U.S. Supreme Court Settles Whether Illegality Claims Go to Arbitrator

Until the recent decision in Buckeye Check Cashing, Inc. v. Cardegna, 126 S.Ct. 1204 (Feb. 21, 2006), there was some uncertainty as to how claims of illegality would fare against attempts to enforce arbitration agreements. The decision did not turn on whether the contract was void or voidable, as did earlier lower court decisions, but simply on whether the illegality claim was directed to the underlying contract or the arbitration clause itself. Relying on Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967), the Court treated the illegality claim in the same manner as a claim of fraud in the inducement and held that 'unless the challenge is to the arbitration clause itself, the issue of the contract's validity is considered by the arbitrator in the first instance.' 126 S.Ct. at 1206.

Buckeye was brought as a class action in the Florida state court, claiming that a check-cashing firm charged usurious interest. The allegedly usurious contract contained a standard arbitration clause and provided it would be governed by the Federal Arbitration Act ('FAA'). On a motion to compel arbitration by the check-cashing firm, the trial court ruled that since the contract was void ab initio (because it was illegal), the arbitration clause could not be enforced. The intermediate appellate court went the other way, holding that since the arbitration clause itself was not challenged as illegal, it could be enforced. The Florida Supreme Court reversed on the basis that to enforce an arbitration clause in an illegal agreement would 'breathe life into a contract that not only violates state law, but also is criminal in nature.' Id. at 1207.

The U.S. Supreme Court reversed, applying the reasoning of Prima Paint that 'unless the challenge is to the arbitration clause itself, the issue of the contract's validity is considered by the arbitrator in the first instance.' 126 S.Ct. at 1206. The Court referred to the 'rule of severability' enunciated in Prima Paint (that the court treat the arbitration agreement as a separate agreement) as a means of ensuring that arbitration contracts will be enforced in the same manner as other contracts as commanded by '2 of the FAA. (9 U.S.C. '2 provides in pertinent part: 'A written provision in … a contract … to settle by arbitration a controversy thereafter arising out of such contract … or an agreement in writing to submit to arbitration an existing controversy arising out of such a contract … shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.')

The Court held that by virtue of Southland Corp. v. Keating, 465 U.S.1 (1984), this rule of severability is part of federal substantive law that must be applied in state court proceedings under '2 of the FAA. 'The rule of severability establishes how this equal-footing guarantee for 'a written [arbitration] provision' is to be implemented.' Id. at 1209.

The Court left open in a footnote whether a court or arbitrator would decide issues pertaining to whether an 'agreement' was ever 'concluded' (ie, where it was claimed that the obligor never signed the contract or lacked authority or lacked the mental capacity to assent). Id. at p. 1208 (n. 1). A number of lower court cases have held that the courts are to decide issues as to the making of the contract in the first instance. See, e.g., Par-Knit Mills, Inc. v. Stockbridge Fabrics, Co., 636 F.2d 51 (3d Cir. 1980); Three Valleys Municipal Water v. E.F. Hutton & Co., Inc., 925 F.2d 1136, 1140 (9th Cir. 1991); Large v. Conseco Finance Servicing Corporation, 292 F.3d 49, 53-54 (1st Cir. 2002); Sandvik AB v. Advent Int'l Corp., 220 F.3d 99, 100-01 (3rd Cir. 2000); Burden v. Check Into Cash of Kentucky, LLC, 267 F.3d 483, 489-90 (6th Cir. 2001). It is doubtful whether the Supreme Court meant to alter those decisions. See, Rubin v. Sona International Corporation 2006 WL 525658 (S.D.N.Y. 2006), a franchise case decided subsequent to Buckeye, in which the court agreed that in situations involving whether a contract to arbitrate even exists, it is for the court to decide.

The defense in Buckeye was left with little to argue. It urged that '2 of the FAA should not apply because no 'contract' was at issue, since any contract would be void ab initio. The Court rejected this argument, noting among other things that '2 of the FAA contemplated that a 'contract' to arbitrate might be subject to revocation.

Prior to Buckeye, in the franchise arena, franchisees often attempted to avoid the application of arbitration clauses by arguing that because the sale of the franchise violated the applicable franchise disclosure law, it was an illegal agreement. By and large, the courts dealing with this issue usually ruled in favor of allowing arbitration on the theory that most franchise protection statutes made the agreement voidable, by allowing rescission, as opposed to being void ab initio. See, e.g., Harter v. Iowa Grain Co., 220 F.3d 544 (7th Cir. 2000); Sweet Dreams Unlimited, Inc. v. Dial-A-Mattress Inter'l Ltd., 1 F.3d 639 (7th Cir. 1993); Lawrence v. Comprehensive Business Services Co., 833 F.2d 1159 (5th Cir. 1987); Burden v. Check Into Cash of Kentucky, LLC, supra. See also, Mesa Operating Ltd. Partnership v. Louisiana Intrastate Gas Corp., 797 F.2d 238, 243 (5th Cir. 1986). Those cases, relying in large part on Prima Paint, made clear that unless it were shown that the arbitration clause itself were illegal, the court must enforce the arbitration clause notwithstanding claims that the underlying franchise agreement was illegal. As articulated in Lawrence, supra, parties to a contract are precluded from arguing that arbitration of an allegedly 'illegal' contract would effectuate the illegality because 'the legality of the contract has not yet been decided.' Id. at 1162. Burden, supra, even went further and held that even though it was claimed the underlying contract was 'void' under the relevant statute, the matter would nonetheless be submitted to arbitration because the challenge was to 'the substance, rather than the existence, of the [underlying] agreements.' Id. at 490.

It will be interesting to see whether the decision in Buckeye will have an impact on Nagrampa v. Mailcoups, Inc., 40 F.3d 1024 (9th Cir. 2005), Bus. Fran. Guide (CCH) ' 13,034 (March 21, 2005), rehearing granted. The issue in Nagrampa is whether the court or arbitrator should decide claims of unconscionability. The now vacated panel opinion held, like Buckeye, that the arbitrator decides if the contract is unconscionable, and the court decides if the arbitration clause is unconscionable. The holding in Buckeye could well convince the en banc panel that the earlier decision was correctly decided.

Charles G. Miller is a shareholder of Bartko, Zankel, Tarrant & Miller in San Francisco. He can be reached by phone at 415-956-1900 or by e-mail at [email protected].

Until the recent decision in Buckeye Check Cashing, Inc. v. Cardegna , 126 S.Ct. 1204 (Feb. 21, 2006), there was some uncertainty as to how claims of illegality would fare against attempts to enforce arbitration agreements. The decision did not turn on whether the contract was void or voidable, as did earlier lower court decisions, but simply on whether the illegality claim was directed to the underlying contract or the arbitration clause itself. Relying on Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967), the Court treated the illegality claim in the same manner as a claim of fraud in the inducement and held that 'unless the challenge is to the arbitration clause itself, the issue of the contract's validity is considered by the arbitrator in the first instance.' 126 S.Ct. at 1206.

Buckeye was brought as a class action in the Florida state court, claiming that a check-cashing firm charged usurious interest. The allegedly usurious contract contained a standard arbitration clause and provided it would be governed by the Federal Arbitration Act ('FAA'). On a motion to compel arbitration by the check-cashing firm, the trial court ruled that since the contract was void ab initio (because it was illegal), the arbitration clause could not be enforced. The intermediate appellate court went the other way, holding that since the arbitration clause itself was not challenged as illegal, it could be enforced. The Florida Supreme Court reversed on the basis that to enforce an arbitration clause in an illegal agreement would 'breathe life into a contract that not only violates state law, but also is criminal in nature.' Id. at 1207.

The U.S. Supreme Court reversed, applying the reasoning of Prima Paint that 'unless the challenge is to the arbitration clause itself, the issue of the contract's validity is considered by the arbitrator in the first instance.' 126 S.Ct. at 1206. The Court referred to the 'rule of severability' enunciated in Prima Paint (that the court treat the arbitration agreement as a separate agreement) as a means of ensuring that arbitration contracts will be enforced in the same manner as other contracts as commanded by '2 of the FAA. (9 U.S.C. '2 provides in pertinent part: 'A written provision in … a contract … to settle by arbitration a controversy thereafter arising out of such contract … or an agreement in writing to submit to arbitration an existing controversy arising out of such a contract … shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.')

The Court held that by virtue of Southland Corp. v. Keating, 465 U.S.1 (1984), this rule of severability is part of federal substantive law that must be applied in state court proceedings under '2 of the FAA. 'The rule of severability establishes how this equal-footing guarantee for 'a written [arbitration] provision' is to be implemented.' Id. at 1209.

The Court left open in a footnote whether a court or arbitrator would decide issues pertaining to whether an 'agreement' was ever 'concluded' (ie, where it was claimed that the obligor never signed the contract or lacked authority or lacked the mental capacity to assent). Id. at p. 1208 (n. 1). A number of lower court cases have held that the courts are to decide issues as to the making of the contract in the first instance. See, e.g., Par-Knit Mills, Inc. v. Stockbridge Fabrics, Co., 636 F.2d 51 (3d Cir. 1980); Three Valleys Municipal Water v. E.F. Hutton & Co., Inc., 925 F.2d 1136, 1140 (9th Cir. 1991); Large v. Conseco Finance Servicing Corporation , 292 F.3d 49, 53-54 (1st Cir. 2002); Sandvik AB v. Advent Int'l Corp., 220 F.3d 99, 100-01 (3rd Cir. 2000); Burden v. Check Into Cash of Kentucky, LLC , 267 F.3d 483, 489-90 (6th Cir. 2001). It is doubtful whether the Supreme Court meant to alter those decisions. See, Rubin v. Sona International Corporation 2006 WL 525658 (S.D.N.Y. 2006), a franchise case decided subsequent to Buckeye, in which the court agreed that in situations involving whether a contract to arbitrate even exists, it is for the court to decide.

The defense in Buckeye was left with little to argue. It urged that '2 of the FAA should not apply because no 'contract' was at issue, since any contract would be void ab initio. The Court rejected this argument, noting among other things that '2 of the FAA contemplated that a 'contract' to arbitrate might be subject to revocation.

Prior to Buckeye, in the franchise arena, franchisees often attempted to avoid the application of arbitration clauses by arguing that because the sale of the franchise violated the applicable franchise disclosure law, it was an illegal agreement. By and large, the courts dealing with this issue usually ruled in favor of allowing arbitration on the theory that most franchise protection statutes made the agreement voidable, by allowing rescission, as opposed to being void ab initio. See, e.g., Harter v. Iowa Grain Co., 220 F.3d 544 (7th Cir. 2000); Sweet Dreams Unlimited, Inc. v. Dial-A-Mattress Inter'l Ltd., 1 F.3d 639 (7th Cir. 1993); Lawrence v. Comprehensive Business Services Co., 833 F.2d 1159 (5th Cir. 1987); Burden v. Check Into Cash of Kentucky, LLC, supra. See also , Mesa Operating Ltd. Partnership v. Louisiana Intrastate Gas Corp., 797 F.2d 238, 243 (5th Cir. 1986). Those cases, relying in large part on Prima Paint, made clear that unless it were shown that the arbitration clause itself were illegal, the court must enforce the arbitration clause notwithstanding claims that the underlying franchise agreement was illegal. As articulated in Lawrence, supra, parties to a contract are precluded from arguing that arbitration of an allegedly 'illegal' contract would effectuate the illegality because 'the legality of the contract has not yet been decided.' Id. at 1162. Burden, supra, even went further and held that even though it was claimed the underlying contract was 'void' under the relevant statute, the matter would nonetheless be submitted to arbitration because the challenge was to 'the substance, rather than the existence, of the [underlying] agreements.' Id. at 490.

It will be interesting to see whether the decision in Buckeye will have an impact on Nagrampa v. Mailcoups, Inc. , 40 F.3d 1024 (9th Cir. 2005), Bus. Fran. Guide (CCH) ' 13,034 (March 21, 2005), rehearing granted. The issue in Nagrampa is whether the court or arbitrator should decide claims of unconscionability. The now vacated panel opinion held, like Buckeye, that the arbitrator decides if the contract is unconscionable, and the court decides if the arbitration clause is unconscionable. The holding in Buckeye could well convince the en banc panel that the earlier decision was correctly decided.

Charles G. Miller is a shareholder of Bartko, Zankel, Tarrant & Miller in San Francisco. He can be reached by phone at 415-956-1900 or by e-mail at [email protected].