A New York appellate court has held that a company’s bankruptcy trustee was not bound by an arbitration agreement entered into by the company and an accounting firm.

In this action, Millennium Lab Holdings Inc. and Millennium Lab Holdings II LLC (Millennium Holdings LLC), pursuant to an engagement letter, retained petitioner KPMG LLP to audit their financial statements for certain time periods. The engagement letter contained a clause requiring the arbitration of “[a]ny dispute or claim arising out of or relating to this Engagement Letter or the services provided hereunder.”

In 2014, Millennium Holdings LLC and Millennium Laboratories LLC (collectively, Millennium) entered into a $1,825,000 credit agreement with various banks. On November 10, 2015, Millennium Holdings LLC and its affiliates filed for Chapter 11 bankruptcy. The bankruptcy court confirmed Millennium’s reorganization plan, which resulted in the creation of the Millennium Lender Claim Trust. Respondent Kirschner, as the bankruptcy trustee, commenced a California action against KPMG asserting claims for negligent and intentional misrepresentation.

KPMG brought an article 75 special proceeding to stay the California action and to compel arbitration. The Supreme Court of New York, New York County, granted the petition “to the extent of compelling arbitration on the issue of arbitrability and staying the California action for 30 days.” The trustee appealed.

The appellate court stated that the trial court should have decided the threshold issue of whether the arbitration provision was binding on the trustee, who did not sign the engagement agreement, but in the interest of judicial economy, the appellate court decided this issue.

Reversing the order of the Supreme Court, the appellate court found that KPMG did not meet its “heavy burden” under the direct benefits theory, as the benefits that the investors whose interests the trustee represents derived from the engagement letters between KPMG and Millennium were “merely indirect.” This was so because, in the California action, the trustee did not invoke the engagement agreement, but asserted solely common law claims, and because Millennium and KPMG did not contemplate that the investors represented by the respondent would benefit from the engagement letter.

Moreover, recognizing that for a non-signatory to be compelled to arbitrate, it must have knowingly exploited the agreement containing the arbitration clause, the appellate court found that there was no indication in the record that the investors had actual knowledge of the engagement letters between KPMG and Millennium.

Accordingly, the appellate court unanimously reversed the order of the Supreme Court, on the law, denied the petition and dismissed the proceeding.

In re KPMG LLP v. Kirschner, No. 11400N, Index No. 655664/18 (N.Y. App. Div. Apr. 16, 2020).