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According to the Seventh Circuit Court of Appeals, the preclusive effect of a parallel state court decision must be determined by the arbitrator when a valid arbitration agreement exists.
In Zurich American Insurance Co. v. Watts Industries, Inc., No. 06-1415, 2006 WL 1101484 (7th Cir. Oct. 20, 2006), Watts sued Zurich for breach of contract when Zurich refused to cover its insurance claims. Jones, a subsidiary of Watts, also brought an action against Zurich for related claims. None of the insurance contracts executed by Watts and Jones contained arbitration provisions, but Watts signed deductible contracts which did.
Previously, the Seventh Circuit determined that Jones could continue with its parallel suit against Zurich, but remanded Watts’ case to the district court to determine whether the arbitration agreements in the deductible contracts were valid. Before the district court reviewed the case, a California state court held that Zurich had breached its duties to Jones under the insurance contract.
The district court held that valid arbitration agreements existed between Watts and Zurich and that the arbitrator, not the court, should determine whether the decision in Jones’ case had any preclusive effect on Watts’ claims. Watts appealed the decision.
On appeal, the Court held that the preclusive effect of the judgment in the Jones case was properly left for the arbitrator to decide. The Court categorized Watts’ argument as a substantive defense disguised as a defense to the validity of the arbitration agreement. The Court observed: “Watts wishes to use the preclusive effect of the California state court judgment as a defense to Zurich’s attempt to compel arbitration.” However, the district court had already determined that a valid arbitration agreement existed between the parties.
While the Court affirmed the general principle that courts can review the merits of a dispute if they relate to whether a valid arbitration agreement existed, it concluded that Watts’ defense required review of the merits of the dispute, but was unrelated to the validity of the arbitration agreement. Therefore, it was properly reserved for the arbitrator.
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