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Gatekeepers of Arbitrability: Fraud, Mistake, and the Absence of Consideration

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  • Posted on: Mar 30 2022

By: Jeffrey M. Haber

Generally, whether a claim is subject to arbitration is a decision for the court, not the arbitrator. However, the U.S. Supreme Court has held that “parties can agree to arbitrate ‘gateway’ questions of ‘arbitrability.’”1 As discussed below, such “delegation clauses” are enforceable where “there is ‘clea[r] and unmistakabl[e]’ evidence” that the parties intended to arbitrate arbitrability issues.2 “When deciding whether the parties agreed to arbitrate a certain matter (including arbitrability), courts generally . . . apply ordinary state-law principles that govern the formation of contracts.”3 

In Fritschler v. Draper Mgt., LLC, 2022 N.Y. Slip Op. 02087 (1st Dept. Mar. 29, 2022) (here), the foregoing principles were considered by the Appellate Division, First Department.

Fritschler involved the purchase of seven Subway franchises by plaintiff, Charles Fritschler. Plaintiffs alleged that defendants materially breached the franchise agreements and that certain defendants breached a separate agreement for the management of the franchises. 

The facts of Fritschler, which were obtained from the motion court’s decision and order and the First Department’s decision and order, are as follows. In connection with the purchase of the Subway franchises, Fritschler executed seven franchise agreements. Each agreement contained an identical arbitration provision, requiring the resolution of “[a]ny dispute, controversy or claim arising out of or relating to [the Franchise] Agreement or the breach thereof” by arbitration pursuant to the rules of the American Arbitration Association or its successor (“AAA”) or the American Dispute Resolution Center or its successor (“ADRC”) “at the discretion of the party first filing a demand for arbitration.” 

In addition to the arbitration clause, each franchise agreement contained a choice of law provision, which stated that “[a]ny disputes concerning the enforceability or scope of the arbitration clause [would] be resolved pursuant to the Federal Arbitration Act, 9 U.S.C. § 1, et seq. (“FAA”), and … that the FAA [would] preempt[] any state law restrictions (including the site of the arbitration) on the enforcement of the arbitration clause in [the Franchise] Agreement.” Notably, the parties agreed “to waive any right to disclaim or contest this pre-dispute arbitration agreement.”

Separately, Plaintiff EB5Overseer, LLC (“EB5”) entered into a management agreement with defendant Draper Management, LLC (“Draper”) with respect to the management of Fritschler’s Subway franchises. Neither party was a signatory to the franchise agreements. 

The management agreement provided that Draper would act as the “sole and exclusive manager” for the Subway franchises. The management agreement did not have an arbitration provision. In the event of a dispute under the management agreement, the parties were required to make a good faith attempt to resolve the dispute. If that attempt was unsuccessful, a party could commence a litigation “exclusively in a court of competent jurisdiction located in New York City.”

Defendants claimed the dispute should be resolved by arbitration and moved to stay the action, pending arbitration. Plaintiffs cross-moved for expedited discovery and a jury trial to resolve disputed issues of fact as to arbitrability, and for a stay of arbitration on the ground that a valid agreement was not made. The motion court granted defendants’ motions for a stay of the action pending arbitration and denied plaintiffs’ cross motions for expedited discovery and a jury trial.

As a threshold matter, the motion court held that the FAA governed the franchise agreements and the pending motions. None of the parties disputed its applicability. 

Turning “to [the] critical issue of whether it is for the court or the arbitrator to determine issues of arbitrability – i.e., issues as to the scope, validity, and enforceability of the arbitration agreement,” the motion court held that it was for the arbitrator to make this determination. 

Defendants argued that the franchise agreements evidenced the parties’ intent to delegate issues of arbitrability to the arbitrator. In response, plaintiffs maintained that “the majority of claims [were] clearly outside the scope of the Arbitration Provision, the majority of parties [were] not signatories to the Provision, and the Provision [was] not clear, explicit and unequivocal.” Plaintiffs contended that “[t]he court, not an arbitrator, [should] determine[] whether the subject in dispute [fell] within the scope of the arbitration agreement.”

“Under the FAA, there is a general presumption that the issue of arbitrability should be resolved by the courts.”4 When applying the FAA, “courts should not assume that the parties agreed to arbitrate arbitrability unless there is clear and unmistakable evidence that they did so.”5 As noted, to determine whether the parties clearly and unmistakably intended to refer the question of arbitrability to the arbitrator, the courts construe the arbitration agreement under “relevant state law.”6 

In applying the FAA, the Second Circuit has held that where the “parties explicitly incorporate rules that empower an arbitrator to decide issues of arbitrability, the incorporation serves as clear and unmistakable evidence of the parties’ intent to delegate such issues to an arbitrator.”7 New York courts applying the FAA have held, similarly, that when the parties’ agreement both specifically incorporates by reference the rules of an arbitration organization that permit the arbitrator to decide the scope of the arbitration agreement and “employs language referring all disputes to arbitration,” the issue of arbitrability will be left to the arbitrator.8 

Based upon the foregoing principles, the motion court held “that the parties’ agreements evidence[d] a clear and unmistakable intent to delegate arbitrability questions to the arbitrator.” The court noted that the arbitration provision at issue was “unquestionably broad” and expressly incorporated the rules of the AAA, which provided that the arbitrator has “the power to rule on his or her own jurisdiction, including any objections with respect to the existence, scope, or validity of the arbitration agreement or to the arbitrability of any claim or counterclaim.” 

In holding that issues of arbitrability were delegated to the arbitrator, the motion court rejected plaintiffs’ contention that the arbitration provision was procured by fraud. The alleged fraud, as described by plaintiffs, was based on, inter alia, a representation made during the negotiation of the management agreement that any claims against defendants would be subject to judicial determination. Plaintiffs claimed that defendants knew the falsity of their representation.

Plaintiff also maintained that the franchise disclosure document (“FDD”) that was provided to them omitted material facts with respect to arbitration; namely, who determines jurisdiction and arbitrability; whether claims against DAL and/or its BDAs must be arbitrated without regard to the genesis, scope and nature of the claims; whether the parties could obtain judicial review of errors of law or fact made by the arbitrators; and whether an arbitration award was subject to only minimal judicial review. 

The motion court found that plaintiffs failed to demonstrate or raise a triable issue of fact as to whether the arbitration provision was procured by fraud. The court noted that plaintiffs cited “no authority whatsoever in support of their contention that the types of omissions and misrepresentations cited by Fritschler, regarding the meaning or effect of the arbitration provision, [could] support a claim of fraudulent inducement.” The court agreed with defendants that “Fritschler’s ‘subjective confusion about the [arbitration] provision’s meaning [did] not create an issue of fact.’” “Significantly”, said the motion court, “the terms of the Franchise Agreements contradict[ed] Fritschler’s claim of lack of understanding of the arbitration provision”, as did the franchise disclosure questionnaire. 

In sum, concluded the motion court, “plaintiffs fail[ed] to raise an issue of fact as to whether the arbitration provision was procured by fraud, or to make any showing that discovery may lead to relevant evidence on this issue or on any of their fraud claims. The acts alleged by plaintiffs in support of their fraud claims are patently insufficient to support the claims.”

The motion court also rejected plaintiffs’ assertion that the arbitration provision was unenforceable due to lack of mutuality, lack of consideration, and unconscionability. Whether there is sufficient consideration to support the parties’ agreement to arbitrate is for the court, not the arbitrator, to decide.10 The motion court held that plaintiffs’ contention was conclusory and unsupported by any case authority – plaintiffs contended that the arbitration provision lacked consideration “because DAL and the other Defendants [gave] nothing up in order to be bound to the Provision” or because the provision limited damages. The motion court noted that plaintiffs failed to explain “how a lack of consideration could be found given that, by means of the Franchise Agreements containing the arbitration provision, DAI afforded Fritschler licenses to use the Subway ‘System,’ including marks, to own and operate restaurants.” 

The motion court also held that plaintiffs failed to cite any authority in support of their claims that the arbitration provision was unenforceable due to lack of mutuality and unconscionability. The court found their claims to be conclusory. Accordingly, the court held that plaintiffs failed to raise an issue of fact as to whether the arbitration provision was unenforceable on these grounds or to make any showing that discovery may lead to evidence relevant to support these grounds.

Finally, the motion court held that the non-signatories to the franchise agreements were required to arbitrate their disputes. The non-signatory plaintiffs argued that “[t]he damages or benefits Plaintiffs assert derive directly from the Management Agreement and contacts with the BDAs, not from the Franchise Agreements” and, therefore, did not implicate the franchise agreements and the arbitration provisions therein. Defendants countered that the non-signatory plaintiffs were obligated to arbitrate because “[t]hey [were] asserting claims arising directly from the Franchise Agreements, the franchise relationship, and the Franchises.” 

Making the threshold determination as to whether the non-signatory defendants had a “sufficient relationship” with the signatory defendant,11 the motion court held that plaintiffs agreed that they were the intended beneficiaries under the franchise agreements (noting that they constituted agents within the meaning of the relevant provision of the agreements). As a result, the motion court found “Plaintiffs’ argument that the BDA’s [were] not third-party beneficiaries or agents within the meaning of section 10(d) [of the franchise agreements] [was] unpersuasive.” The court concluded that it would be for the arbitrator to determine which of plaintiffs’ claims against the non-signatory defendants had to be arbitrated and which of the non-signatory defendants were entitled to enforce the arbitration provision.

Moreover, the motion court found that the non-signatory plaintiffs asserted a direct benefit arising from the franchise agreements.13 The court noted that while plaintiffs also asserted claims under the management agreement, which did not contain an arbitration provision, they failed to make any showing that the management agreement claims differed in any significant respect from, or that they did not substantially overlap with, the franchise agreement claims.

Review of the allegations of the complaint confirms that the non-signatory plaintiffs, like signatory plaintiff Fritschler, claim a direct benefit from the Franchise Agreements, and that they have sustained loss as a result of defendants’ breaches of those Agreements. 

On appeal, the First Department affirmed.

The Court held that, as to the signatories to the franchise agreements, those parties clearly and unmistakably agreed that issues concerning the arbitrability of claims would be determined by the arbitrator. “Here,” said the Court, “plaintiff Fritschler and defendant Doctor’s Associates, LLC (DAL) evidenced their intent to delegate the issue of arbitrability to the arbitrator by incorporating the AAA (and/or the substantively identical ADRC) rules into the Franchise Agreements’ broad arbitration clauses.”14 

The Court rejected plaintiffs’ arguments that there was no binding agreement to arbitrate because the franchise agreements were procured by fraud, lack of mutuality, were not supported by consideration, and/or were unconscionable. The Court found plaintiffs’ arguments to be unpersuasive. Like the motion court, the Court held that “[b]ecause these issues implicate whether the parties formed a valid contract to arbitrate, they were properly decided by the court in the first instance.”15 In any event, the Court found that plaintiffs’ contention that Fritschler did not enter into a binding agreement was contradicted by the allegations of the complaint. Furthermore, observed the Court, plaintiffs failed to allege “that there were any specific misrepresentations regarding the arbitration clauses themselves.”17 Finally, “Fritschler’s supposed subjective misunderstanding of the plain terms of the agreements does not amount to fraud,” said the Court.18 

The Court also rejected plaintiffs’ “argument that the exclusive jurisdiction provision found in the Management Agreement trump[ed] the Franchise Agreements’ arbitration provisions.” 

The Management Agreement was entered into by plaintiff EB5Overseer LLC and defendant Draper Management, LLC in February 2014, shortly before the Franchise Agreements were signed by Fritschler and DAL. However, nothing in the Management Agreement purported to modify or limit the scope of the later agreements that nonparties to the Management Agreement (i.e., Fritschler and DAL) might enter into, nor does it render the clear arbitration and delegation provisions found in the Franchise Agreements ambiguous. While plaintiffs may very well argue that the terms of the Management Agreement make claims asserted by or against certain parties nonarbitrable, that is a question of arbitrability for the arbitrator, not the court. 19

Finally, the Court rejected plaintiffs’ contention “that the Franchise Agreements did not clearly delegate disputes about arbitrability to the arbitrator because certain plaintiffs and the majority of the defendants were not signatories to the Franchise Agreements.”20 Similar to the motion court, the Court found that the non-signatories “were agents of DAL and in the Franchise Agreements themselves, Fritschler promised that he would not bring any claims against DAL’s agents or affiliates outside of arbitration.”21 Moreover, held the Court, “[t]he non-signatory plaintiffs also [fell] within the scope of the arbitration clauses under the direct benefits theory of estoppel.”22


Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.

This article is for informational purposes and is not intended to be and should not be taken as legal advice.

Footnotes

  1. Rent-A-Center, West, Inc. v. Jackson, 561 U.S. 63, 68-9 (2010).
  2. First Options of Chicago, Inc. v. Kaplan, 514 U.S. 938, 943, 944 (1995) (quoting, AT&T Technologies, Inc. v. Communications Workers, 475 U.S. 643, 649 (1986)).
  3. Id. at 944.
  4. Contec Corp. v. Remote Solution, Co., Ltd., 398 F.3d 205, 208 (2d Cir. 2005) (citing, First Options of Chicago, 514 U.S. at 944-45).
  5. Henry Schein, Inc. v. Archer and White Sales, Inc., ___ U.S. ___, 139 S.Ct. 524, 531 (2019) (internal quotation marks and citation omitted).
  6. Contec, 398 F.3.d at 208.
  7. Id.
  8. E.g., Life Receivables Trust v. Goshawk Syndicate 102 at Lloyd’s, 66 A.D.3d 495, 496 (1st Dept. 2009) (internal quotation marks and citation omitted), aff’d, 14 N.Y.3d 850 (2010), r’arg. denied, 15 N.Y.3d 769 (2010), cert. denied, 562 U.S. 962 (2010).
  9. Touloumis v. Chalem, 156 A.D.2d 230, 232 (1st Dept. 1989) (One who enters into a plain and unambiguous contract cannot avoid the obligation by merely stating that he erred in understanding its terms…”).
  10. Doctor’s Assocs., Inc. v. Alemayehu, 934 F.3.d 245, 250-52 (2d Cir. 2019) (internal quotation marks and citation omitted).
  11. Contec, 398 F.3d at 209.
  12. Citing, Dormitory Auth. of the State of N.Y. v. Samson Constr. Co., 30 N.Y.3d 704, 710 (2018). 
  13. Matter of Belzberg v. Verus Invs. Holdings Inc., 21 N.Y.3d 626, 630 (2013) (internal quotation marks and citations omitted); MAG Portfolio Consultant, GmbH v. Merlin Biomed Grp. LLC, 268 F.3d 58, 61 (2d Cir. 2001). 
  14. Slip Op. at *1.
  15. Id. (citing, Doctor’s Assocs., 934 F3d at 251-52).
  16. Id.
  17. Id. (citing, Rent-A-Center, 561 U.S. at 70-72).
  18. Id. (citation omitted).
  19. Id. (citing, Matter of WN Partner, LLC v. Baltimore Orioles L.P., 179 A.D.3d 14, 17 (1st Dept. 2019)).
  20. Id. at *2.
  21. Id.
  22. Id. (citing, Belzberg, 21 N.Y.3d at 631).
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