Kevin Schlosser Writes, “Federal Court Rejects Challenge to Arbitration Clause Based Upon Alleged Fraudulent Inducement”

Overturning an agreement to arbitrate by claiming fraudulent inducement is not easy or straightforward. I have explained the analysis applied by the New York State Courts in a number of posts. See,e.g., Special Rules for Nullifying Arbitration Agreements for Alleged Fraud, Nov 29, 2016; Courts Reinforce Strict Standards for Nullifying Arbitration Provision Based Upon Fraud, Jul 5, 2017; Second Department Reinforces Vitality of Arbitration Clauses in Face of Fraud Claim, Jul 16, 2018.

Basically, as I have explained, 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, rather than the entire agreement. Thus, even when there are grounds to rescind a contract based upon established fraud, courts will still enforce provisions of that contract in which the parties agreed to arbitrate disputes regarding that contract unless it can be shown that the alleged fraud related specifically to the arbitration clause. So, even if the broader contract itself would be subject to rescission based upon fraud, the issue of fraud must be decided in arbitration.

EDNY Case

A recent decision by the United States District Court for the Eastern District of New York (Garaufis, J.), followed a similar analysis and rejected a challenge to an arbitration clause, in More Roofing, Inc. v. Scrivens, 19-CV-4925 (NGG)(LB) (E.D.N.Y. Feb. 5, 2021).

In Scrivens, the plaintiff was a construction contractor. Plaintiff had hired two employees, a manager for its New Jersey office, and an assistant to work with him. The manager caused plaintiff to enter into eight contracts with two subcontractors. Plaintiff alleged that the manager breached his fiduciaries duties to plaintiff and falsified information about these subcontractors that he supplied to the plaintiff’s principal to induce the plaintiff to give these jobs to the respective subcontractors, certain of whom the manager allegedly had a personal interest in. Plaintiff asserted a number claims, including fraud against the individual (former) employees as well as a claim of fraudulent inducement against one of the subcontractors which entered into the subcontracts with plaintiff.

The defendant subcontractor moved to dismiss or to compel arbitration based upon an arbitration clause contained in the subcontract with plaintiff. The relevant arbitration clauses provided: “‘Any claim arising out of or related to this Subcontract … shall be subject to arbitration.’”

The Court therefore determined whether the claim of fraudulent inducement of the subcontracts was to be decided in arbitration or in the federal court action.

Federal Principles

The Court in Scrivens relied upon the Second Circuit’s analysis of federal arbitration principles explained in Sphere Drake Ins. v. Clarendon Nat. Ins. Co., 263 F.3d 26 (2d Cir. 2001). Sphere involved a similar fact pattern in which employees were accused of breaching their fiduciary duties by causing the plaintiff to enter into contracts. As relevant, the Second Circuit explained the principles to be applied when arbitration clauses are challenged:

If a party alleges that a contract is void and provides some evidence in support, then the party need not specifically allege that the arbitration clause in that contract is void, and the party is entitled to a trial on the arbitrability issue pursuant to 9 U.S.C.A. § 4 and the rule of Interocean [Shipping Co. v. Nat’l Shipping Trading Corp., 462 F.2d 673 (2d Cir. 1972)]. However, under the rule of Prima Paint [Corp. v. Flood Conklin Mfg. Co., 388 U.S. 395, 87 S.Ct. 1801, 18 L.Ed.2d 1270 (1967)], if a party merely alleges that a contract is voidable, then, for the party to receive a trial on the validity of the arbitration clause, the party must specifically allege that the arbitration clause is itself voidable. Accordingly, to defeat the arbitration clauses in the contracts at issue, Sphere Drake must allege that the contracts as a whole are void or that the arbitration clauses in the contracts are voidable. Of course, it is not enough for Sphere Drake to make allegations — Sphere Drake must also produce some evidence substantiating its claim. See Interbras Cayman Co. v. Orient Victory Shipping Co., S.A.,663 F.2d 4, 7 (2d Cir. 1981) (per curiam).

Sphere, 263 F.3d at 32.

The Second Circuit further explained what is referred to as “the severability doctrine:”

— that “arbitration clauses as a matter of federal law are `separable’ from the contracts in which they are embedded, and that where no claim is made that fraud was directed to the arbitration clause itself, a broad arbitration clause will be held to encompass arbitration of the claim that the contract itself was induced by fraud.’ 388 U.S. at 402, 87 S.Ct. 1801; cf. Doctor’s Assocs., Inc. v. Distajo, 66 F.3d 438, 452 (2d Cir. 1995) (discussing, in dicta, separability of arbitration clauses).”)

Id. at 31.

In following Sphere, the District Court in Scrivens found the facts analogous, and ruled:

[Plaintiff] has made specific allegations of fraud against [the former employees], including that they falsified documents and signatures, and engaged in undisclosed self-dealing. … However, [plaintiff] makes no claims about [the defendant subcontractor’s] knowledge of or involvement in any fraudulent activity. The closest allegation that could be so construed is [plaintiff]’s assertion that Defendant Frank Cyrwus was “complicit in the fraud,” …, but it offers no evidence of his complicity, nor does it ever clarify the relationship between Cyrwus and [the defendant subcontractor], the company that bears his name. To show that its contracts with [the defendant subcontractor] are void, [plaintiff] would need to offer evidence of [the defendant subcontractor’s] knowledge of or involvement in the fraud beyond “merely speculation.” Sphere Drake, 263 F.3d at 33. Because it has failed to do so, and because it makes no claims about fraud in the inducement of the arbitration clauses specifically, [plaintiff] has not met its burden to show that the dispute is unsuitable for arbitration. … Accordingly, [plaintiff] must direct its claims against [the defendant subcontractor] to an arbitrator, not the court.

Commentary

The analysis applied by federal courts and under the Federal Arbitration Act is similar to that applied by the New York State Courts. Unless the entire contract at issue is void, the arbitration clause must specifically be tainted by alleged fraud in order to be disregarded. In federal court, the issues are decided in a manner similar to summary judgment, so the party alleging that the arbitration clause is voidable for fraud must raise material factual issues so as to require a trial on that issue in federal court rather than in arbitration.