Federal law’s much-talked-about presumption in favor of enforcing arbitration clauses has its limits. On August 11, 2014, the United States Court of Appeals for the Third Circuit identified one of those limitations: the presumption does not apply to attempts to enforce an arbitration agreement against a non-signatory to that agreement. Instead, a non-signatory can be bound to such an agreement only under narrower circumstances. In Griswold v. Coventry First LLC, the Third Circuit held those circumstances did not exist and thus reaffirmed the district court’s decision to deny a motion to compel arbitration over fraud claims relating to an arbitration agreement. The decision is not only a powerful reminder of the limitations to the federal policy in favor of arbitration, but it also provides an excellent explanation of when a non-signatory can and cannot be bound by an arbitration clause.

Griswold involved claims of fraud in connection with the sale of a life insurance policy. In January 2006, Plaintiff/Appellee Lincoln T. Griswold (Griswold) purchased an $8.4 million life insurance policy and established the Lincoln T. Griswold Irrevocable Trust for the “sole and exclusive purpose” of owning the policy. Griswold named Plaintiff/Appellee Griswold Family LLP, of which Griswold and his son were members, as the Trust’s sole beneficiary. The Trust later sold the life insurance policy to Defendant/Appellant Coventry First LLC (Coventry).

Griswold claimed that Coventry committed fraud when, unknown to the Trust or to Griswold, Coventry entered into a written agreement with the broker – Kevin McGarrey – that required McGarrey to refrain from seeking any further bids and to report any competing offers and their material terms to Coventry in exchange for $145,000 commission (the Secret McGarrey Agreement). The Trust sold its policy to Coventry without having received a competing offer. The written purchase agreement between the Trust and Coventry contained a standard arbitration clause requiring “[a]ll disputes and controversies of every kind and nature between the Parties arising out of or in connection with this Agreement” be arbitrated. Only the Trust and Coventry signed the purchase agreement. Neither of the Plaintiff/Appellees – Griswold and Griswold Family LLP – signed the purchase agreement.

Griswold (and Griswold Family LLP) sued Coventry and its affiliates on behalf of himself and on behalf of a class of persons who had sold their life insurance policies to Coventry. After removing to federal court, Coventry filed a motion to dismiss for lack of standing or, in the alternative, to compel arbitration pursuant to the purchase agreement. The district court denied Coventry’s motion to dismiss, finding standing and holding that the arbitration clause was “unenforceable as to Plaintiffs who are non-signatories.”

On appeal, and after first disposing of a jurisdictional issue, the Third Circuit began its analysis with two observations: (1) it was “undisputed” that the purchase agreement contained a “broad” arbitration clause; and (2) “[c]ourts generally apply a presumption in favor of enforcing arbitration clauses.”

That much was clear before this decision, but the court then made it clear that “the presumption in favor of arbitration does not extend, however, to non-signatories to an agreement.” Instead, the court turned to narrower “traditional principles” of state law to determine whether the non-signatory Appellees could be forced to arbitrate. Coventry argued that the traditional contract principle equitable estoppel supported its request for arbitration.

Relying on its prior precedent, the Third Circuit stated that equitable estoppel may apply under one of two theories. First, a non-signatory could be held to an arbitration clause when “the non-signatory knowingly exploits the agreement containing the arbitration clause despite having never signed the agreement.” Second, a non-signatory can force a signatory to arbitrate based on “the close relationship between the entities involved, as well as the relationship of the alleged wrongs to the non[-]signatory’s obligations and duties in the contract ... and [the fact that] the claims were intimately founded in and intertwined with the underlying contract obligations.” The latter theory did not apply because a signatory (Coventry) sought to bind the non-signatory (Griswold), not the inverse, and so the Third Circuit focused its attention on the first theory.

A non-signatory is deemed to have “embraced” a contract under equitable estoppel when it (1) knowingly seeks and obtains a direct benefit from the contract; or (2) seeks to enforce terms of that contract or asserts claims based on the contract provisions. Equitable estoppel thus prevents a non-signatory from “cherry-picking” the provisions of a contract that it will benefit from and ignoring those that do not benefit it. Against this background, the Third Circuit reviewed several of its prior decisions that highlighted its “relatively narrow application of the equitable estoppel exception.” Those cases showed even when the non-signatory’s claims may implicate an agreement containing the arbitration clause, the equitable estoppel exception does not apply if the non-signatory’s claims do not “hinge” on that agreement.

Turning to the facts before it, the Third Circuit reached the same conclusion. Griswold’s fraud claims hinged on the “Secret McGarrey Agreement” between Coventry and the broker. The Third Circuit noted “what saves the day” for Griswold is the fact the “Secret McGarrey Agreement” occurred “prior to and apart from the execution of the purchase agreement,” which contained the arbitration clause. While the purchase agreement was “[o]f course” relevant to damages because it set the purchase price and allegedly inflated the broker’s commission, “that alone is not sufficient to compel arbitration under the equitable estoppel doctrine: the claims must be based directly on the agreement.” The Third Circuit noted the Amended Complaint sufficiently pled injury without mentioning the purchase agreement. Because the fraud claims were not directly based on the purchase agreement, the arbitration clause in that agreement did not apply.

Pepper Points

Griswold teaches several important arbitration lessons. First, the presumption favoring arbitration stops at the feet of the non-signatory. Indeed, had Griswold signed the purchase agreement, query whether the “broad” arbitration clause would have covered Griswold’s fraud claims, given that Coventry then could have benefited from the presumption. Second, narrower “traditional” state law principles will dictate whether a non-signatory can be bound to an arbitration clause. Third, those principles require the claims to be directly based on the contract containing the arbitration clause. Merely because certain terms of an agreement containing an arbitration clause are relevant will not mean the arbitration clause will apply. Finally, as a practitioner pleading tip, a party seeking to avoid an arbitration clause from a potentially relevant agreement should plead its claims in a manner that does not require reliance on the agreement. Griswold sufficiently pled its injury without mentioning the purchase agreement, even though clearly the agreement was relevant to that injury. The Third Circuit found this persuasive.