When an agreement contains a mandatory arbitration clause, the scope of the clause may present a critical threshold issue in any dispute relating to the agreement. In particular, the question may arise whether the arbitration clause binds or benefits nonsignatories, such as the affiliates, directors, officers, or agents of the parties to the agreement.
As discussed below, well-settled principles of common law dictate that, in appropriate circumstances, nonsignatories may enforce or be bound by arbitration clauses contained in contracts signed by other persons. However, the proposition that nonsignatories may be bound by or benefit from an arbitration agreement raises other questions, including: What law should apply to determine a nonsignatory's obligation or right to arbitrate? Can the parties to an arbitration agreement choose the law that will govern the issue of who is bound? Under what circumstances is a nonsignatory bound to arbitrate or entitled to compel arbitration? Who, the courts or the arbitrators, determines whether a nonsignatory is bound by an arbitration agreement?
What Law Governs?
Section 2 of the Federal Arbitration Act ("FAA") declares that any written agreement to arbitrate contained in "a contract evidencing a transaction involving commerceshall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract." Section 2 of the FAA implements a liberal federal policy favoring the validity and enforcement of arbitration agreements, notwithstanding any state law or policy to the contrary. Section 2 creates a "federal substantive law of arbitrability," applicable to any arbitration agreement or controversy subject to the FAA. This federal substantive law is enforceable in both the state and federal courts.
The federal substantive law of arbitrability governs any arbitration agreement or dispute that is subject to the FAA; but ordinary state law principles governing the validity, revocability, or enforceability of contracts generally remain applicable, even though they render an arbitration agreement invalid, unenforceable, or revocable. The FAA preempts state law principles that purport to apply only to arbitration agreements to the extent they conflict with the liberal federal policy in favor of arbitration. For example, state laws that prohibit the arbitration of specific disputes are preempted by the FAA.
The parties to an arbitration agreement may designate state law, including a state's law of arbitration, as the governing law of the arbitration. Courts will apply the designated state law to determine whether the parties intended that state's law of arbitration to apply. However, a choice of law clause designating state law as the governing law of an agreement will not preclude the application of the FAA and the federal substantive law of arbitration unless the parties' intention is abundantly clear. This means that parties must specifically reference any state law restrictions on their substantive rights under the FAA or the arbitrator's powers.
Applying these principles, the federal substantive law of arbitrability controls whether a nonsignatory is bound by or may invoke an arbitration agreement.
Six Binding Theories
Under the federal substantive law of arbitrability, nonsignatories may be bound to an arbitration agreement under ordinary principles of contract and agency law. Most courts recognize five traditional theories under which a nonsignatory to an arbitration agreement may be bound or benefited by an arbitration agreement: (1) incorporation by reference; (2) assumption; (3) agency; (4) veil-piercing/alter-ego; and (5) estoppel. Some courts also recognize a nonsignatory's status as a third-party beneficiary to a contract containing an arbitration clause as a basis for binding the nonsignatory to the arbitration agreement.
These theories are most often asserted against plaintiffs, either to bind a plaintiff to an arbitration agreement and/or compel a plaintiff to arbitrate. This occurs when a signatory defendant asserts that a nonsignatory plaintiff is bound by an arbitration agreement, or a nonsignatory defendant asserts that a signatory plaintiff must arbitrate the plaintiff's claims against the nonsignatory. Nonsignatory defendants are seldom compelled to defend claims in arbitration.
Incorporation by Reference
Under the doctrine of incorporation by reference, a nonsignatory may be bound to arbitrate with a signatory to an agreement containing an arbitration clause when he signs a separate agreement with that signatory expressly incorporating the other contract.
Courts may apply agency theory to bind principals to arbitration agreements entered into by their agents. However, the requirements for such vicarious responsibility are exacting. Not only must an agency relationship exist, but the relationship must be relevant to the legal obligation in dispute. The agent must have been acting within the scope of the agency relationship when he signed the contract on behalf of the principal. Thus, the party seeking to bind the principal must prove that the signatory signed the agreement as agent. In this regard, the existence of a parent-subsidiary relationship does not, by itself, create the required agency relationship. Moreover, the absence of contractual language clarifying the agent's status and signifying the intent to bind the nonsignatory should weigh against binding the alleged principal, especially when a signatory to the contract is asserting the agency relationship against a nonsignatory defendant.
Equitable estoppel is typically applied against signatory plaintiffs who have filed suit in court, to compel them to arbitrate claims asserted against defendant nonsignatories to the arbitration agreement. Equitable estoppel is typically available in two circumstances: first, when the signatory to a contract containing an arbitration clause must rely on the terms of the contract in support of its claims against the nonsignatory; and second, when the signatory alleges that the nonsignatory and a signatory to the contract engaged in substantially interdependent and concerted misconduct that is intimately founded in and intertwined with the obligations imposed by the contract. Some courts recognize "direct benefits" estoppel, which applies to bind a nonsignatory who knowingly exploits the agreement that contains the arbitration clause. Regardless of how the test is expressed, the estopped party's reliance on the underlying contract (containing the arbitration clause) is the sine qua non for applying equitable estoppel. While such reliance may consist of the assertion of contract-based claims, in the case of "direct benefits" estoppel it may consist of direct benefits to the nonsignatory during the life of the contract.
Third-Party Beneficiary Theory
Courts allow nonsignatory intended third-party beneficiaries to compel arbitration against signatories of arbitration agreements, and will compel nonsignatory, third-party beneficiary plaintiffs to arbitrate claims asserted against signatories; provided, the claims arise from the contract containing the arbitration agreement.
Although third-party beneficiary theory bears a superficial resemblance to direct benefits estoppel, the two theories are distinct. Whereas all variants of equitable estoppel are based upon the estopped party's reliance on or exploitation of the underlying contract; third-party beneficiary status rests on the signatories' specific intent at the time they signed the contract to confer the benefits of the contract on the nonsignatory. In other words, the subsequent receipt of incidental benefits by a nonsignatory does not necessarily constitute the nonsignatory a third-party beneficiary under the contract-the beneficiary must be an intended beneficiary.
Courts apply a strong presumption against third-party beneficiary status, which can be overcome only by language clearly and unambiguously expressing the parties' intent to confer a direct benefit on the nonsignatory. Language in the contract that expressly restricts rights and obligations to the parties will exclude nonsignatories.
Under the theory of assumption, a nonsignatory may be bound if his conduct indicates he intended to assume the contract containing the arbitration clause and/or the obligation to arbitrate, or that he waived any objection to being bound. For example, a nonsignatory's active and voluntary participation in arbitration constitutes an assumption of the obligation to arbitrate and a waiver of his objections to arbitration.
Generally, the affiliation between a corporate signatory and a nonsignatory parent or subsidiary is not sufficient to bind the nonsignatory. However, in appropriate circumstances, courts may apply the doctrine of veil-piercing/alter-ego to bind a nonsignatory corporation to an arbitration agreement signed by its affiliate. There is no uniform federal law test for piercing the corporate veil, and courts apply various formulae, which may differ significantly. Generally speaking, the courts will pierce the corporate veil where the parent dominates and controls the subsidiary and/or the parent uses the subsidiary to perpetrate fraud. Whatever the test, the courts agree that a veil-piercing/alter-ego analysis is highly fact intensive, and the totality of the circumstances must be examined before piercing the veil.
Who Has the Last Word?
The Supreme Court has held that the judiciary determines whether a nonsignatory is bound to arbitrate or entitled to compel arbitration, unless the parties "clearly and unmistakably" reserve this issue to the arbitrators. The Court recognizes a distinction between an arbitrator's jurisdiction to arbitrate the merits of a dispute, and an arbitrator's jurisdiction to determine whether the dispute is subject to arbitration. The latter question-also known as "the question of arbitrability"-is not subject to the ordinary presumption in favor of arbitration. Instead, the question of arbitrability is reserved to the courts, unless there is "clear and unmistakable evidence" that the parties intended that the arbitrators should decide the question.
Dwayne E. Williams is a litigation partner in the Miami office of Holland & Knight LLP. He can be contacted at (305) 789-7786.