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U.S. SUPREME COURT MAKES AVOIDING ARBITRATION MORE DIFFICULT

Earlier this year, the United States Supreme Court issued an important decision that will affect arbitrations in New York and throughout the United States. In Buckeye Check Cashing, Inc. v Cardegna, __ U.S.__, 126 S. Ct. 1204 (February 21, 2006), the Supreme Court held that, under the Federal Arbitration Act, 9 U.S.C §1 et seq., the question of whether a contract that contains an arbitration provision is void is to be determined by the arbitrator, and not by a court, unless the challenge is to the validity of the arbitration provision itself. That means that a party will not be able to avoid arbitration by asserting that an arbitration clause is contained in an agreement that is void, unless the party can establish that the arbitration clause itself is unenforceable. Under the Supreme Court’s decision, the court should enforce the agreement to arbitrate and refer the question of the legality of the overall contract to the arbitrator.

The Supreme Court’s decision applies to all contracts that are subject to the Federal Arbitration Act, and will override state arbitration law in those cases, regardless of whether the litigation concerning the arbitration takes place in federal or state court. The Supreme Court previously held in The Citizen’s Bank v. Alafabco, Inc. 539 U.S. 52, 123 S. Ct. 2037 (2003) that the Federal Arbitration Act has very broad coverage and applies to all arbitration agreements contained in contracts that affect interstate commerce. New York’s highest court agrees. Diamond Waterproofing Systems, Inc. v. 55 Liberty Owners Corp., 4 N.Y.3d 247, 793 N.Y.S.2d 831 (2005)).

In the Buckeye Check Cashing case, the plaintiffs entered into various deferred-payment transactions with Buckeye Check Cashing (“Buckeye”), in which the plaintiffs received cash in exchange for a personal check in the amount of the cash plus a finance charge. For each separate transaction, plaintiffs signed a “Deferred Deposit and Disclosure Agreement” that contained a clause providing that disputes would be decided by binding arbitration. The plaintiffs commenced a class action lawsuit against Buckeye in Florida state court, alleging that Buckeye charged usurious interest rates and, therefore, that the Deferred Deposit and Disclosure Agreement violated various Florida lending and consumer-protection laws, rendering it criminal on its face.

Buckeye moved to compel arbitration. The trial court denied the motion, holding that a court rather than an arbitrator should resolve a claim that the contract containing the arbitration clause is illegal and void. The District Court of Appeal of Florida for the Fourth District reversed, holding that, because plaintiffs did not challenge the arbitration provision itself, but instead claimed that the entire contract was void, the agreement to arbitrate was enforceable, and the question of the contract's legality should be decided by the arbitrator. Plaintiffs appealed, and the Florida Supreme Court reversed, reasoning that to enforce an agreement to arbitrate in a contract challenged as unlawful “ ‘could breathe life into a contract that not only violates state law, but also is criminal in nature ... .’ ” 126 S. Ct. at 1207.

The United States Supreme Court reversed the decision of the Florida Supreme Court by a 7-1 vote. The Court stated that challenges to the validity of arbitration agreements can be divided into two types. “One type challenges specifically the validity of the agreement to arbitrate. [citations omitted]. The other “challenges the contract as a whole, either on a ground that directly affects the entire agreement (e.g., the agreement was fraudulently induced), or on the ground that the illegality of one of the contract's provisions renders the whole contract invalid.” 126 S.Ct. at 1208. The Court noted that the plaintiff’s claim is of the second type. “The crux of the complaint is that the contract as a whole (including its arbitration provision) is rendered invalid by the usurious finance charge.” Id.

[ Justice Scalia wrote the opinion of the Court, Justice Thomas dissented, and Justice Alito did not participate in the decision.]

The court stated that two of its previous decisions –Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395, 87 S.Ct. 1801 (1967) and Southland Corp. v. Keating, 465 U.S. 1, 104 S.Ct. 852 (1984) – established the following three propositions that govern the issues in the Buckeye Check Cashing case:

First, as a matter of substantive federal arbitration law, an arbitration provision is severable from the remainder of the contract. Second, unless the challenge is to the arbitration clause itself, the issue of the contract's validity is considered by the arbitrator in the first instance. Third, this arbitration law applies in state as well as federal courts.

126 S.Ct at 1209.

The Court applied these principles to the facts in Buckeye and held that because the plaintiffs “challenge the Agreement, but not specifically its arbitration provisions, those provisions are enforceable apart from the remainder of the contract. The challenge should therefore be considered by an arbitrator, not a court.” 126 S.Ct at 1209.

Under the Supreme Court’s decision, a valid agreement to arbitrate will not be rendered unenforceable by the fact that it is contained in an otherwise void and unenforceable contract. Indeed the Court acknowledged that its decision “permits a court to enforce an arbitration provision in a contract that the arbitrator later finds to be void.” 126 S.Ct. at 1210.

The Court carefully noted in a footnote that the question it was deciding was different from the issue of whether any agreement to arbitrate disputes was ever concluded. 126 S. Ct. at 1208, fn. 1. Accordingly, the Court stated that its decision “does not speak to” the issues of whether the alleged agreement to arbitrate was signed by the parties, whether the persons who signed the contract had authority to sign on behalf of their alleged principals, and whether the persons who signed the contract lacked the mental capacity to agree to arbitration. Id. Therefore, the Court’s decision does not preclude a party seeking to avoid arbitration from asserting that those issues must be decided by a court as a precondition to arbitration.

If you have questions about the foregoing article please feel free to call Stephen D. Hoffman at 212-981-2309 or send email to shoffman@wilkauslander.com.

This article was prepared as a service to our clients and friends. This article does not constitute legal advice and should not be relied upon as legal advice by the reader or any other party.