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Fraudulent inducement as to an entire contract, an arbitrable issue under federal law, may be made non-arbitrable through the parties' designation of contrary state law, according to the Kentucky Court of Appeals.
In Morgan Keegan & Co., Inc. v. Force, No. 2006-CA-000311-ME, 2007 WL 1954025 (Ky. Ct. App. July 6, 2007), Force had an investment account with Morgan Keegan. The client agreement contained an arbitration clause and the following choice of law provision: "This agreement and its enforcement shall be governed by the laws of the State of Tennessee and federal law as applicable including the Federal Arbitration Act . . . ."
When the SEC penalized Force for insider trading, he sued Morgan Keegan for fraudulent inducement. Morgan Keegan moved to compel arbitration. The trial court denied the motion on the ground that a claim for fraudulent inducement is not subject to arbitration under Tennessee law.
On appeal, Morgan Keegan argued that the Federal Arbitration Act (FAA), not Tennessee law, governed the scope of the arbitration clause. In rejecting this interpretation of the choice-of-law provision, the Court reasoned that "[t]he federal authorities are clearly positioned in the agreement in a sequence secondary to the primary and preeminent placement of Tennessee law."
As the Court acknowledged, under the federal law of arbitrability, a claim of fraudulent inducement presents a question for the arbitrator unless it is specifically directed at the arbitration agreement. However, under Tennessee law, a claim of fraudulent inducement is not subject to arbitration even if it is directed at the contract as a whole. See City of Blaine v. John Coleman Hayes & Associates, Inc., 818 S.W.2d 33, 38 (Tenn. Ct. App. 1991).
Finally, the Court concluded that the application of Tennessee law would not run afoul of the FAA because the parties elected the application of Tennessee law, and "parties are generally free to structure their arbitration agreements as they see fit." Accordingly, the Court affirmed the denial of Morgan Keegan's motion to compel.
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