Karl Bayer’s and Victoria VanBuren’s Texas-based Disputing blog recently reported on In re Morgan Stanley & Co., Inc., __ S.W.3d __ (Texas 2009) (No. 07-0665), in which the Texas Supreme Court held that whether a contracting party had the capacity to enter into a contract containing an arbitration agreement was for the court to decide, notwithstanding that, under the severability (a/k/a “separability”) doctrine, a challenge to the validity or enforceability of a contract as a whole, including the arbitration agreement, is generally for the arbitrators to decide under a broad arbitration clause. Ms. VanBuren did an excellent job summarizing the case and explaining its significance in her post, “Texas Supreme Court Holds that the Court, not the Arbitrator Should Decide the Issue of Capacity to Contract,” and we recommend that anyone interested in learning more about the case read her thoughtful and nicely-written post.
Morgan Stanley illustrates that the severability doctrine — first espoused by the United States Supreme Court in Prima Paint v. Conklin Mfg. Corp., 388 U.S. 395, 403-04 (1967) and later clarified in Buckeye Check Cashing v. Cardengna, 546 U.S. 440, 449 (2006) — is not without its limits. Severability is a legal fiction, which Courts apply for the purpose of determining whether arbitrators have the authority to determine certain disputes concerning the enforceability or validity of a contract containing an arbitration clause. It deems the arbitration clause to be an agreement which stands on its own footing from the contract in which it is contained.
The key to understanding the sometimes elusive severability doctrine is Federal Arbitration Act Section 2, which makes arbitration agreements within its scope “valid, irrevocable and enforceable,” unless state law applicable to contracts generally says the agreement is invalid, revocable or unenforceable. Whether or not an arbitration agreement is subject to such a defense is generally a question for the court, but the severability doctrine provides that challenging the validity, revocability or enforceability of the contract containing the arbitration agreement is not enough; the challenge must relate directly to the arbitration agreement, whether or not it also relates to the contract as a whole. So if A and B enter into a contract containing a broad arbitration clause, and B seeks to rescind the contract because it was induced by fraud relating to the contract as a whole — but not to the arbitration clause specifically — the arbitrators get to decide the fraud claim. But if A and B enter into the same contract, and B later claims that A made fraudulent misrepresentations concerning the arbitration agreement itself (and was not simply duped into entering into a contract containing an arbitration agreement), the court gets to decide whether the arbitration agreement was fraudulently induced.
Section 2 tells us that we need to focus on the arbitration agreement itself, and determine whether the validity, enforceability or revocability challenge is one directly related to the arbitration agreement or simply to the contract as a whole, in which case the challenge is only indirectly related to the arbitration agreement. And if the challenge only indirectly relates to the arbitration agreement, then Section 2 tells us that the arbitration agreement must be enforced, which means that the arbitrators get to decide the challenge to the contract as a whole.
All this is well and good as long as there is no question that the contract and its severable arbitration agreement came into existence in the first place. Section 2 does not tell us how or when an arbitration agreement comes into existence; state law applicable to the formation of ordinary contracts does. Section 2 concerns only the validity, recovability and enforceability of an arbitration agreement, and those issues can arise only when the parties have entered into an arbitration agreement in the first place.
Suppose A forges B’s signature on a contract containing an arbitration clause. Neither a contract or an arbitration agreement within a contract comes into existence because B never assented to a contract or an arbitration agreement. B can easily defeat A’s motion to compel arbitration and is entitled to a declaratory judgment that no contract exists. The doctrine of severability is irrelevant in this scenario because nobody entered into an arbitration agreement in the first place (or for that matter any contract whatsoever). In a broad sense, Section 2 is no more relevant to this type of dispute than it is to a dispute over the existence of a contract that does not contain an arbitration clause.
What the Court faced in Morgan Stanley was a slightly less extreme variation on our forgery hypothetical. The investor who purported to contract with Morgan Stanley suffered from dementia, and her guardian argued that she was mentally incompetent at the time she signed the document containing an arbitration clause. This argument went to her capacity to contract, which, under applicable state law, meant that her guardian was claiming that she never assented to a contract or an arbitration agreement within a contract – just as B in our hypothetical never assented to the purported contract on which A forged B’s signature. Assent, of course, is an issue that relates to the formation of contracts, not their enforceability, revocability or validity. As the Texas Supreme Court correctly held, the doctrine of severability did not apply because no arbitration agreement was concluded.
What made things a little dicey was that the United States Court of Appeals for the Fifth Circuit had previously ruled that a defense alleging lack of mental capacity was arbitrable because it was a defense to the contract as a whole, not the arbitration agreement contained within it. But the Fifth Circuit’s reasoning assumed that the doctrine of severability applied even though nobody had established that an arbitration agreement subject to Section 2 ever came into being.
The Texas Supreme Court – which, like other state supreme courts, is bound to follow only United States Supreme Court decisions on federal law questions – recognized this error and correctly did not follow the Fifth Circuit decision. It deftly analyzed the issue before it and unquestionably reached the correct result.
The Texas Supreme Court relied not only on numerous prior decisions from various courts, and on dictum in a footnote from the Buckeye Check Cashing decision, but also on a quote from an article by Professor Alan Scott Rau of the University of Texas at Austin School of Law, which Ms. VanBuren, in turn, quoted in her excellent post. After Disputing published its post on Morgan Stanley Professor Rau submitted to Disputing his own insightful comments about the case, which Disputing published in a follow-up post (here), and which we, in turn, reproduce below:
The Texas Supreme Court gets it absolutely right [and totally without regard to the fact that they quote me.] How could it be otherwise? Compare Justice Hecht’s dissent:
A raving lunatic in a strait-jacket ‘agrees’ to a contract, including an arbitration clause. Her guardian later seeks to avoid it, but the question of the contract’s validity must be submitted to the arbitrators for a final and binding decision. But where do the arbitrators get such authoritative decisionmaking power? Why, where they always get their power—from the agreement of the parties! Now, just what agreement of the parties is that? Well, there is something written and signed—it ‘exists,’ doesn’t it? ‘It happened,’ didn’t it? That the signatory was out of her head is just an inconvenient detail.
Such an approach could only make sense if one is living in some world of words and labels totally divorced from reality. The ‘law’ rarely permits such silly results—and it never, ever, absolutely requires them.
All of this is reasonably obvious. What I find more interesting here is Justice Hecht’s argument that the result should be different because the Texas courts need to align themselves with the Fifth Circuit. This is really rather striking when you think about it: As a matter of constitutional law the Texas courts have an equal claim with the lower federal courts to interpret the dictates of federal law; I can’t believe that it’s better to acquiesce in foolish Fifth Circuit opinions than to try to get the Fifth Circuit to reconsider.
Now it may well be, as Justice Brister points out, that even if the plaintiff’s incapacity is ultimately confirmed by a court, she [or her guardian] may still be bound to arbitrate; where ‘estoppel’ kicks in, arbitration is no longer consensual and becomes irrelevant anyway. But this is a different point, and the case hadn’t been argued on that basis—which just reflects the fact that the lawyering was inadequate and that we’re in a messy state on appeal.
Alan Scott Rau
Burg Family Professor of Law
University of Texas at Austin School of Law
We believe Professor Rau’s comments are right on the mark, and thank him for sharing them with Disputing and the ADR blogosphere.
Tags: Arbitration Agreement, Buckeye Check Cashing v. Cardengna, Disputing, Federal Arbitration Act, Fraudulent Inducement, Karl Bayer, Lack of Capacity, Prima Paint v. Conklin, Professor Alan Scott Rau, Re Morgan Stanley & Co., Separability, severability, Texas Supreme Court, University of Texas, Victoria VanBuren
