Closely-held business owners often hope to avoid the costs and delays of litigation by including arbitration provisions in their partnership, shareholder, and operating agreements. Things can get tricky, though, when nonsignatories get embroiled in the dispute, as the plaintiff learned in a recent decision from Suffolk County Commercial Division Justice Elizabeth H. Emerson.
In Fritch v Bron (74 Misc 3d 1217 [A] [Sup Ct, Suffolk County Mar. 1, 2022]), Justice Emerson considered, but ultimately rejected as inapplicable under the particular facts of the case, three of the five theories under New York law for binding nonsignatories to arbitration agreements. Fritch was a thoughtful discussion of the law of enforcement of arbitration agreements against nonsignatories, and offers an opportunity for us to author our first article devoted exclusively to the subject.
The Five Theories
Before we talk about Fritch, what are the theories in New York for binding nonsignatories to arbitration agreements?
Codifying nationwide federal case law on the subject, in Thomson-CSF, S.A. v Am. Arbitration Assn. (64 F3d 773 [2d Cir 1995]), the U.S. Court of Appeals for the Second Circuit announced that it “recognize[s] five theories for binding nonsignatories to arbitration agreements: 1) incorporation by reference; 2) assumption; 3) agency; 4) veil-piercing/alter ego; and 5) estoppel.” These theories, the Court explained, “arise out of common law principles of contract and agency law.”
- Under incorporation by reference, a nonsignatory may be bound to arbitration where a party “has entered into a separate contractual relationship with the nonsignatory which incorporates the existing arbitration clause” (id.).
- Under assumption, a non-party “may be bound by an arbitration clause if its subsequent conduct indicates that it is assuming the obligation to arbitrate” (id.).
- Under agency, “[t]raditional principles of agency law may bind a nonsignatory to an arbitration agreement,” such as where an agent signs an agreement for, or with the apparent authority of, the nonsignatory (id.).
- Under veil piercing/alter ego, “the corporate relationship between a parent and its subsidiary are sufficiently close as to justify piercing the corporate veil and holding one corporation legally accountable for the actions of the other” or binding one to the other’s arbitration agreement (id.).
- Finally, under estoppel, some courts “have been willing to estop a signatory from avoiding arbitration with a nonsignatory when the issues the nonsignatory is seeking to resolve in arbitration are intertwined with the agreement that the estopped party has signed” (id.). In this line of cases, “the courts held that the parties were estopped from avoiding arbitration because they had entered into written arbitration agreements, albeit with the affiliates of those parties asserting the arbitration and not the parties themselves” (id.).
Although there is a menu of theories for binding nonsignatories to arbitration agreements, they are devilishly elusive in practice, as Fritch shows.
In Fritch, Maureen Fritch, as 51% member, and Igor Bron, as 49% member, entered into an amended operating agreement (the “OA”) for E. Electrical Contracting, LLC (“EEC”). The OA’s arbitration agreement provided, “The parties hereto agree to binding arbitration . . . with respect to the entire subject matter of any and all disputes relating to or arising under this Agreement . . . .”
According to the complaint, Fritch and Bron formed EEC as an electrical constructing company and Women-Owned Business Enterprise. Fritch alleged that Bron, in concert with certain non-parties to the OA, including a competing business owner and friend of Bron’s, “R.S.”, and his company, “SEI” had “concocted a scheme to divert EEC assets . . ., including labor and material, for the benefit of Defendants at the expense of Mrs. Fritch thereby causing millions of dollars in damages . . . .”
Fritch alleged causes of action for fraud, constructive fraud, breach of fiduciary duty, and accounting against Bron only; aiding and abetting fraud, aiding and abetting breach of fiduciary duty, and tortious interference against the nonsignatories, including R.S. and SEI; and unjust enrichment against all defendants.
Numerous rounds of motion practice ensued, including Bron moving to compel arbitration and to stay or dismiss the litigation; the remaining defendants moving to dismiss or stay the litigation; and Fritch, following her service of a demand to arbitrate, moving to compel arbitration against Bron, R.S., and SEI.
In her attorney affirmation and memorandum of law, Fritch asserted veil piercing/alter ego, estoppel, and agency theories, repeatedly described Bron and R.S. as “secret” or “silent” partners, an arrangement Fritch characterized as an “inherently unlawful arrangement whereby the parties involved are partners/owners/principals to insiders, but to outsiders no extrinsic evidence of any such arrangement is revealed.” According to Fritch, Bron allegedly actively funneled business from EEC to SEI while also holding a nondocumented principal / equity position at SEI.
As to veil piercing/alter ego, Fritch argued, “Mr. Bron, R.S. and SEI have abused the corporate form (including EEC through no fault of Mrs. Fritch) in every way, shape and form and have acted in extreme bad faith resulting in wrongful and inequitable consequences.”
As to estoppel, Fritch argued she “established with overwhelming evidence that R.S. and SEI knowingly derived substantial benefits from the Amended Operating Agreement,” and that their “intent was to use Mr. Bron to strip Mrs. Fritch of her equity in EEC, which stems directly from the Amended Operating Agreement.”
As to agency, Fritch argued: “Agency and partnership go hand-in-hand: Mr. Bron, as the partner of R.S., can bind R.S. as a nonsignatory, and Mr. Bron, as principal of SEI, can bind SEI as a nonsignatory to be compelled to submit to arbitration under the Amended Operating Agreement.”
The problem for Fritch: there was no bona fide direct evidence in the record to support any of her three theories, as R.S. and SEI argued in the memorandum of law in opposition, characterizing Fritch’s allegations of a “secret” partnership between Bron and R.S. as “ludicrous,” “libelous,” “malicious,” and “knowingly false.”
Justice Emerson led with Fritch’s agency-law theory, finding it inapplicable for two reasons.
First, “while an agent may bind its nonsignatory principal to an arbitration agreement where the nonsignatory seeks to compel arbitration with a signatory,” the opposite is not true and here, “the plaintiff, a signatory, seeks to compel arbitration with nonsignatories, i.e., the SEI defendants.”
Second, the Court ruled that Fritch’s “contention that Igor Bron and R.S. are ‘silent partners’ is unavailing” because “individuals may not, as a matter of law, operate as a business entity as a partnership for purposes of defining their rights vis-a-vis each other while concurrently holding the entity out to the general public as a corporation.” Moreover, the Court ruled, the “record reflects that SEI was formed” in the 1960s, “long before the alleged partnership between Igor Bron and R.S. was formed.”
With respect to estoppel, the Court held:
The record does not reflect that the SEI defendants have taken affirmative steps to exploit a benefit flowing from EEC’s amended and restated operating agreement . . . . The court finds that, at most, the SEI defendants may have exploited the contractual relation of the parties to the amended and restated operating agreement, but not the agreement itself. Contrary to the plaintiff’s contentions, the alleged diversion of corporate assets and opportunities from EEC to the SEI defendants may be a breach of Mr. Bron’s duties to the plaintiff and EEC, but they do not flow from EEC’s amended and restated operating agreement” (citations omitted).
Lastly, with respect to veil piercing/alter ego, the Court held:
The record does not reflect that Mr. Bron has an ownership interest in SEI. In any event, even if he did, the record does not establish that Mr. Bron so dominated or controlled SEI that it was an alter ego of himself. . . . A corporate relationship or interrelatedness, standing alone, is not enough to subject a nonsignatory to arbitration. Moreover, the record does not reflect that SEI is a sham entity and that it exists for no other purpose than as a vehicle for fraud” (citations omitted).
As a result, the Court ruled that Fritch “is directed to proceed to arbitration on her claims against the defendant Igor Bron only” and the rest of the lawsuit against the remaining defendants “is stayed pending the outcome of the arbitration” because “the issues to be decided in the arbitration against Mr. Bron are inextricably interwoven with, and may well dispose of, the claims against the remaining defendants.”
Fritch involves a common problem for business divorce plaintiffs: to obtain full relief against all potentially responsible parties, it may be necessary to sue some who are bound to arbitration agreements, but also others who are not. This can result in a few permutations: (i) litigation trumping arbitration (in the event of mutual waiver of arbitration); (ii) arbitration over litigation (in the event of mutual consent to arbitration); (iii) a split outcome, where claims against some parties are litigated, others are arbitrated; or (iv) in the case of Fritch, a stay of litigation against some parties, and an arbitration against only one or a few others.
Given the outcome, Fritch certainly would have been better off to take the arbitration route against Bron from the outset, and to separately sue R.S. and SEI. Had she done so, it’s less likely her claims against R.S. and SEI would have been stayed. Instead, she got the worst of both worlds: no forum, either litigation or arbitration, in which to pursue her claims against R.S. and SEI, and a compelled arbitration against Bron after a year of expensive litigation in Supreme Court.