Commercial Division Blog
Nonsignatories Bound by Arbitration Provisions in Contract They Relied Upon in Asserting Claims
On May 29, 2020, Justice Ostrager of the New York County Commercial Division issued a decision in 2004 Parker Family LP v. BDO USA LLP, 2020 NY Slip Op. 50614(U), holding that non-signatories were bound by an arbitration provision in a contract upon which they had relied in asserting claims, explaining:
As the First Department recently emphasized in KPMG LLP v Kirschner, 182 AD3d 484 (2020), quoting Matter of 215-219 W. 28th St. Mazal Owner LLC v Citiscape Bldrs. Group Inc., 177 AD3d 482, 483 (1st Dept 2019): The issue of whether a party is bound by an arbitration provision in an agreement it did not execute is a threshold issue for the court, not the arbitrator, to decide. The principles the Court must apply in making that determination were clearly set forth by the Court of Appeals in Matter of Belzberg v Verus Invs. Holdings Inc., 21 NY3d 626, 630-31 (2013):
Arbitration is a matter of contract grounded in agreement of the parties" As a consequence, notwithstanding the public policy favoring arbitration, nonsignatories are generally not subject to arbitration agreements . However, under limited circumstances nonsignatories may be compelled to arbitrate. Some New York courts have relied on the direct benefits estoppel theory, derived from federal case law, to abrogate the general rule against binding nonsignatories. Under the direct benefits theory of estoppel, a nonsignatory may be compelled to arbitrate where the nonsignatory knowingly exploits the benefits of an agreement containing an arbitration clause, and receives benefits flowing directly from the agreement. Where the benefits are merely indirect, a nonsignatory cannot be compelled to arbitrate a claim. A benefit is indirect where the nonsignatory exploits the contractual relation of the parties, but not the agreement itself. The Court here agrees with the Auditors' assertion that plaintiffs may be compelled to arbitrate because they knowingly exploited the benefits of the Engagement Agreements by asserting claims against the Auditors expressly based on those Agreements. The clearest example is the cause of action titled Third-Party Breach of Contract wherein plaintiffs explicitly allege they are third-party beneficiaries of the contracts between the Auditors and the PPVA Funds and that the Auditors breached the contracts by failing to properly audit the PPVA Funds, knowing the audit reports would be sent to plaintiffs in connection with their investment decisions and causing plaintiffs economic injury. Plaintiffs begin that claim by directly referencing the Agreements between the Auditors and the Funds. They cite the Auditor's contractual duty to properly perform the audits. They go on to allege that the Auditors "understood that Plaintiffs relied on the Auditors to conduct a proper audit of the PPVA Funds in accordance with GAAS, GAAP, and other applicable auditing standards, and accurately opine that the financial statements fairly represented the financial condition of the PPVA Funds. The benefits to Plaintiffs under the contracts were immediate, not simply incidental. Plaintiffs add that the Auditors' failure to fulfill their contractual duty to conduct proper audits "proximately caused Plaintiffs to lose all or, substantially all, of their investments in the PPVA Funds. And they conclude that the Auditors are therefore "liable to Plaintiffs as third-party beneficiaries of those contracts..
Where, as here, plaintiffs expressly rely on the Auditors' contracts with the Funds to seek compensatory damages related to their investment losses, they may not pick and choose which provisions suit its purposes, disclaiming part of a contract while alleging breach of the rest.
Particularly persuasive is the Auditors' reliance on Matter of Long Is. Power Auth. Hurricane Sandy Litigation, 165 AD3d 1138 (2nd Dep't 2018). In that putative class action, the plaintiffs sued to recover, among other things, compensatory damages from Long Island Power Authority ("LIPA") and its former management services provider, National Grid Electric Services, LLC ("National Grid"), claiming they suffered damages as a result of the interruption of electric services that occurred in the wake of the October 2012 storm known as Hurricane Sandy. As explained by the Appellate Division, plaintiffs in their complaint specifically relied on the Management Services Agreement between LIPA and National Grid ("the MSA") pursuant to which National Grid was responsible for the day-to-day operations and maintenance of LIPA's electricity transmission and delivery system.
As particularly relevant here, the Complaint in Matter of LIPA also alleged that the plaintiffs were third-party beneficiaries of the MSA since they were the known and intended recipients of the electric service that National Grid was responsible for providing. The complaint further alleged that the plaintiffs sustained damages as a result of National Grid's breach of the MSA. The Appellate Division modified the trial court's decision and granted National Grid's motion to compel arbitration, even though plaintiffs were nonsignatories to the MSA between LIPA and National Grid containing the arbitration clause, because plaintiffs had expressly relied on the MSA in pursuing their claims. Directly applying the principles of law discussed above, the Court held that:
Here, National Grid was responsible for the day-to-day operations and maintenance of LIPA's electricity transmission and delivery system pursuant to the MSA. The plaintiffs were paying customers of LIPA and the recipients of the electric service that National Grid was responsible for providing under the terms of the MSA. In this action, the plaintiffs seek to recover compensatory damages for interruptions of service that allegedly arose out of National Grid's breach of the MSA. National Grid thus demonstrated that the plaintiffs derived a direct benefit from the MSA and that the plaintiffs are explicitly relying upon the terms of that agreement to support their claims against National Grid. Accordingly, under these circumstances, the plaintiffs should be compelled to arbitrate in accordance with the arbitration clause contained in the MSA by application of the direct benefits theory of estoppel.
The similarities between Matter of LIPA and this case could not be more striking. In both cases, plaintiffs brought suit seeking compensatory damages based on an alleged breach of a services contract they did not sign. Yet they relied on the contract to bring suit, claiming they suffered damages due to the breach of contract. They further assert they received a direct benefit from the Agreements in that the audit reports were shared with plaintiff investors to provide information related to investment decisions. Thus, under the direct benefits theory of estoppel, and based on plaintiffs' assertion of third-party beneficiary rights under the Engagement Agreements between the Auditors and the PPVA Funds, plaintiffs are bound by the arbitration clause in the Agreements.
This ruling applies to all three claims against the Auditors. The negligence and fiduciary duty claims plead the same essential facts as the third-party beneficiary breach of contract claim, albeit slightly tailored to state the elements of the particular cause of action. But all three causes of action rely on the same duty of the Auditors created in the first instance by the Engagement Agreements to properly audit the PPVA Funds. Moreover, the arbitration provision is a classically broad one, stating that arbitration is mandated for: Any dispute, controversy, or claim arising out of or relating to the services or the performance or breach of this Agreement. As the Second Circuit stated in Collins & Aikman Prod. Co. v Bldg. Sys., Inc., 58 F3d 16, 20-21 (2d Cir. 1995) when discussing the scope of an arbitration clause:
In determining whether a particular claim falls within the scope of the parties' arbitration agreement, we focus on the allegations in the complaint rather than the legal causes of action asserted. If the allegations underlying the claims "touch matters" covered by the parties' agreements, then those claims must be arbitrated, whatever the legal labels attached to them.
Thus, applying the above-stated cases and principles of law, the Court will sever all the claims against the Auditors and direct that they proceed to arbitration. The one caveat is that the BDO defendants must comply with the first step in the applicable dispute resolution procedure, whether it is facilitated negotiations or mediation, before proceeding with arbitration as discussed above.
(Internal quotations and citations omitted) (emphasis added).
Commercial litigation involves more than courts. Disputes often are--by agreement--decided by private arbitrators. Contact Schlam Stone & Dolan partner John Lundin at email@example.com if you or a client have a question regarding a dispute that is subject to an arbitration agreement.