Sixth Circuit Ignores Separability; Holds Arbitration Clause Unenforceable Where Underlying Contract Void for Lack of Consideration

On September 12, 2013, the Sixth Circuit Court of Appeals upheld a District Court’s refusal to compel arbitration of a dispute arising under a contract that the court found contained “illusory” promises by one party and therefore lacked consideration.

In Day v. Fortune Hi-Tech Marketing, Inc., 2013 WL 4859781 (6th Cir. Sept. 12, 2013), plaintiffs initiated litigation, alleging that they had been lured by Fortune into an illegal pyramid scheme. The parties’ sales representation agreement contained an arbitration clause, but also gave Fortune the right to modify any term of the contract, effective upon notice. The District Court rejected Fortune’s motion to compel arbitration, finding that because Fortune had the ability to modify the contract at any time, its promises were illusory and the agreement lacked consideration under Kentucky law. The Sixth Circuit affirmed, holding that “because the contract lacked consideration, the entire contract, including the arbitration clause, is void and unenforceable” [emphasis added].

The Sixth Circuit decision in Day appears to ignore completely the doctrine of separability articulated in Prima Paint Corp. v. Flood & Conklin (388 U.S. 395, 402 (1967)) and its progeny. The Supreme Court held in Prima Paint that “arbitration clauses as a matter of federal law are ‘separable’ from the contracts in which they are embedded,” so that a claim that the underlying contract is invalid is to be determined by the arbitrators, rather than the court. The Day decision also appears to go further than two other recent decisions refusing to enforce “illusory” arbitration agreements. Flemma v. Halliburton Energy Servs., Inc., 303 P.3d 814 (N.M. 2013) and Carey v. 24 Hour Fitness, USA, Inc., 669 F.3d 202 (5th Cir. 2012) both involved an employer's unilateral ability to change or abolish its internal dispute resolution program, which provided for arbitration and was incorporated by reference in the employment agreements concerned. In Day, the contract was void because the agreement as a whole, rather than specifically the arbitration agreement, was subject to unilateral modification (the Day contract in fact expressly provided that the arbitration agreement would survive any termination of the agreement).

The separabilty doctrine is well established in international arbitration, as reflected in article 16(1) of the UNCITRAL Model Law, which provides that “. . . an arbitration clause which forms part of a contract shall be treated as an agreement independent of the other terms of the contract. A decision by the arbitral tribunal that the contract is null and void shall not entail ipso jure the invalidity of the arbitration clause.” It is also part of national arbitration legislation and most modern arbitration rules, including Rule 7(b) of the AAA Commercial Arbitration Rules. The obvious practical rationale for the doctrine is to prevent (spurious) challenges to the underlying contract from obviating the effect of the arbitration agreement and defeating arbitral jurisdiction.