Integration Clause Proves Fatal to Plaintiffs' Federal Securities Claims That Must Be Arbitrated, According to Eleventh Circuit
Raphael Rosenblatt | Bloomberg Law
Confronted with the “novel question” of who should decide what when considering challenges to a contract that contains an arbitration clause, the U.S. Court of Appeals for the Eleventh Circuit determined that the agreement between the parties contained an integration clause and therefore comprised the parties’ entire agreement. As a result, the parties were obligated to arbitrate their dispute and the district court properly dismissed plaintiffs’ complaint.
Plaintiffs were personal investment holding companies owned by two related Panamanian shareholders. They invested a certain sum of money with a related group of banking corporations operating under the umbrella of Banco Santander (Santander). Santander provided banking, investment, and other financial management services. At the time of the investment, plaintiffs advised Santander that they wanted low-risk investments. Despite this, some of plaintiffs’ funds were invested in Optimal Strategic US Equity Series of Optimal Multiadvisors Ltd. (Optimal), which had engaged the services of Bernard Madoff to execute its trading strategy. Although Santander had a policy against investing in funds managed by a single person, it nonetheless recommended Madoff-run funds to its clients. Needless to say, after Madoff’s massive Ponzi scheme was revealed, plaintiffs lost a substantial portion of their investment with Santander.
After their losses came to light, plaintiffs attempted to negotiate a settlement with Santander. Santander proposed an Exchange Agreement in which it offered to exchange plaintiffs’ “worthless” shares for shares of its own perpetual, non-cumulative 2 percent shares. The Exchange Agreement also contained an arbitration clause. Plaintiffs rejected the Exchange Agreement as the sole basis for settling claims between the parties.
Ultimately, the parties agreed to a comprehensive settlement that included the previously rejected Exchange Agreement, as well as a non-recourse promissory note secured by Santander’s perpetual, non-cumulative 2 percent preferred shares. The promissory note’s term was 10 years. Told that they had to sign the Exchange Agreement within 24 hours or they would not be permitted to enjoy the preferred shares, plaintiffs nevertheless were wary of signing it because they did not want it to stand alone. Santander advised that it “had not yet had time to prepare the necessary paperwork for the other aspects of the agreement and that execution of the Exchange Agreement would be a showing of ‘good faith.’” Relying on these representations, plaintiffs signed the Exchange Agreement, which contained comprehensive release language and an integration clause. At the same time, Santander executed Final Term sheets that specified the terms of the 10-year promissory note and the date by which it would be funded. The parties sent several revisions back and forth regarding the proposed promissory note, but ultimately failed to agree on the substance or structure of the documents. Plaintiffs advised Santander that “they believed no contract had been formed between the parties.”
District Court Action
Plaintiffs sued Santander, asserting causes of action for breach of fiduciary duty, negligence, fraud, state law, equitable relief, and securities violations. Faced with the clear language of the Exchange Agreement, plaintiffs sought to rely on affidavits and parol evidence regarding the parties’ mutual understanding that the Exchange Agreement was part of a larger, more comprehensive settlement. The district court referred the case to a magistrate judge who recommended that plaintiffs’ claims be dismissed because the Exchange Agreement was a fully binding contract. The district court agreed.
Under the Federal Arbitration Act (FAA), arbitration clauses are treated as standard contracts, and any doubts about the scope of arbitral issues should be construed in favor of arbitration. The Eleventh Circuit was required to determine whether the Exchange Agreement itself was binding: “we must discuss whoshall decide what in the context of formation challenges to contracts containing arbitration clauses” (emphasis in original).
— Prima Paint and Granite Rock
In Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967), the U.S. Supreme Court held that courts are the proper forum for determining whether an arbitration clause is valid, but “where the entire agreement of which an arbitration clause is but a part is challenged, such evaluation is properly left to the arbitrator.” The Eleventh Circuit, however, noted that this question is different from the question of whether the parties ever entered into an agreement in the first instance, which is a question the Supreme Court left unanswered, until only recently in Granite Rock Co. v. Int’l. Brotherhood of Teamsters, 130 S. Ct. 2847(2010). As the Eleventh Circuit explained Granite Rock held that, “arbitration of a dispute should only be ordered where ‘the court is satisfied that neither the formation of the parties’ arbitration agreement nor. . . its enforceability or applicability to the dispute is in issue.’” However, “when a party contests either or both matters, the court must resolve the disagreement.”
— Two-Step Inquiry
The Eleventh Circuit rejected plaintiffs’ argument that Granite Rock overturned Prima Paint, as well as their claim that their challenges to the contract speak to its formation, rather than its interpretation. First, Granite Rock did not overturn Prima Paint, but instead makes clear what courts had done before on a de facto basis—decide whether the contract had been formed validly. Once that has been undertaken, and the court is satisfied that neither the formation of the arbitration agreement nor its enforceability or applicability is at issue, it then will consider the nature of the challenge under Prima Paint—determining whether there are valid challenges to the overall agreement or the arbitration clause specifically.
Plaintiffs claimed that although they signed the Exchange Agreement, it was part of a more comprehensive settlement. Moreover, they argued that the ambiguities throughout the Exchange Agreement make it unenforceable. Applying Florida contract law, the Eleventh Circuit disagreed and held that when the terms of a signed contract are not ambiguous, parol evidence is not permitted. The Eleventh Circuit held that the Exchange Agreement is not ambiguous because it contains all the essential terms, as well as an integration clause and a comprehensive release. “On its face, therefore, the Exchange Agreement is a complete and final document.”
— No Fraudulent Inducement
The Eleventh Circuit explained that plaintiffs cannot rely on a fraudulent inducement claim to contravene the parol evidence rule, because the exception does not apply “where the proffered oral testimony sought to be admitted would ‘directly contradict an express provision’ of the Exchange Agreement.” Moreover, the fraudulent inducement exception applies only when the written agreement does not purport to contain the entirety of the parties’ agreement.
— Contract Formed Properly
Once the district court, applying Granite Rock, satisfied itself that the Exchange Agreement was formed properly, it was appropriate to refer the matter to an arbitrator to resolve any outstanding issues. According to the Eleventh Circuit, “asking the district court to assess the validity of the Exchange Agreement relative to a broader, unexecuted agreement would be an invasion of the responsibility that the Supreme Court has reserved for the arbitrator.” Without any dispute that the parties read and executed the Exchange Agreement, which contained an arbitration clause, the district court properly referred the matter to an arbitrator.
Challenges to the Contract
Addressing the “specific formation challenges to the Exchange Agreement as a binding contract,” the Eleventh Circuit rejected such challenges.
— Fraud in the Factum vs. Fraud in the Inducement
First, the Eleventh Circuit distinguished between fraud in the inducement and fraud in the factum. The difference lies between in the parties’ understanding of the contract into which they are entering. “If a party understands the nature of the contract they are executing but contends that there has been some material representation as to the obligations rising thereunder, only a fraud in the inducement claim will lie.” By contrast, fraud in the factum occurs when one party obtains another’s signature on the contract without that party’s knowledge of the contract’s true nature or contents.
The Eleventh Circuit determined that plaintiffs admitted to having signed the Exchange Agreement with knowledge of its contents, thereby negating a fraud in the factum claim. However, plaintiffs alleged that the Exchange Agreement was one part of a more comprehensive agreement. This, the Eleventh Circuit explained, made the claim one of fraud in the inducement, meaning that “the issue becomes one properly reserved for an arbitrator.”
— Lack of Meeting of the Minds
The Eleventh Circuit rejected plaintiffs’ argument that there was no meeting of the minds as to the essential contract terms. “Where a contract is complete on its face, Florida law does not allow further inquiry into whether the contract is a part of a broader contract that is not referenced.” Likewise, the alleged failure of a condition precedent, as plaintiffs claimed, did not undermine the validly formed contract.
Prima Paint Analysis
Having concluded under Granite Rock that the contract was formed validly, the Eleventh Circuit turned to the arbitration clause itself and determined under Prima Paint that there was no challenge to the validity of the arbitration clause separate and apart from the overall challenge to the Exchange Agreement.
The Eleventh Circuit rejected plaintiffs’ additional challenges and found that all claims were encompassed within the Exchange Agreement’s arbitration clause (which referred to “all claims”), as well as its release language. The Eleventh Circuit concluded: “the district court, having correctly found that the Exchange Agreement executed by the parties was a binding contract, was bound by federal arbitration law and state principles of contract law to dismiss [plaintiffs'] challenges to the Exchange Agreement as part of a comprehensive settlement agreement.” Under Granite Rock and Prima Paint, an arbitrator must rule on plaintiffs’ challenges.
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