Wednesday, October 29, 2014

Be Careful What You Ask For: Understanding the Applicability and Enforcement of an Arbitration Clause

The following post is courtesy of Daniel Dorfman at Harris Winick Harris, LLP.

A Texas Court of Appeals has recently handed down an important opinion addressing the applicability and enforceability of arbitration provisions. The case offers important lessons to developers and owners in the construction industry whose contracts generally contain arbitration provisions. Seven Hills Commercial LLC v. Mirabal Custom Homes Inc., No. 05-13-01306-CV, --- S.W. 3d ----, 2014 Tex. App. LEXIS 8705 (Tex. App.--Dallas Aug. 7, 2014, no pet. h.)

The appeals court in the Seven Hills decision made clear that even non-signatories to an arbitration clause may be compelled to arbitrate their disputes, depending upon the terms of the contract.  This means that corporate owner representatives can compel or be compelled to arbitrate claims pursuant to agreements that they did not enter into, or which they may not even had knowledge of before the claims arose.

Moreover, the Seven Hills case demonstrates that it is permissible for a court to make the initial determination as to whether claims asserted by any individual actor are subject to arbitration, by comparing the arbitration clause to the claims being asserted.  In other words, the court in Seven Hills served as a gatekeeper to arbitration: It simply determined that the arbitrator has the primary responsibility to decide whether parties to a dispute are bound by an arbitration provision. 

Factual Background

In November 2009, the Post Real Estate Group (PREG), Mirabal Custom Homes, Inc. (MCHI), and the D&G Investment Group (D&G) formed a construction development group in Texas by the name of Seven Hills Commercial, LLC (Seven Hills).  To formalize the relationship among the partner-companies and to create the entity Seven Hills, PREG, MCHI, and D&G executed an original operating agreement.

Within months of executing this agreement, PREG transferred its membership interest to another entity called Post-Investment Group (Post-Investment) who then subsequently transferred its membership to an entity called the Catenary Group (Catenary) – all of whom were owned and operated by an individual by the name of Jason Post.  Likewise, D&G transferred its interest to another entity called FST Group (FST), also owned by Mr. Post. 

Catenary, PREG, MCHI (owned and operated by an individual by the name of Jason Mirabal), FST, and D&G (owned and operated by Gary Guion) then signed an amended and restated operating agreement which was substantively similar to the first agreement.  Two individuals signed this document twice: Mr. Jason Post as Manager of Catenary and then as President of PREG; and Mr. Gary Guion as Manager of FST and then as president of D&G.  Interestingly, this agreement was signed by partner-companies who were not signatories to the original operating agreement. 

The following is a diagram of the parties (and transfer of interest) for the construction development group of Seven Hills:

Both operating agreements provided that all disputes between the parties arising out of Seven Hills would be subject to arbitration.   Not surprisingly, disputes arose among the partners after the execution of the amended operating agreement, involving various claims against each of the partner-companies, the entity Seven Hills, and against certain individuals involved in the development.

Despite the arbitration provision in the agreements, the disputes were litigated in state court and there was a combined trial of the various claims arising out of Seven Hills—although not all parties to the lawsuit appeared for trial of the matter (objecting to the jurisdiction of the court), including Seven Hills, Catenary, PREG, Post-Investment, and Mr. Post.  The trial court awarded damages against all of the parties not present at the trial of the matter.  Thereafter, Seven Hills, Catenary, PREG, Post-Investment and Mr. Post filed motions to compel arbitration pursuant to the operating agreements.  MCHI, Mr. Mirabal, FST, D&G, and Mr. Guion opposed such motions.  

The issue before the appeals court was jurisdictional, in that it needed to decide which parties and claims were subject to the arbitration clause, and which parties could enforce the arbitration clause (and thereby determine whether the findings of the trial court would be upheld).  The broad arbitration clause as stated in both operating agreements read as follows:

Any dispute, claim or controversy arising out of or relating to this Agreement or breach, termination, enforcement, interpretation or validity thereof, including the determination of the scope or applicability of this Agreement to arbitrate, shall be determined by arbitration….

Court Holding

In interpreting this broad arbitration provision, and sorting through the various claims in the case, the court held as follows: 

Catenary, PREG, and Mr. Post can compel arbitration of MCHI’s claims.

MCHI (the remaining original member of Seven Hills) claimed that the other members and individuals affiliated with Seven Hills, being Catenary, PREG and Mr. Post, engaged in improper distributions from the Seven Hills development company to their own accounts.  Since MCHI, Catenary and PREG signed the amended operating agreement, and thus agreed to arbitration, the court rightly ruled that Catenary and PREG could compel arbitration of MCHI’s claims.  

The more interesting question became that of Mr. Post.  Mr. Post executed the operating agreements, not in an individual capacity, but as manager of Catenary and president of PREG.  The court ruled, however, that Mr. Post can compel arbitration of MCHI’s claims.  As explained by the court:

Mr. Post, the human agent, is alleged to have been the person who committed the alleged offenses… by agreeing to arbitrate all disputes ‘arising out of or related to’ the Operating Agreement [], the parties generally intend to include actions of their agents such as Mr. Post because actions of corporate agents on behalf of their entity are generally deemed to be the corporation’s acts.

In so ruling, the court explained that corporations only act through their human agents, and here, Catenary and PREG acted through their human agent, Mr. Post.  While the operating agreement did not concern, nor specifically mention Mr. Post, Mr. Post as agent of the corporations that signed the operating agreements, could compel arbitration.  In a word, the court found that the arbitration provision was broad enough to encompass the actions of agents of companies that signed the operating agreement.  

Nevertheless, PREG, Post-Investment and Mr. Post cannot compel arbitration of the claims by D&G and Mr. Guion.

Unlike MCHI claims, Mr. Guion and his entity, D&G claims did not concern improper distributions under the operating agreement.  In fact, the claims being asserted by Mr. Guion and D&G had nothing to do with the operating agreement.  Rather, the claims being asserted against PREG, Post-Investment, and Mr. Post arose out of claims of breach of an independent employment agreement and for personal claims of emotional distress.  In reviewing these claims, as compared to the scope of the arbitration clause, the court, as the initial decision maker, determined that the personal claims of D&G and Mr. Guion arising out of Seven Hills, but not out of the actual operating agreements, could not be (and should not be) subject to arbitration – even through PREG, D&G, Mr. Guion and Mr. Post executed the operating agreements (the latter two as agents of their respective companies).

While the facts of the case are rather complicated, the reasoning of the court and the law is really not.  In fact, one may draw two major lessons from the Texas court:  
  1. Non-signatories to an arbitration clause may be compelled to arbitrate their disputes under principles of contract and agency law.  This means that corporate representative (as in this case) can compel or be compelled to arbitrate claims pursuant to agreements that they did not enter or may not have had knowledge of before the claims arose. 
  2. It is permissible for a court to make the initial determination as to whether claims asserted by any individual actor are subject to arbitration, by simply comparing the arbitration clause to the claims being asserted.  A court may make this initial determination so long as the arbitration provision itself does not provide otherwise.   

From a practical standpoint, the implication of this ruling is that developers, and corporate representatives, need to carefully evaluate the scope of an arbitration provisions within their contracts, understand who can compel arbitration and who can (or may be) compelled to arbitrate – including non-signatories to any arbitration provision.  

Daniel Dorfman is a construction lawyer in Chicago, Illinois, with the law firm of Harris Winick Harris LLP.  Daniel focuses his construction practice on the representation of owners and developers in all types of construction disputes.  In particular, Daniel, a LEED® Green Associate, has a focus in sustainable (“green”) building and the renewable energy markets.  Daniel is a frequent guest lecturer on the subject of construction law at academic institutions, such as, Chicago-Kent College of Law, J.L. Kellogg Graduate School of Management, Illinois Institute of Technology School of Architecture, and Northwestern School of Law.  In addition, Daniel routinely lectures at privately held companies, publicly held companies, and prominent trade organizations on a variety of legal issues affecting the construction industry.  Daniel is licensed to practice in the State of Illinois, United States District Court for the Northern District of Illinois, and the United States Court of Appeals for the Seventh Circuit.  Daniel received his J.D., cum laude, from Northwestern University School of Law in 2005.

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