Thomas F. Howley and Robert T. Szyba | Seyfarth Shaw
Who decides the case: a court or an arbitrator? It’s a simple question at the core of any arbitration dispute. Then there’s the question of who decides who decides the case? Typically, the parties decide—they can decide to let an arbitrator decide the case (rather than a court) by entering into a binding arbitration agreement. In a recent case, the U.S. Court of Appeals for the Third Circuit took these seemingly simple questions one level deeper.
In MZM Constr. Co. v. N.J. Bldg. Laborers Statewide Benefit Funds, the Court addressed what it called a “mind-bending question” and the “queen of all threshold issues” in arbitration law: “Who decides—a court or an arbitrator—whether an agreement exists, when the putative agreement includes an arbitration provision empowering an arbitrator to decide whether an agreement exists?”
Under the circumstances here, the Court gave this “mind-bending” question a simple answer: “the court.”
The Federal Arbitration Act (FAA) empowers courts to decide issues concerning the making of an agreement “unless the parties have clearly and unmistakably referred those issues to arbitration in a written contract whose formation is not in issue.” In this instance, the plaintiff claimed fraud in the execution of the contract—thereby disputing its very existence—so the court, not an arbitrator, had authority to decide the existence of the agreement.
While the questions presented may be esoteric, the Court’s decision highlights a simple principle: every contract dispute begins with showing the existence of a contract. An arbitration provision may delegate certain decisions to an arbitrator but, like any contract, it has no effect unless you can show that the parties actually formed an agreement. Simply put, without an agreement to arbitrate, there can be no arbitration.
The Third Circuit’s Decision
In 2001, Plaintiff, a New Jersey construction company, hired union labor for a construction project at Newark Liberty International Airport. One year later, a union representative asked the employer to sign a one-page, short-form agreement (“SFA”), which incorporated by reference a collective bargaining agreement (“CBA”). The union representative allegedly said he would pull the workers if the construction company did not sign and that the SFA was “only for the Newark Airport job.” The company signed and, from 2001 through 2018, used union labor for various jobs and remitted more than $500,000 in contributions to the union’s benefit funds (the “Funds” wound up being the defendant in this case).
In 2018, the Funds audited the company’s records and determined that the company owed $230,000 in additional contributions. When the company balked at the demand for payment, the Funds initiated arbitration, citing the CBA’s arbitration provision. In response, the company sued in the federal District Court to enjoin the arbitration, arguing that there was fraud in the execution of the SFA and therefore, no agreement existed and the parties were not required to arbitrate. The Funds argued that this issue should be decided by the arbitrator because the CBA stated: “[t]he Arbitrator shall have authority to decide whether an Agreement exists, where that is in dispute.” The District Court enjoined the arbitration, holding that issues of “arbitrability” were for the court to decide.
The Court of Appeals broke the issue into two questions. First, does the District Court have the power to resolve questions about the formation of a contract when the putative contract delegates “the authority to decide whether an Agreement exists” to the arbitrator? Second, did the Plaintiff construction company put formation of the arbitration agreement “in issue” by claiming fraud in the execution
1. The District Court’s Power
Arbitration agreements often include a “delegation provision,” which gives the arbitrator authority to decide issues of arbitratbility—as the Supreme Court described it, “[t]hink of a delegation provision as a mini-arbitration agreement within a broader arbitration agreement within a broader contract, something akin to Russian nesting dolls.” Here, the delegation provision gave the arbitrator (not the court) authority to decide whether an agreement existed, but the company argued that the parties never formed a valid agreement due to fraud in the execution.
These facts presented a “catch-22.” If the Court took up the issue of arbitratbility and determined that there was a valid contract, then the parties were denied their contractual right to have an arbitrator decide that issue. On the other hand, if the Court enforced the delegation provision and later the arbitrator determined that there was no valid contract, then the parties were compelled to arbitration based on an agreement that never existed!
Ultimately, the Court here turned to section 4 of the FAA—which provides that a federal court must compel arbitration “upon being satisfied that the making of the agreement for arbitration … is not in issue”—and precedent that this section “affirmatively requires” a court to decide questions about the formation of a contract. This “tilts the scale in favor of a judicial forum” when a party contends that it never agreed to arbitrate at all. The Court held that, unless the parties clearly and unmistakably agreed to arbitrate questions of contract formation in a contract whose formation is not in issue, those gateway questions are left for the courts to decide. In so holding, the Third Circuit joins its sister circuits in the Fourth, Fifth, Sixth, and Eighth Circuits, as well as district courts in the Seventh Circuit.
2. Putting Formation of the Contract “In Issue”
Next, the Court resolved the question of whether the company put the formation of the arbitration agreement “in issue” by stating a claim of fraud in the execution.
It was undisputed that the construction company signed the SFA, which created a presumption that it “read, understood, and assented to” the terms of that document. Generally, failure to read is not by itself sufficient to avoid the legal effects of a signature. There is an exception, however, when there is fraud in the execution, which may be present “when a party executes an agreement with neither knowledge nor reasonable opportunity to obtain knowledge of its character or its essential terms” by reason of “excusable ignorance.” “Excusable ignorance” typically involves misconduct that cuts off the signer’s opportunity to read, such as “significant time pressure” and reliance on an erroneous “assurance.”
The Court found that the construction company adequately claimed fraud in the execution because the union representative’s “threat of halting construction” created a heightened sense of urgency and the company relied on his assurance that the SFA “was only for the Newark Airport job” and not a statewide CBA. Fraud in the execution renders the entire agreement “void ab initio” as if it never existed—this is in contrast to a claim of fraud in the inducement, which presumes the existence of a contract and merely renders it “voidable.” Here, the formation of the delegation provision was put in issue, thereby triggering the District Court’s power to adjudicate the claim.
The Court covered some complicated issues in this case—it unpacked a mini-arbitration provision, within a broader arbitration agreement, within a collective bargaining agreement, incorporated by reference in a short-form agreement. The underlying principles, however, provide practical takeaways for contract negotiations and any ensuing litigation (or arbitration):
- Always read the contract and any documents that it incorporates: In general, failure to read a contract isn’t a good defense. As one court put it, “[w]alking blindfolded through one’s business affairs does not excuse the ensuing collision.” This is especially true for experienced, sophisticated parties. The Court here noted that “this entire dispute could have been averted” if the plaintiff had requested and studied the CBA before signing.
- Let your counter-party read everything: The defendant was unable to enforce the delegation provision here, in part, because the plaintiff wasn’t given a copy of the CBA, was rushed to sign the agreement, and relied on verbal assurances. When contracting with another party, give them everything and time to read it all so they can’t claim ignorance later.
- Make sure you have an agreement!: The Court emphasized that, despite this ruling, nothing precludes parties from delegating issues of contract formation. However, the legal effect must come from an “independent source” outside of the contract whose formation is being disputed. For instance, parties can agree to arbitrate issues of arbitrability in pre-negotiation contracts or, after a dispute arises, stipulate to submit their dispute to arbitration. Either way, make sure you have an agreement that is undisputed.
For additional tips on drafting arbitration agreements and contracts in general, please contact the authors, your Seyfarth attorney, or any member of the Seyfarth team.