, the panel stated that equitable estoppel was inappropriate since Schmidt is “not invoking the terms of the Warrant against Wachovia in such a way as to render it inequitable to deny Wachovia the benefit of the Warrant's arbitration clause."
In affirming the district court's denial of Wachovia's petition to compel arbitration, Circuit Judge King wrote that the "fact that a signatory receives benefits from a contract is therefore insufficient, in and of itself, to estop it from asserting that a nonsignatory is not entitled to invoke the contract's arbitration clause." Id. at *7.
--Eric Laufgraben, Dewey Ballantine LLP