State Supreme Court’s Interpretation of FAA Sidesteps SCOTUS Court Review

by Ellis & Winters LLP

The U.S. Supreme Court’s recent string of pro-arbitration decisions is well documented. In those decisions, the Court has not hesitated to admonish state courts for failing to follow the Federal Arbitration Act (FAA).

Will the trend continue in the Supreme Court’s upcoming term? One petition for certiorari offered the Supreme Court the chance to opine on two important issues of arbitration law: (1) the FAA’s “severability rule,” and (2) whether an arbitration clause in an unsigned addendum can be incorporated by reference into an enforceable, signed contract.

Though the Court recently denied certiorari, the petition in that case reflects the types of issues that will be teed up for the Court’s consideration in coming terms. This article describes that case, a decision of West Virginia’s highest appellate court called State ex rel. U-Haul Co. of West Virginia v. Zakaib, 752 S.E.2d 586 (W. Va. 2013).

Key Facts from Zakaib
Zakaib concerns rental agreements between three individuals and U-Haul. Each agreement contained a nominal “environmental charge” one, three, or five dollars—a charge they allege was unlawful and concealed from them.

The plaintiffs filed a putative class action against U-Haul in West Virginia state court; their claims were all premised on state law.

U-Haul—citing the rental agreements—moved to compel arbitration. The rental agreements themselves did not contain arbitration provisions. The rental agreements, however, said that the plaintiffs agreed to the terms in a “Rental Contract Addendum.” The addendum contained a mandatory arbitration provision.

The plaintiffs fought back; they said they did not receive the addendum until after they signed the rental agreement itself. Indeed, U-Haul agreed that, in most cases, customers received the addendum only after they signed the agreement.

The trial court denied the motion to compel. U-Haul sought appellate relief but lost. U-Haul has now filed a petition for a writ of certiorari with the U.S. Supreme Court. The case has been scheduled for the Court’s September 29, 2014, conference.

The Severability Rule
U-Haul’s petition contends that the West Virginia courts misapplied the FAA’s “severability rule.” Under this rule, an attack on the validity of an arbitration provision is distinct from an attack on the validity of the contract that contains the provision. The latter attack—on the validity of the contract—is to be resolved by the arbitrator, not by the court. Nitro-Lift Techs., LLC v. Howard, 133 S. Ct. 500, 503 (2012).

The severability rule dates back to the Supreme Court’s decision in Prima Paint Corp. v. Flood & Conklin Manufacturing Co., 388 U.S. 395 (1967). There, the Supreme Court examined which forum should decide a claim of fraud in the inducement of a contract containing an arbitration clause. The Supreme Court held that, if the claim was for fraud in the inducement of the arbitration clause itself, that matter may be adjudicated by a court because it is an issue that goes to the “making of the agreement to arbitrate.” On the other hand, if the alleged fraud went to inducement of the contract as a whole, then that is an issue for the arbitrator. The Court expressly rejected the idea that the question of “severability” was one of state law.

The Supreme Court later delineated three propositions relating to the severability rule. First, as a matter of substantive federal arbitration law, an arbitration provision is severable from the remainder of the contract. Second, unless it goes solely to the arbitration clause itself, any challenge to the contract’s validity is considered by the arbitrator in the first instance. Third, these principles apply in both state and federal courts. Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440, 445–46 (2006).

The circumstances in Zakaib do not fit neatly into these rules. The plaintiffs, after all, did not challenge the validity of the entire rental agreements. At the same time, they challenged something more—the addendum—than just the arbitration provision.

Faced with these choices, the Zakaib court effectively treated the challenge as one to the arbitration provision itself, affirming the trial court’s analysis because it centered on whether the parties had mutually agreed to arbitrate in the first instance. Thus, the court, rather than the arbitrator, could address the challenge. The court then concluded that, because the plaintiffs never saw the addendum, no arbitration agreement was ever formed. In the court’s view, sizing up the formation of the part of the contract (the addendum) that contained the arbitration agreement was analytically distinct from sizing up the entire contract’s validity.

The court had good precedent for the proposition that contract formation—as opposed to validity—is a question to be decided by the court. The U.S. Supreme Court reached this holding in Granite Rock Co. v. International Brotherhood of Teamsters, 561 U.S. 287, 296 (2010). In Granite Rock, the Supreme Court wrote that “the court must resolve any issue that calls into question the formation or applicability of the specific arbitration clause that a party seeks to have the court enforce.”

On one hand, the plaintiffs’ theory is supported by cases such as Solymar Investments., Ltd. v. Banco Santander, S.A., 672 F.3d 981, 992–93 (11th Cir. 2012). There, the Eleventh Circuit affirmed that Granite Rock did not change the distinction between a challenge to validity (for the arbitrator) and a challenge to formation (for the court).

On the other hand, Supreme Court precedent and section 2 of the FAA permit a court to evaluate only the “specific agreement to arbitrate.” See Rent-A-Center, W., Inc. v. Jackson, 561 U.S. 63, 71 (2010). U-Haul might argue that the plaintiffs’ challenge—which attempts to invalidate the entire addendum—goes beyond the “specific agreement to arbitrate.”

Incorporation by Reference
The question of who decides enforceability is only the first act in Zakaib. The second act is just as juicy: Is an arbitration provision in a contract’s addendum effectively incorporated by reference, even when the party signing the contract has not seen the arbitration provision at the time of formation?

This was a question of first impression under West Virginia law; the doctrine, however, has appeared in arbitration cases for decades. See, e.g., Exch. Mut. Ins. Co. v. Haskell, 742 F.2d 274, 275–76 (6th Cir. 1984); Tower Ins. Co. of N.Y. v. Davis/Gilford, 967 F. Supp.2d 72, 79 (D.D.C. 2013).

The doctrine comes up frequently in the construction context. A general contractor, for example, might have an arbitration clause in its prime contract with the property owner. The general contractor may then have a subcontract stating that the prime contract’s terms and conditions are incorporated by reference into the subcontract. And the subcontract might be incorporated by reference into the performance bond between the subcontractor and its surety. In this situation, parties are often compelled to arbitrate claims even though they did not sign an agreement containing an arbitration clause and, like the plaintiffs in Zakaib, may have been unaware that such a clause existed.

Most courts have concluded that, under the doctrine, the party against whom enforcement is sought need not have actually read the terms or conditions sought to be incorporated—even if those terms include an arbitration provision. See, e.g., Wallace v. Red Bull Distrib. Co., 958 F. Supp. 2d 811, 822 (N.D. Ohio 2013).

The doctrine, however, has prerequisites; the West Virginia court listed three in Zakaib. First, the main contract must clearly refer to the other document so that the parties’ assent to the referenced document is unmistakable. Second, the main contract must describe the other document in a manner that allows the other document to be ascertained beyond doubt. Finally, to avoid surprise or hardship, the parties’ knowledge and assent to the incorporated document must be certain.

Applying these requirements to U-Haul’s contract, the court found that the rental agreement’s reference to the addendum was too brief and general to satisfy them. Again, the court was particularly troubled by U-Haul’s apparent practice of giving a copy of the addendum to its customers only after the customer executed the rental agreement. For these reasons, the court could not conclude that a U-Haul customer would have the requisite knowledge of the terms of the addendum to establish the customer’s intent to be bound by those terms.

From U-Haul’s perspective, the rental agreement’s references to the addendum were clear and conspicuous; any customer could have asked to read the addendum before he or she signed the agreement. The plaintiffs’ assertion, then, that they did not know the addendum’s contents—including the arbitration provision—arguably does not tell the whole story.

Final Thoughts
The practical takeaway from Zakaib is clear: A business can avoid time-consuming litigation by including an arbitration provision in the portion of its contract that its customers actually receive and sign.

Zakaib, however, raises broader jurisprudential questions. In particular, to what extent is a challenge to an arbitration provision truly a severability challenge when the arbitration clause is separate from the main contract? Relatedly, is formation really distinct from validity when the parties agree that some contract has been formed?

The Supreme Court ultimately elected not to weigh on in this case; had it done so, we would not have been surprised to see an opinion that employs language from one of its recent arbitration decisions:“We reaffirm today that . . . a challenge to the validity of the contract as a whole, and not specifically to the arbitration clause, must go to the arbitrator.” Buckeye Check Cashing, 546 U.S. at 449.

*This article first appeared in the American Bar Association Section of Litigation Appellate Practice Fall 2014 Newsletter.

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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