Commercial Litigation and Arbitration

Arbitration / Sanctions — Claim Party Was Fraudulently Induced to Enter Contract, as Opposed to Just Arbitration Clause, Is for Arbitrator to Decide — Even If Rule 11 Violated, Sanctions Are Discretionary

Ipcon Collections LLC v. Costco Wholesale Corp., 2012 U.S. App. LEXIS 20944 (2d Cir. Oct. 9, 2012):

This appeal arises out of a contract dispute between Costco and ES Electrosales Leadsinger, Co., Ltd. ("Leadsinger"), a company that sold, inter alia, karaoke systems. Between October 2005 and September 2008, Leadsinger and Costco entered into a series of agreements by which Costco agreed to sell Leadsinger's goods on a consignment basis. Each agreement contained a clause obliging the parties to arbitrate any dispute arising out of the agreements. Costco allegedly did not perform its obligations under these contracts, and Leadsinger's business eventually failed.

Ipcon, the successor-in-interest to Leadsinger, brought suit against Costco on December 2, 2010, alleging that Costco induced Leadsinger to consign its products to Costco, while never intending to honor its agreements to pay Leadsinger for its products. Ipcon's complaint alleged six counts: (1) fraud; (2) fraudulent returns and misaccounting; (3) conversion; (4) negligent bailment; (5) unfair trade practices--fraud; and (6) fraud in the inducement.

Costco then initiated arbitration proceedings and, on May 16, 2011, moved "pursuant to Federal Rule of Civil Procedure 12(b), and the Federal Arbitration Act," to dismiss the action as barred by the arbitration clause in each contract. Costco then requested sanctions against Ipcon pursuant to Federal Rule of Civil Procedure 11 ("Rule 11"). Ipcon, pointing to Costco's purported fraud, argued that the arbitration clauses were ineffective because the parties had never formed valid contracts in the first place. On this basis, Ipcon also cross-moved to stay arbitration.

On August 24, 2011, the District Court held that Ipcon had not presented a valid defense to arbitration and dismissed the action in favor of the pending arbitration proceeding. Specifically, the Court determined that Ipcon could not defeat the otherwise-valid arbitration clauses because its "complaint allege[d] a claim for fraud in the inducement insofar as [it] assert[ed] [that Costco] lied and misrepresented its intentions to induce Leadsinger to enter into the agreements." Joint App'x 277. Having dismissed Ipcon's suit, the District Court then denied Costco's motion for sanctions, although it noted that Ipcon's "submissions to the Court ha[d] not rested on the strongest precedent or arguments." Id. at 281.***


A. Arbitration

***As the Supreme Court explained in Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S 440 (2006), challenges to a contract containing an arbitration clause fall into two categories: those that challenge the contract as a whole, and those that challenge the arbitration clause in particular. Id. at 444. If the challenge is to "'the arbitration clause itself--an issue which goes to the making of the agreement to arbitrate--the federal court may proceed to adjudicate it.'" Id. at 445 (quoting Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395, 403-04 (1967)).

The Federal Arbitration Act, 9 U.S.C. § 1 et seq., however, "'does not permit the federal court to consider claims of fraud in the inducement of the contract generally.'" Buckeye Check Cashing, 546 U.S. at 445 (quoting Prima Paint Corp., 388 U.S. at 404). Rather, such claims must be decided by the arbitrator. Prima Paint Corp., 388 U.S. at 403-04. Nevertheless, a limited exception to the requirement of arbitration for general contract challenges may be available where a party "questions . . . whether a contract was ever made." Telenor Mobile Commc'ns AS v. Storm LLC, 584 F.3d 396, 406 n.5 (2d Cir. 2009); see Buckeye Check Cashing, 546 U.S. at 444 n.1.

Ipcon claims that the contracts between Leadsinger and Costco were void at their signing because Costco "never intended to honor [them]." Appellant Br. 9; see also id. at 5 (alleging that "Costco never intended to perform in accordance with the terms of the written document[s]," and that the documents were "nothing more than an artifice to take possession of goods belonging to Leadsinger, after which Costco would follow its standard, but hidden, fraudulent practices"). If the contracts were never formed, Ipcon argues, the case would appropriately be tried before the District Court rather than before an arbitrator. It further alleges that Costco committed "fraud in the factum," id. at 10, a claim that would mean that the contracts were void ab initio.

Ipcon's argument is meritless. Although Ipcon argues on appeal that the complaint alleges fraud in the factum, the complaint actually asserts--both in form and substance--fraud in the inducement. Indeed, Ipcon's allegation that Costco "never intended to honor" its contract is a quintessential example of the latter type of fraud. A party has made out a claim of fraudulent inducement if it has pled "(i) a material misrepresentation of a presently existing or past fact; (ii) an intent to deceive; (iii) reasonable reliance on the misrepresentation by appellants; and (iv) resulting damages." Johnson v. Nextel Commc'ns, Inc., 660 F.3d 131, 143 (2d Cir. 2011) (citing Ross v. Louise Wise Servs., Inc., 8 N.Y.3d 478, 488 (2007)). By alleging that Costco knew at the time of signing that it did not intend to abide by the contract and deceived Leadsinger into thinking that it would abide by the contract..., Ipcon has stated the first two elements of fraud in the inducement. Moreover, even if Ipcon had alleged fraud in the factum, the factual allegations in the complaint have nothing to do with that type of claim, which is only appropriate "in those 'rare cases' where 'the misrepresentation is regarded as going to the very character of the proposed contract itself, as when one party induces the other to sign a document by falsely stating that it has no legal effect.'" Revak v. SEC Realty Corp. 18 F.3d 81, 91 (2d Cir. 1994) (quoting E.A. Farnsworth, CONTRACTS § 4.10 (1990)). ***

B. Sanctions

Costco appeals from the District Court's denial of Rule 11 sanctions, and simultaneously moves for Rule 38 sanctions. We review a district court's denial of a motion for Rule 11 sanctions for abuse of discretion. Johnson v. Univ. of Rochester Med. Ctr., 642 F.3d 121, 125 (2d Cir. 2011). Sanctions may be--but need not be--imposed when court filings are used for an "improper purpose," or when claims are not supported by existing law, lack evidentiary support, or are otherwise frivolous. Fed. R. Civ. P. 11(b)-(c); see Storey v. Cello Holdings, L.L.C., 347 F.3d 370, 391 (2d Cir. 2003) (noting that a particular legal argument forms the basis for sanctions only if it is "patently contrary to existing law").

Further, even when a district court finds a violation of Rule 11, "[t]he decision whether to impose a sanction for a Rule 11(b) violation is . . . committed to the district court's discretion." Perez v. Posse Comitatus, 373 F.3d 321, 325 (2d Cir. 2004). The cases Costco relies on to suggest that sanctions may be mandatory are inapplicable or no longer good law. In Gurary v. Winehouse, 235 F.3d 792 (2d Cir. 2000), sanctions were mandatory only because the case arose under the Private Securities Litigation Reform Act. Id. at 797. Our Gurary decision has no bearing on Rule 11 sanctions outside of that context. See id. ("The PSLRA . . . mandates the imposition of sanctions if the court determines that Rule 11 has been violated" (emphasis in original)). The other two cases offered by Costco, Eastway Constr. Corp. v. City of New York, 762 F.2d 243 (2d Cir. 1985), and Norris v. Grosvenor Mktg. Ltd., 803 F.2d 1281 (2d Cir. 1986), were decided before Rule 11 was revised in 1993 to include crucial language that "the court may impose an appropriate sanction." Fed. R. Civ. P. 11(c)(1) (emphasis added). Those cases are therefore no longer good law on this issue. In short, sanctions under Rule 11 are discretionary, not mandatory.

Although Ipcon's arguments are weak, given the confusing nature of the division of responsibility between courts and arbitrators as to contract formation, we decline to disturb the considered decision of the District Court to "err on the side of finding that [Ipcon's] arguments were not objectively unreasonable." Joint App'x 282. Furthermore, even if the District Court had abused its discretion in finding Ipcon's arguments not objectively unreasonable, we would see no reason to disagree with the District Court's decision not to award sanctions. The denial of Costco's motion for Rule 11 sanctions is affirmed. For the same reason, we decline to impose sanctions in the first instance pursuant to Rule 38.

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