Delaware Chancery Defines ‘Quick’ Court Inquiry Before Referral to Arbitration

By Kelly Zhang

An action for a preliminary injunction to enjoin arbitration proceedings by officers of a Delaware limited liability company has been denied by the Delaware Court of Chancery.

The decision supports the vitality of a limited liability company’s use of arbitration in its operating agreement. But as it develops the Delaware business court’s view of cases to be sent for arbitration, the case arguably increases the chancery court’s gatekeeping function. Angus v. Ajio LLC, Civil Action No. 11895-VCG (May 13, 2016)(available for download at http://bit.ly/1sXAChn).

The matter concerned whether a dispute was arbitrable, and the question was whether the dispute should go to an arbitrator, or be decided by a court. The underlying suit included allegations of a breach of fiduciary duties and fraud brought by some members the company, MoGo Sport LLC, against MoGo’s officers, for entering into a transaction that ultimately sold the company.

Traditionally, questions of arbitrability have been left to the arbitrators, once a court has found that parties had agreed to submit their disputes to arbitration. The landmark case of Moses H. Cone Memorial Hosp. v. Mercury Construction Corp., 460 U.S. 1, 24 (1983) confirmed that the Federal Arbitration Act created a “liberal federal policy favoring arbitration agreements,” and that “any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration.”

This suggested a first look to the arbitration tribunal, which further U.S. Supreme Court cases developed. But the determination of arbitrability ultimately follows the contract. First Options of Chicago Inc. v. Kaplan, 514 U. S. 938 (1995), enshrined the principle that “courts should not assume that the parties agreed to arbitrate arbitrability unless there is “clea[r] and unmistakabl[e]” evidence that they did so.” (Internal citation omitted.) The First Options inquiry turned upon what parties agreed to; the question was settled by the court once it was shown that parties had not agreed to arbitrate.

Subsequent cases like Howsam v. Dean Witter Reynolds Inc., 537 U.S. 79 (2002), and Green Tree Financial Corp. v. Bazzle, 539 U.S. 444 (2003), further narrowed courts’ ability to decide on arbitrability.

Howsam focused on time bars on arbitration, which the Supreme Court ruled was to be determined by arbitrators. Green Tree Financial further held that an ambiguity in the arbitration provision was to be resolved by an arbitration tribunal.

But the May Angus opinion in Delaware’s Chancery Court doesn’t follow the general deference toward arbitration. It shows the Delaware business court examining the frivolity of claims.

In his 12-page opinion, Vice Chancellor Sam Glasscock III affirmed a two-pronged test to show a “clear and unmistakable” intent to arbitrate issues of arbitrability in James & Jackson LLC v. Willie Gary LLC, 906 A.2d 76 (Del. 2006)(available at http://bit.ly/1NZBonr).

The test, Glasscock wrote, requires a “’clear and unmistakable evidence’ of intent to arbitrate arbitrability . . . where there is:

‘1) an arbitration clause that generally provides for arbitration of all disputes; and
2) a reference to a set of arbitration rules that empower arbitrators to decide arbitrability, such as the American Arbitration Association . . . Rules.’”

Glasscock then expanded the test by citing McLaughlin v. McCann, 942 A.2d 616 (Del. Ch. 2008)(available at http://bit.ly/1RGfmke), noting that

only where “a non-frivolous argument in favor of substantive arbitrability exists and the first two prongs of Willie Gary are satisfied, [should] the Court . . . defer to the arbitrator.” [Emphasis added; citation omitted.]

The Angus opinion notes that the additional requirement serves the interests of justice by preventing wasted resources from the adjudication or arbitration of frivolous claims, allowing the court to strike the frivolous claims. But the court’s examination is limited; cases where “more than a quick, facial review of claims would be required” would proceed to arbitration.

Out of the four officers against whom the arbitration demand was brought, only Bruce Angus was a party to the MoGo operating agreement. Consistent with the contractual approach, the motion to halt the arbitration preliminarily against the remaining three officers was granted, as it was held that they would more likely would not be bound to arbitrate because of the lack of contractual obligations under the LLC operating agreement.

On the other hand, the court found at least one “non-frivolous” claim with regard to the original plaintiffs’ standing to force arbitration. As a result, Vice Chancellor Glasscock denied the motion for a preliminary injunction in Angus’s case, and deferred the decision to the arbitrators on the substantive issue of whether the case should be arbitrated.

The court conducted an analysis to determine if there were non-frivolous claims to arrive at the conclusion that the case should be arbitrated.

First, Angus and the other officers who sought to block the arbitration argued that the LLC members who filed for arbitration over the company’s sale lacked standing to enforce arbitration under the operating agreement when they cited a covenant not to compete. The theory was that only MoGo itself could enforce the non-compete provisions, and not the Members.

Glasscock saw these “issues of standing by signatories to a contract to enforce breaches of that contract” as non-frivolous, and that the officers failed to demonstrate that the original plaintiffs’ assertion of standing was frivolous. That finding sent the case to arbitrators for the determination of whether the case arbitrable.

In addition, the defendant officers had said that the arbitration claims against them for a breach of fiduciary duties were outside the scope of the LLC operating agreement because the contract was silent on fiduciary duty.

The court noted that the arbitration provision only covered disputes “among Members or former Member over the provisions of the Operating Agreement.” [Emphasis is the court’s.] It said that whether a breach-of-fiduciary-duties claim would arise from the agreement, and whether the agreement’s silence on the point incorporates default fiduciary duties from state law, was a “nice question” that needed deeper examination.

“This question,” Glasscock wrote, “which warrants more than a cursory inquiry by the Court into the frivolousness of the claim, should be referred to arbitration” under the parties’ agreement.

Angus arguably paves the way for courts to have more say in deciding the arbitrability of disputes despite arbitration provisions. “Litigants’ economy,” the opinion notes, mandates courts to conduct at least the “quick, facial review” of the frivolousness of claims, discussed above, before allowing them to proceed to arbitration. Cases would have to both show a clear intent to arbitrate, as well as present non-frivolous claims, in order to strike a balance between serving the economy and providing parties the benefits of their bargain.

Attorneys from both sides declined to comment.

The case proceeds. An answer and counter-claim was filed by the MoGo LLC members, as they proceed on their fiduciary and fraud claims against the officers not subject to arbitration, on May 27.

The author was a Summer 2016 CPR Institute summer intern and is a third-year LL.B. student from the Singapore Management University.

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