Federal Court Holds That Subsidiary of Insured Parent Company Cannot Be Compelled to Arbitrate Pursuant to an Arbitration Clause in a Deductible Agreement It Did Not Execute
September, 2005
The Seventh Circuit Court of Appeals recently ruled that an insured corporation’s subsidiary cannot be compelled to arbitrate a dispute with the liability insurer under a deductible agreement containing an arbitration clause which the subsidiary did not execute. Zurich American Ins. Co. v. Watts Ind., Inc., 417 F.3d 682 (7th Cir. 2005). The case arose in relation to a program of primary liability policies and accompanying deductible agreements issued by Zurich American Insurance Company (“Zurich”) to Watts Industries, Inc. (“Watts”) and its wholly owned subsidiary, James Jones Company (“Jones”). Both companies are manufacturers of valves and other waterworks parts used in municipal water systems. Both Watts and Jones were sued for fraud by third-parties in California, in 1997 and 1998. Zurich denied its duty to defend and indemnify Watts and Jones; in response, Watts filed suit against Zurich in California, seeking both defense and indemnity in the two California actions. Zurich then filed a petition to compel arbitration against both Watts and Jones in federal court in Illinois and asked the California court to stay the coverage actions based on the broad arbitration clauses contained in the separate deductible agreements. The Illinois district court’s initial order stated that Jones was not subject to arbitration, but that Zurich was entitled to compel arbitration against Watts.
On appeal, a critical issue before the Seventh Circuit was whether the district court had properly exempted Jones from the arbitration. Zurich argued that Jones was compelled to arbitrate under the deductible agreements based on the fact that: (1) Watts, Jones’ parent company, had signed the deductible agreements and, therefore, Jones was bound to the agreements, and (2) Jones had invoked the benefits of the insurance policies and therefore could not avoid the obligations in the deductible agreements associated with the insurance policies. Jones countered that it did not sign the deductible agreements containing the arbitration clause and that it cannot be compelled to arbitrate because it never agreed to arbitrate.
The deductible agreements contained language that stated “[Watts] and each named insured stated in the Policy(s) shall be jointly and severally responsible for the obligations under [the agreements].” Jones as a subsidiary of Watts was a “named insured” in the policies. However, the Court cited the following tenant of arbitration contract law: “[a]rbitration is contractual by nature - - ‘a party cannot be required to submit to arbitration any dispute which he has not agreed to submit.’” Thomson-CSF, S.A. v. Am. Arbitration Ass’n, 64 F.3d 773, 776 (2d Cir. 1995) (quoting United Steelworkers of Am. v. Warrior & Gulf Navigation Co., 363 U.S. 574, 582, 80 S.Ct. 1347, 4 L.Ed.2d 1409 (1960)).
There are five doctrines through which a non-signatory can be bound by arbitration agreements entered into by others: (1) assumption; (2) agency; (3) estoppel; (4) veil piercing; and (5) incorporation by reference. Frynetics (H.K.) Ltd. v. Quantum Group, Inc., 293 F.3d 1023, 1029 (7th Cir. 2002); accord Am. Bureau of Shipping v. Tecara Shipyard S.P.A., 170 F.3d 349, 352 (2d Cir. 1999). Zurich argued that Jones should be bound under both the agency and estoppel theories; the Court rejected Zurich’s arguments.
The appellate court upheld the district court’s finding that the relationship between Watts and Jones was insufficient for Jones to be bound to the terms of the deductible agreements based on Watts’ signature on those documents. The court noted “a mere parent-subsidiary relationship ‘does not create the relation of principal and agent or alter ego between the two.’” (quoting Caligiuri v. First Colony Life Ins. Co., 318 Ill. App. 3d 793, 252 Ill. Dec. 212, 742 N.E.2d 750, 756 (Ill. App. 1st Dist. 2000)). The Court also noted the Thomson-CSF decision, held that a corporate relationship is generally not enough to bind a non-signatory to an arbitration agreement. Thomson-CSF, 64 F.3d at 777.
Zurich’s estoppel theory was based on case law, which has held that a non-signatory party is estopped from avoiding arbitration if it knowingly seeks the benefits of the contract containing the arbitration clause. Thomson-CSF, 64 F.3d at 778; Elecs. Corp. of Wis. v. iPower Distribution Group, 215 F.3d 677, 680 (7th Cir. 2000). Zurich argued that Jones could not seek the benefit of the terms of the insurance policy without also being bound to the terms of the associated deductible agreements which contained the arbitration clause. The Seventh Circuit also rejected this argument; it held that there must be a “direct benefit” under “the contract containing the arbitration clause” in order for the reluctant party to be bound by the arbitration clause. Thomson-CSF, 64 F.3d at 779. The Court noted that Jones was not seeking to enforce any rights or derive any benefits under the deductible agreements (Jones was seeking to enforce its rights and benefits under the insurance policies). The Court further held that any benefit Jones gained from paying lower insurance premiums based on the associated deductible agreements was too “attenuated and indirect” to force arbitration under the estoppel theory.
Learning Point:
The Watts decision makes it clear that carriers seeking to enforce an arbitration clause against a named insured (subsidiary or otherwise) must insist that the insured sign any separate agreement containing the arbitration clause. Alternatively, the insurer may choose to include the arbitration clause in the actual policy of insurance under which the insured will seek to enforce its rights or derive a benefit. Insurers can no longer expect that subsidiaries that are named insureds under the principal company’s insurance policy will be bound to separate agreements, including arbitration clauses, that the principal has signed, but the subsidiary has not. •
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