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In a case of first impression, the Pennsylvania Superior Court has instructed trial courts on the proper test to use when deciding whether an arbitration agreement contained in an allegedly fraudulent contract is enforceable when the parties claim to be in a confidential relationship. The majority in Paone v. Dean Witter Reynolds Inc. said such a fact pattern urges the application of a more stringent test than the general rule that an arbitration provision in a fraudulent contract is enforceable unless the allegations of fraud go specifically to the arbitration provision. The test calls for the trial court to decide whether a confidential relationship does exist and whether the contract between the parties was entered into voluntarily, with knowledge of its nature and terms. The plaintiff, Joseph Paone, is a mentally challenged adult who sued Dean Witter Reynolds Inc. and one of its brokers for fraud. Paone lived with his mother for all of his life, Superior Court Judge Debra M. Todd said in the majority opinion. He graduated from high school after five years, but with barely passing grades, Todd said. Paone held a minimum wage job for 10 years, but for the most part, Todd said, his mother supported him through her Army disability pension. Paone’s mother also handled all of his financial affairs. In 1996, Paone’s mother died. Paone was 45 at the time. He received slightly more than $72,000 in insurance death benefits. Paone followed the advice of his uncle and invested the money with Dean Witter Reynolds Inc. Paone met with Robert Smith, an account executive with Dean Witter. Paone told Smith he wished to invest his inheritance, which at that time was $52,000. Smith visited Paone at his home, where Paone signed a new brokerage account form. The form did not contain an arbitration provision, Todd said. According to Paone’s testimony, he thought investing his money with Dean Witter would be like placing it into a savings account at a bank and that he would earn interest on the money. Paone said he was skeptical about investing his money in stocks but that Smith “egged him on.” Throughout late 1996 and early 1997, Todd said, Paone gave Smith $72,000 to invest. In 1997, Paone opened an active assets account in order to open a checking account with Dean Witter. Without Paone’s knowledge, Smith took the first four blank checks from Paone’s checkbook and wrote checks totaling $25,000 to various credit card companies. Paone had no accounts with any of the companies. Smith later admitted to Paone that he had stolen the money. Todd said there was one other similar incident of Smith stealing money from Paone to pay a credit card company, but Smith invoked his Fifth Amendment privilege on the topic during cross-examination. Paone also opened a calls-and-options agreement at Smith’s suggestion, Todd said. Smith filled out the form and included false information about Paone’s income and the value of his house, Todd said. According to the opinion, Paone was unaware that there were any problems with Smith’s work until he was fired from Dean Witter in May 1998. Paone’s new broker, Scott Rivitto, told Paone that he had $52,000 in his account and that he owed Dean Witter $32,000 on a margin loan. Paone thought he had more than $100,000 in his account at that time, Todd said. In December 1999, Paone filed a complaint against Dean Witter and Smith for fraud and other claims. Dean Witter filed a petition to compel arbitration, arguing the active assets account application contained an enforceable binding arbitration provision. Smith filed preliminary objections alleging there was a binding arbitration provision in the calls and options agreement. The Lackawanna County Common Pleas Court found that Paone never signed the active assets account application and, therefore, was not aware of the arbitration provision it contained. The court found that Paone did sign the calls and options agreement, however, but it said that agreement did not contain an arbitration provision. Ultimately, the court said neither contract was enforceable because each was induced by fraud and denied Dean Witter’s motion to compel arbitration. Dean Witter appealed. CASE LAW CONFLICT Dean Witter first argued that the calls and options agreement did contain an arbitration provision, and the Superior Court agreed. Todd said the front page of the agreement contained a bold-faced statement saying: “This agreement contains an arbitration clause on the reverse side at paragraph six.” The related paragraph was, in fact, an arbitration clause, Todd said. Dean Witter then argued that an attack on the validity of a contract for fraud does not invalidate an arbitration provision in the contract unless the allegation of fraud goes specifically to the arbitration provision. Because Paone’s allegations of fraud were not directed at the arbitration provision, Dean Witter argued its petition to compel arbitration should have been granted. However, Paone claimed that his limited intelligence and experience, considered along with Smith’s experience in financial matters, created a confidential relationship much like a fiduciary duty. That relationship made the contracts and their arbitration provisions voidable, Paone argued. Todd said the arguments created a sticky situation for the court to resolve. “As both Dean Witter and Paine rely on generally sound legal principles,” Todd said, “this case presents a conflict between case law that regards an arbitration provision as enforceable even where an agreement is challenged as fraudulently induced, and case law that requires that an agreement borne of a confidential relationship be given special scrutiny.” Todd cited a 1975 state supreme court case, Flightways Corp. v. Keystone Helicopter Corp., in which the justices set out the rule for deciding the validity of an arbitration provision in an allegedly fraudulent contract. The Flightways court said the arbitration provision should be considered a severable part of the agreement unless the allegation of fraud goes directly to that provision. Paone did not specifically allege the arbitration provision was fraudulently induced, so the Flightways rule would appear to control, Todd said. However, Paone’s case was unique because, unlike Flightways and the recent cases that have cited it, the agreements at issue were alleged to be the product of a confidential relationship, Todd said. “Entirely different presumptions come into play when a confidential relationship is at issue,” Todd said. According to another state supreme court case, Frowen v. Blank, from 1981, once a confidential relationship is shown to exist, it is the obligation of the party attempting to enforce the agreement to prove that there has not been a breach of the other party’s trust. Todd said Dean Witter had not shown that the contract was fair or entered into with an understanding of its nature and terms, as Frowen requires. In addition, Todd said, under Flightways, the court is limited to examine whether an agreement to arbitrate was “entered into” and whether the dispute is governed by the arbitration agreement. “Here, it is true that Paone signed the calls and options agreement. However, in the context of a confidential relationship, the fact that the party against whom an agreement is to be enforced signed the agreement is insufficient for its enforceability,” Todd said. “Rather, it must be shown that the party had an ‘understanding and knowledge of its nature, terms and consequences’ … before the agreement may be enforced against him.” TRIAL COURT’S INSTRUCTION In essence, Todd said, the court’s decision means that the “presumptions and burden-shifting” espoused by Frowen take precedence over the general principles of Flightways. When a trial court is presented with an arbitration agreement between parties alleged to be in a confidential relationship, the court must first determine whether the evidence supports the existence of the confidential relationship. “If so, the trial court must determine whether the proponent of the arbitration provision (presumably the stronger party) has met its burden of showing that the provision is unfair under all the circumstances … that it was entered into with knowledge of its nature and consequences … and thus that the provision was not itself a result of a violation of the trust reposed in the confidential relationship,” Todd said. “If this burden is not met, then the arbitration provision is unenforceable. Where this burden is met, or if the evidence does not support a finding that a confidential relationship exists, then Flightways dictates the enforceability of the arbitration provision.” Todd said the trial court’s order was vacated and remanded for a hearing to give Dean Witter an opportunity to comply with the standards set out in the majority opinion. Superior Court Judge Frank L. Musmanno joined Todd in the majority. DISSENT Superior Court Judge John T.J. Kelly Jr. dissented. He maintained that, even in a confidential relationship, when a contract contains an arbitration provision, any challenges to the contract’s validity should be submitted to arbitration unless the arbitration provision itself is attacked. “Guided by Pennsylvania’s strong policy favoring arbitration and, the holdings of Flightways and its progeny (reserving for the arbitrators general challenged to the validity of a contract), and to reinforce the vigor of arbitration clauses generally, I would send the instant dispute concerning the validity of the contract to arbitration,” Kelly wrote. Thomas H. Chiacchio and Alexander D. Bono of Blank Rome and Sal Cognetti of Foley Cognetti & Comerford in Scranton, Pa., represented Dean Witter. James J. O’Connor of Abrahamsen Moran in Scranton represented Paone. Scranton attorney Timothy P. Polishan was counsel for Smith.

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