United States: Arbitration Agreements — Incorporation By Reference Of An Arbitration Clause In Another Document Is A Simple Matter ... Isn't It?

Drafting an arbitration clause for your agreement is a straightforward matter most of the time. Sometimes it can be as simple as incorporating by reference an arbitration provision in another document or agreement. Easy peasy. Or is it?

First, a little background. Arbitrations that are subject to the Federal Arbitration Act ("FAA") are creatures of contract, and so a party is bound to arbitrate only if it agreed or may be deemed to have agreed to do so under applicable contract law. So sayeth the Supreme Court.

For example, a party that has not executed an arbitration agreement may nevertheless be deemed bound by one by reason of any of several contract law-related theories: (1) successor-in-interest; (2) assumption; (3) third-party beneficiary; (4) agency; (5) incorporation by reference; (6) estoppel; or (7) veil piercing/alter ego. Incorporation by reference of a contract term seems a simple example of such a theory. Generally, if a contract expressly incorporates by reference a provision in another document, the parties to the principal agreement are deemed bound by the incorporated term. Such an incorporated provision might be an arbitration clause, for example. Simple. Or is it?

The recent Federal District Court decision in Cooperativa Agraria Industrial Naranjillo Ltda. v. Transmar Commodity Group, Ltd., 2016 U.S. Dist. LEXIS 129969 (Sept. 22, 2016), tells us to look closely at the facts and the governing law before assuming so.

Naranjillo was a Peruvian agricultural cooperative of cocoa and coffee farmers, and Transmar was a New Jersey cocoa trading house. The parties entered into six substantially similar one-page agreements for the delivery of cocoa butter to Transmar in Germany. (The agreements differed only in shipment dates, product amounts, and consequent pricing.) Each one-page agreement was written on Transmar letterhead and titled "Standard 2-A Contract." And each agreement had a final "Condition" that read in pertinent part:

"This contract is subject to the terms and conditions of Standard 2-A Contract of the Cocoa Merchant Association of America, Inc. ["CMAA"]...."

Naranjillo made none of the required deliveries; Transmar obtained an arbitration Award of $2.6 million against Naranjillo, which had defaulted in the arbitration proceeding; and Naranjillo petitioned the court to vacate that Award under FAA § 10(a)(4).

The CMAA Standard 2-A Contract form contained an arbitration provision, the terms of which were set out in its Sections 13 and 22. Transmar did not furnish a copy of that form to Naranjillo at any time through the execution of the cocoa butter contracts, nor was it brought to Naranjillo's attention that there was an arbitration clause in that CMAA form. On the other hand, nothing prevented Naranjillo from obtaining a copy of the CMAA form and reading its terms before signing the cocoa butter contracts.

Naranjillo argued to the Court that the arbitrators had exceeded their powers because the dispute was not subject to arbitration because Naranjillo had made no arbitration agreement. Transmar argued incorporation by reference.

The Court confirmed that the question of whether the parties had agreed to arbitrate would in effect be determined by state contract law principles, and thus applied New York law.

The Court opined that, under New York law, "a paper referred to in a written instrument and sufficiently described" may be incorporated by reference, but it must be clear that "the parties knew of and consented to the terms to be incorporated by reference...." Among other things, it is essential under New York law (i) that the principal agreement sufficiently describes the document to be incorporated such that the referenced document may be identified beyond all reasonable doubt, and (ii) that the parties to the principal agreement clearly had knowledge of and assented to the incorporated terms.

In Naranjillo, the decisive principle was that an offeree cannot assent to an offer unless the offeree knows of its existence. The Court found that there had been no showing that Naranjillo actually knew of the existence of the arbitration clause terms.

Transmar argued that Naranjillo was nonetheless on notice to make inquiry regarding the terms that were to be incorporated by reference. The Court disagreed, finding that "Naranjillo was not on notice to search for an arbitration agreement, for it was not warned that an arbitration agreement existed." In that regard, the Court noted that neither the one-page cocoa butter contracts nor the reference in those contracts to "Standard 2-A Contract of the Cocoa Merchant Association of America, Inc." indicated the existence of an arbitration agreement.

Contrast this decision with, for example, the opinion in an analogous situation by the California Supreme Court in Sanchez v. Valencia Holding Co. (Aug. 3, 2015), applying California law. There, Sanchez opposed a motion to compel arbitration based on an arbitration clause in an agreement by which he purchased a $50,000 used Mercedes automobile. He argued that the arbitration clause was "hidden" on the back-bottom of one of the pages of the agreement, that the arbitration clause was never called to his attention, and that he never read it. The California Supreme Court, reversing a lower court decision, held that Sanchez's failure to read the contract was unreasonable, and that California law did not require the seller to call the arbitration clause to Sanchez's attention.

In order to protect arbitration agreements from the unfavorable treatment that they have historically received in many state courts (and some federal courts), the Supreme Court mandated that they are to be treated no differently – and in particular no worse – than other types of agreements under applicable contract laws. Their enforcement is not to be disfavored.

In Naranjillo, the Court arguably treated the arbitration provision in a way that it would not likely have treated another provision of the CMAA form. See also, Narayan v. The Ritz-Carlton Dev. Co., Inc., 2015 WL 3539805 (Haw. June 3, 2015). Whether that treatment is characterized as less favorable or more favorable, it is most likely different and not obviously justifiable as such. (Perhaps the result could be rationalized as the product of an application of the contra proferentem maxim of contract interpretation. But the Court's opinion says no such thing.)

In any event, the takeaway is that when an arbitration clause is to be incorporated by reference, the principal contract should expressly state that fact in order to assure that the arbitration provision will be given full effect.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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