Texas Supreme Court Confirms Arbitration Is a Creature of Contract

In 2001, Wagner Oil Company purchased oil-and-gas-related assets pursuant to a purchase and sale agreement (PSA) from Apache Corporation. The PSA contained an indemnification provision requiring Wagner to

defend, indemnify, release and hold harmless Seller against all losses, damages, claims, demands, suits, costs, expenses, liabilities and sanctions of every kind and character, including without limitation reasonable attorneys’ fees, court costs and costs of investigation, which arise from or in connection with (i) any of the claims, costs, expenses, liabilities and obligations assumed by Buyer . . . , or (ii) any breach by Buyer of this agreement.

The PSA also contained an arbitration clause, which contained an arbitration carve-out, as follows:

Arbitration. Any disputes arising out of or in connection with this Agreement or the application, implementation, validity, breach or termination of this Agreement shall be finally and exclusively resolved by arbitration in Houston, Texas pursuant to the dispute resolution provisions contained in Exhibit B. Notwithstanding the above, in the event a third party brings an action against Buyer or Seller concerning this Agreement or the Assets or transactions contemplated herein, Buyer and Seller shall not be subject to mandatory arbitration under this section and Buyer or Seller shall each be entitled to assert their respective claims, if any, against each other in such third party action.

Shortly after the transaction, Wagner assigned the assets purchased from Apache to additional parties related to Wagner (referred to below as the Wagner assignees).

Beginning in 2010, third-party landowners filed lawsuits against Apache, seeking damages for alleged environmental contamination caused by Apache’s operation of the assets before it sold them to Wagner Oil. In 2017, Apache filed a demand for arbitration in Harris County with the American Arbitration Association (AAA) against Wagner and the Wagner assignees to recover over $15 million in legal fees and costs pursuant to the indemnity provision in the PSA.

Wagner argued that the assignees were not bound by the arbitration clause in the original PSA and filed a declaratory judgment action in state court denying any liability to Apache and also moved to stay the arbitration. In response, Apache filed a motion to compel arbitration. The trial court granted the Wagner assignees’ application to stay the arbitration proceedings and denied Apache’s motion to abate and compel arbitration.

Apache appealed that ruling to the Second Court of Appeals (Fort Worth), which held that the carve-out provision—which stated that the parties “shall not be subject to mandatory arbitration under this section and [Wagner Oil] or [Apache] shall each be entitled to assert their respective claims, if any, against each other in such third party action . . .”—did not apply to all third-party lawsuits but, rather, only if the two parties to the agreement chose to lodge counterclaims against each other in a lawsuit brought by a third party. The Second Court of Appeals stated that the trial court’s interpretation improperly stretched the language of the contract “under the guise of interpretation.”

Wagner petitioned the Texas Supreme Court, which agreed to hear oral arguments on the matter.

Was the Arbitration Carve-Out Limited to Specific Claims?

Wagner argued that Apache’s claims were not within the scope of the arbitration clause because the provision included a clear carve-out for disputes arising out of third-party claims. Apache contended that Wagner’s interpretation was unreasonable as a matter of law because it treated key language in the carve-out as surplusage and violated basic grammar rules. See generally Christopher R. Drahozal & Erin O’Hara O’Connor, “Unbundling Procedure: Carve-Outs From Arbitration Clauses,” [PDF] 66 Fla. L. Rev. 1945 (2015).

In its analysis, the Texas Supreme Court first noted that the Federal Arbitration Act (FAA) governed the arbitration agreement and reiterated that arbitration agreements are contracts and that the plain terms of the agreement will be enforced. Thus, a party will be required to arbitrate any issue that is specifically identified in the arbitration agreement, just as parties are free to exclude claims that they do not wish to include with the scope of the agreement to arbitrate. See generally Katie Shonk, “What is an Arbitration Agreement?,” Daily Blog (Harvard Law School Program on Negotiation), May 24, 2021.

In reviewing the arbitration carve-out language, the court held that the carve-out did not permit Wagner to pursue its request for a declaratory judgment regarding defense and indemnity obligations in court. Specifically, the court explained that the plain meaning of the agreement gave the parties two options in the event of a third-party action concerning the assets.

First, the court noted, Wagner and Apache could have waited and submitted their resulting claims against each other to arbitration because the carve-out provides that in the event of a third-party action, the parties “shall not be subject to mandatory arbitration.” In that regard, however, the court also expressed that there was nothing in the agreement that prohibited the parties from choosing arbitration in accordance with their general agreement to arbitrate.

Second, the court reviewed the language in the agreement that provides that the parties “shall each be entitled to assert their respective claims, if any, against each other in such third-party action,” and held that this second option applied only if the claims were brought in a third-party action. The court stated that the language did not also allow the claims to be brought in a separate suit.

In affirming the lower court, the supreme court explained the basic principles of contract interpretation, noting that its function was to review the entire contract and give effect to all provisions and to determine the intent of the parties as expressed by the plain language of the contract. The court reasoned that parties are free to enter into contracts and the intent to be bound by arbitration was clearly expressed in the language of the arbitration provision. Based on those guiding principles, the court determined that the arbitration exemption applied only if the parties pursued counterclaims against one another in litigation by a third party, not disputes over third-party actions in general.

Who Is Bound by an Agreement to Arbitrate?

Wagner also argued that the assignees were not bound by the agreement to arbitrate in the original PSA because the assignees only agreed to a share of the PSA’s obligations in proportion to their stake in the assets of Apache. See generally William D. Gilbride Jr., ADR Column, “Who Is Bound to an Agreement to Arbitrate?,” [PDF] Legal News, Dec. 2017.

In rejecting that argument, the court explained the general principle that a non-signatory can be bound to an agreement to arbitrate. In this instance, the court noted that the Wagner assignees expressly assumed and agreed to be bound by all of Wagner Oil’s obligations, including its obligation to arbitrate. See generally Farrell Fritz P.C., “Commercial Division Holds Nonsignatories Are Bound By Agreement’s Arbitration Clause,” July 20, 2020.

In so holding, the court rewrote the language of the assignment, which clearly expressed that the assignees “[1] assume and [2] agree to [a] be bound by and [b] perform their proportionate parts” of “all obligations imposed upon Wagner Oil.” Reading the plain language of the assignment, the court concluded that the assignees’ position that they assumed only proportionately divisible obligations was inconsistent with the language of the entire assignment and that the assignees were bound by “all” obligations imposed on Wagner Oil because “[a]ll obligations means all obligations.”

Practice Pointers

The Texas court, like many other state courts, affirmed that arbitration is a favored mechanism for resolving disputes between parties. See Jon O. Shimabukuro & Jennifer A. Staman, Cong. Research Serv., R44960, Mandatory Arbitration and the Federal Arbitration Act [PDF] (Sept. 20, 2017). However, while it is clear that courts generally agree that there is a presumption toward arbitration if a valid agreement exists, a court will not compel the arbitration of claims that are outside the scope of the parties’ arbitration agreement. Thus, if the parties want to arbitrate any and all claims relating to their relationship, they need to clearly express this intent in their written agreement.

Kenneth E. Sharperson is a partner with Weber Gallagher in Bedminster, New Jersey.

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