Commercial Division Holds Nonsignatories Are Bound By Agreement’s Arbitration Clause

Farrell Fritz, P.C.
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“Read before you sign”, is what we counsel our clients, since we all know that courts will bind one contractually to a signed agreement even if not read. But, what if you never signed the agreement? Can you still be bound by it?  In earlier blogs — here and here — we addressed this very issue where the courts will, under certain circumstances, bind parties to an “unsigned agreement”.  Now, we examine the latest decision out of the Commercial Division considering whether a non-signatory to an arbitration agreement can be bound to arbitrate.

In a recent decision, Justice Barry R. Ostrager addressed important contract principles, including when a party will be bound by a contract’s arbitration provision where the party did not sign the contract.

In 2004 Parker Family LP v BDO USA LLP, a group of investors brought causes of action based on third-party breach of contract, negligence, and aiding and abetting breach of fiduciary duty against auditors who had been retained by the hedge funds that plaintiffs invested in to audit the hedge funds’ financial statements.  Plaintiffs’ claims stemmed from the Engagement Agreements (“Agreements”) entered into only between the hedge funds and defendants.  Plaintiffs alleged that defendants recklessly issued clean audit reports and ignored the hedge funds’ grossly inflated value of investments, failure to pay redemptions, and improper related-party transactions.  Defendants’ negligence, ultimately, allowed the hedge funds’ management to continue its scheme to defraud investors and led to the funds’ ultimate collapse.

In bringing their motion to compel arbitration, defendants also relied on the Agreements, which contained an arbitration provision requiring any dispute “between the parties” to be resolved in arbitration. Although plaintiffs weren’t parties to the Agreements, Defendants argued that because plaintiffs, as non-signatories to the Agreements, alleged third-party beneficiary status under the Agreements in plaintiffs’ third-party breach of contract claims, plaintiffs should also be bound by the arbitration provision in those Agreements.

As a threshold issue, a court, not the arbitrator, decides whether a party is bound by an arbitration provision in an agreement that the party did not execute (KPMG LLP v Kirschner).

The New York Court of Appeals previously noted in Matter of Belzberg v Verus Investment Holdings Inc. that as a general rule in New York, nonsignatories are not subject to arbitration agreements.  However, this rule is not without exception.

For example, a nonsignatory can be forced to arbitrate based on a contract’s arbitration provision where the party “knowingly exploits” the benefits of the contract and receives benefits flowing directly from the agreement (MAG Portfolio Consultant, GMBH v Merlin Biomed Group LLC).  This is referred to as the direct benefits theory of estoppel.  However, where the party merely exploits the contractual relation of the parties, but not the agreement itself, the benefit is considered “indirect” and the nonsignatory cannot be compelled to arbitrate based on the contract’s arbitration provision (Matter of Belzberg).

New York federal courts have also relied on the direct benefits theory of estoppel.  Specifically, the Second Circuit has held that where the agreement at issue is the direct source of the benefit, a direct benefit to the party exists and arbitration required by the agreement must be imposed on the nonsignatory (Deloitte Noraudit A/S v Deloitte Haskins & Sells, U.S.).

Here, the Court, ultimately, determined that where plaintiffs expressly relied on the Agreement in asserting their Third-Party Breach of Contract claims against defendants, thereby alleging that defendants are liable to plaintiffs as “third-party beneficiaries” of the Agreements based on plaintiffs’ reliance on the audit reports in making investment decisions, plaintiffs were bound by the Agreements’ arbitration clause under the direct benefits theory of estoppel.  Thus, the Court severed all claims against defendants and directed that they proceed to arbitration.

Takeaway:  The direct benefit theory of estoppel and this decision have wide application for corporate and commercial litigation.  Potential litigants should be aware that they may be bound by a contract’s arbitration provision and cannot avoid it by simply asserting their “nonsignatory” relationship to the contract.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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