Texas Supreme Court Holds that the Court, not the Arbitrator Should Decide the Issue of Capacity to Contract

The Texas Supreme Court held that a trial court did not abuse its discretion by declining to submit to the arbitrator the question of whether a party to an arbitration agreement lacks the mental capacity to assent. Justice Medina delivered the opinion of the court, in which Chief Justice Jefferson and Justices Wainwright, Green, Johnson, and Willett joined. Justice Brister filed a concurring opinion, Justice Willett filed a concurring opinion, Justice Hecht filed a dissenting opinion, and Justice O’Neill did not participate.

In In re Morgan Stanley & Co., Inc., __ S.W.3d __ (Texas 2009) (No. 07-0665), Helen Taylor was worth several million dollars in 1999. Having been diagnosed with dementia that year, Taylor transferred several accounts to Morgan Stanley & Co. Each account agreement contained an arbitration clause. In 2005, Nathan Griffin, guardian of Taylor’s Estate, sued Taylor’s granddaughters and others for violation of of the Texas Uniform Fraudulent Transfer Act, civil theft, conversion and for imposition of a constructive trust. About a year later, Griffin added Morgan Stanley & Co. as a defendant, claiming breach of fiduciary duty, negligence and malpractice, unsuitability of investments, violations of the Texas Security Act, and breach of contract.

When Morgan Stanley moved to compel arbitration, Griffin argued that Taylor lacked capacity to contract when she signed the account agreements containing the arbitration clause. Therefore, according to Griffin, the appropriate forum to resolve the dispute was the court, not arbitration. The trial court agreed with Griffin and denied the order to compel arbitration. The court of appeals also declined to order arbitration.

The Texas Supreme Court now considers whether a court or an arbitrator should determine the issue of mental capacity to contract. The court began by highlighting section 2 of the Federal Arbitration Act (“FAA”), “an agreement to arbitrate is valid except on grounds as exist at law or in equity to revoke the contract.” The court continued to say that “[s]ection 2 of the FAA provides that courts shall compel arbitration on issues subject to an arbitration agreement.” However, the court noted that “[s]ection 4 of the FAA provides that a court may consider only issues relating to the making and performance of the agreement to arbitrate.”

Next, the court explained that the U.S. Supreme Court rejected the reasoning that “any defense that would render the entire contract unenforceable or void was for the court to decide because if the underlying contract was invalid so too was the agreement to arbitrate.” Prima Paint Corp. v. Flood & Conklin Manufacturing Co., 388 U.S. 395 (1967). The court noted that in Prima Paint, the U.S. Supreme Court created the “separability” doctrine, in which “an arbitration provision was separable from the rest of the contract under section 4 and the issue of the contract’s validity was to be determined by the arbitrator unless the challenge was to the agreement to arbitrate itself.”

The court then turned to the question of whether the defense of mental capacity is an attack on the validity of the contract as a whole (therefore a matter for the arbitrator to decide) or specifically aimed to the agreement to arbitrate (a matter for the court to decide). The court pointed out that the Fifth Circuit decided in Primerica Life Insurance Co. v. Brown, 304 F.3d 469 (5th Cir. 2002), that “the arbitrator should decide a defense of mental incapacity because it is not a specific challenge to the arbitration clause but rather goes to the entire agreement.” But the court also noted that the Tenth Circuit reached the opposite result in Spahr v. Secco, 330 F.3d 1266 (10th Cir. 2003), concluding that the “mental incapacity defense naturally goes to both the entire contract and the specific agreement to arbitrate in the contract.”

Explaining that the U.S. Supreme Court has not decided the present issue, the court cited Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440 (2006). It then stated that in Buckeye, “the [U.S. Supreme] Court noted that an illegality defense, raising the issue of the contract’s validity, was different from a formation defense, raising the issue of whether a contract was ever concluded.”

Finally, citing Alan Scott Rau’s article Everything You Really Need to Know About “Separability” in Seventeen Simple Propositions, 14 Am. Rev. Int’l Arb. 1, 17 (2003), the court concluded that Primerica misapplies Prima Paint’s separability doctrine:

Despite casual assumptions to the contrary, Prima Paint does not merely preserve for the courts challenges that are “restricted” or “limited” to “just” the arbitration clause alone—this would be senseless; it preserves for the courts any claim at all that necessarily calls an agreement to arbitrate into question. To send a dispute to arbitration where “not only” the arbitration clause itself, but “also,” in addition, the “entire” agreement is subject to challenge, is to lose sight of the only important question—which is the existence of a legally enforceable assent to submit to arbitration. Someone lacking the requisite mental capacity to contract cannot, I dare say, assent to arbitrate anything at all.

Accordingly, the court denied the petition for writ of mandamus.

This opinion is noteworthy for several reasons. First, the U.S. Supreme Court has not ruled on whether the issue of capacity to contract should be decided by a court or by the arbitrator. Second, the Fifth and Tenth Circuits have reached opposite outcomes on this issue. Third, the Texas Supreme Court declined to follow the precedent set by Fifth Circuit case law. Finally, the Texas Supreme Court’s majority opinion agreed with the analysis by Alan Scott Rau, professor at The University of Texas School of Law and contributor to this blog.

[Ed note: find professor Alan Scott Rau’s comments about this case here.]

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