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Kevin Schlosser Authors, "Special Rules for Nullifying Arbitration Agreements for Alleged Fraud"

Nov 29, 2016Commercial LitigationLitigation & Dispute Resolution
Media Source: One of the powerful remedies for establishing fraud is the ability to rescind or nullify an agreement that was induced by fraud. See my post discussing the broad scope of remedies for fraud. There are special rules, however, for nullifying provisions in which parties agree that disputes regarding a given agreement are to be resolved by arbitration. Courts are particularly fond of agreements to arbitrate and take pains to see that they are enforced. If the agreement to arbitrate is part of a broader agreement, courts focus on whether the arbitration provision itself was the subject of a scheme to defraud. Even when there are grounds to rescind an agreement based upon established fraud, courts will still give effect to the provisions of that agreement in which the parties agreed to arbitrate disputes regarding that agreement unless it can be shown that the fraud related specifically to the agreement to arbitrate. So, even if the broader agreement itself would be subject to rescission based upon fraud, the issue of fraud is to be decided in arbitration. A recent decision of the Appellate Division, Second Department, addresses the issues and illustrates the point -- Markowits v Friedman, 2016 NY Slip Op 07932 (2d Dep’t Decided on November 23, 2016). In Markowits, defendants entered into two agreements with the plaintiff whereby they agreed to sell an interest in the subject companies and an option to purchase the remainder interests. The parties then modified the agreements to provide supplemental payment terms. In connection with the modification, they executed related documents, including a promissory note from plaintiff for a portion of the purchase price, and a confession of judgment in the same sum. They also agreed “to submit to arbitration ‘any disputes [which should] arise between them concerning the sale . . . relating directly or indirectly to the aforementioned transaction,’” except for filing and entering of the confession of judgment. Thereafter, plaintiff allegedly failed to make a payment due pursuant to the agreements. The defendants held him in default of the promissory note, accelerated the debt, and filed the confession of judgment. Plaintiffs thereafter sued alleging, among other things, that the defendants “breached warranties in the contracts of sale by concealing civil actions and government investigations pending against the companies, and that the [defendants’] failure to disclose these actions and investigations fraudulently induced plaintiff to enter into the modification agreements.” Defendants then moved “pursuant to CPLR 7503 to stay all … proceedings in the action [that were not subject to a substantive motion to dismiss] and compel arbitration” -- relying upon the agreement to arbitrate their disputes regarding the subject transactions. The lower court granted the motion to compel arbitration and the Second Department affirmed. The Second Department first acknowledged: “Arbitration is a favored method of dispute resolution in New York.” The Court then instructed that the threshold issue of whether there is a valid agreement to arbitrate is for the court, and that once it determines the parties agreed to arbitrate, the court’s role ends without addressing the merits of the particular claims. Although the plaintiffs contended that the arbitration agreement was invalid because it was fraudulently induced, the Court noted that a “broad arbitration provision is separable from the substantive provisions of a contract such that the agreement to arbitrate is valid even if the substantive provisions of the contract were induced by fraud.” The court continued: “The issue of fraud in the inducement affects the validity of the arbitration clause only when the fraud relates to the arbitration provision itself, or was part of a grand scheme that permeated the entire contract” for which the plaintiff “must … establish[] that the agreement was not the result of an arm's length negotiation, or the arbitration clause was inserted into the contract to accomplish a fraudulent scheme.” The Court then found that plaintiffs failed to make the required showing to nullify the arbitration provisions, ruling that “the arbitration agreement was not a free-standing contract which was fraudulently induced, but was one of numerous documents executed as part of the … modification agreement, which must be ‘read together and interpreted as forming part of one and the same transaction.” The Court concluded: “Since the plaintiffs' claim of fraudulent inducement relates to the … modification agreement, with all its related documents, and not the arbitration agreement itself, the arbitration agreement is valid and the claim of fraudulent inducement is for the arbitrator” to decide. Thus, where there is what the courts consider a “broad” arbitration clause in an agreement, the issue as to whether fraud can be established will be for the arbitrator to decide (not the courts) if the court finds that the arbitration provision itself was not induced by fraud. Examples of “broad” arbitration clauses for these purposes are found in Anderson St. Realty Corp. v New Rochelle Revitalization, LLC, 78 AD3d 972 (2d Dep’t 2010)(“the arbitration clause was broad, since it applied if ‘any disagreement, deadlock, interpretation or dispute shall arise’ under the … agreement”); Riverside Capital Advisors, Inc. v Winchester Global Trust Co. Ltd., 21 AD3d 887 (2d Dep’t 2005)(“An arbitration clause in the severance agreement stated that ‘any controversy or claim arising out of or in relation to this Agreement or the breach thereof will, to the fullest extent permitted by law, be settled by arbitration.’”); and Ferrarella v Godt, 131 AD3d 563 (2d Dep’t 2015)(“Stock Purchase Agreement contained an arbitration clause which provided, in pertinent part: ‘In the event any dispute shall arise pursuant to any term or provision of this Agreement, the same shall be settled by arbitration in accordance with the rules and regulations of the American Arbitration Association (hereinafter 'AAA') within the County of Queens.’”).