Third Circuit: Challenges to Contract’s Validity Must Be Arbitrated, But Challenges to Contract’s Formation May Proceed in Court

In its recent decision in SBRMCOA, LLC v. Bayside Resort, Inc., the Third Circuit clarified when challenges to a contract containing an arbitration clause must be arbitrated and when they must be decided by a court. Emphasizing that the relevant distinction is between challenges to a contract’s validity, which are subject to arbitration, and challenges to a contract’s formation, which generally are not, the Court concluded that a claim that a contract was coerced must be arbitrated, but a claim that a contract was beyond a signatory’s authority or ultra vires requires judicial determination.

The dispute in Bayside Resort arose after a condominium association’s initial sponsor attempted to assign its exclusive right to supply water to the association. To obtain the association’s consent to the assignment, the sponsor and one of its creditors, the potential assignee, threatened to stop providing water and wastewater treatment services to the association’s members. Yielding to those threats, the association’s board consented to the assignment and signed a water supply agreement that contained an arbitration clause. When a dispute later arose, the association filed suit against both the initial sponsor and the assignee, alleging, among other things, that the water supply agreement was void because it was coerced and because the board lacked the authority to sign it. Finding that all of the association’s claims were within the scope of the parties’ arbitration clause, the District Court dismissed the association’s complaint and ordered arbitration.

In its analysis, the Third Circuit found a distinction in the Supreme Court’s decisions on when contract disputes must be arbitrated. Under a well-settled principle established in Prima Paint v. Flood & Conklin Mftg. Co., if a contract contains an arbitration clause, challenges to the validity of the contract as a whole—for example, on the ground that the contract is illegal or was fraudulently induced—are for the arbitrator to decide. But, more recently, the Supreme Court explained that “[i]t is similarly well settled that where the dispute at issue concerns contract formation, the dispute is generally for courts to decide.” Granite Rock Co. v. Int’l Bhd. Of Teamsters. Relying on that distinction as well as a prior decision in which it held that a claim that a contract was beyond a signatory’s authority was not subject to mandatory arbitration—a conclusion it noted is consistent with five of the six other courts of appeals to have addressed the issue—the Third Circuit concluded that the condominium association’s ultra vires argument is a challenge to the water supply agreement’s formation and therefore must be decided by the District Court.

Turning to the claim that the contract was coerced, the Third Circuit explained that, although it had never squarely addressed the issue, the distinction it had previously drawn “between claims that a contract is void, which are not arbitrable, and claims that a contract is voidable, which are arbitrable” may not have survived the Supreme Court’s recent decision in Buckeye Check Cashing v. Cardegna. Indeed, in that decision, the Supreme Court rejected the void/voidable distinction in favor of an analysis that focuses on distinguishing challenges to a contract’s validity from challenges to a contract’s formation. Under that analysis, the Third Circuit concluded, the condominium association’s coercion claim must be arbitrated because it constitutes a challenge to the validity of the water supply agreement.

Based on the Third Circuit’s guidance in Bayside Resort, when deciding whether to pursue a challenge to a contract containing an arbitration clause in court or before an arbitrator, it is important to attempt to determine if the challenge goes to the formation of the contract as opposed to its validity. If it does, the challenge may proceed in court. If it instead goes to the validity of the contract as a whole, the challenge will be subject to arbitration. Despite the Third Circuit’s guidance in Bayside Resort, the thin line that separates formation challenges and validity challenges makes distinguishing between the two difficult in many cases.

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