Litigation

It is common for agreements to contain a clause mandating that any dispute be decided in private arbitration—rather than in state or federal court. In private arbitration, a neutral arbitrator will hear evidence and render a decision that is most likely binding on all involved. Is such a clause, precluding a litigant from suing in open court, enforceable?

The Federal Arbitration Act provides a framework for the implementation and enforcement of private arbitration agreements.  As explained by the Third Circuit in Sandvik AB v. Advent Int'l Corp, the FAA establishes a strong presumption in favor of arbitration over litigation. The FAA provides that, when the court is "satisfied that the making of the [arbitration clause] ... is not in issue," it "shall ... stay the trial of the action" pending arbitration. 9 U.S.C. §§ 2-4. Accordingly, the court may decline to enforce an arbitration clause only when the making of the clause itself, not merely the making of the contract as a whole, is disputed. This is known as the severability doctrine established by the United States Supreme Court in Prima Paint Corp. v. Flood & Conklin Mfg. Co.

Although the severability doctrine may require enforcement of an arbitration agreement embedded in an otherwise voidable contract, it does not permit enforcement when the encompassing contract is considered void ab initio (void from the beginning). The reason for the different treatment of void ab initio contracts lies in the distinction between voidable and void contracts. A voidable contract is one in which a party has the power to either disaffirm the agreement, avoiding the legal duties imposed by it, or to ratify the agreement, mandating performance of the contractual obligations by both parties. In contrast, a declaration that a contract is void nullifies all aspects of the agreement, including an embedded arbitration clause, giving neither party the power to ratify or disaffirm its provisions. A void contract lacks legal existence from inception, and that the subsequent judicial declaration merely clarifies, rather than alters, the legal relationship of the parties. A common example of void ab initio contracts are illegal agreements, such as gambling agreements in certain states.

So, a clause mandating arbitration in a contract is enforceable pursuant to the FAA in all but two circumstances: (1) when a party alleges that the contract as a whole is void ab initio for any reason, or (2) when a party alleges that the arbitration clause itself is voidable for reasons related specifically to the arbitration clause. In all other situations, the FAA requires the court to enforce the terms of the clause and to refer the matter to arbitration.

If you have any questions on the above topic, contact Samuel Simon (ssimon@hh-law.com), Matthew Lautman (lautmanmj@hh-law.com), Erik Bergenthal (bergenthalem@hh-law.com), or your existing contact at Houston Harbaugh.