Rice v. Dean Witter Reynolds, Inc.

• Decision Date: 31 October 1991
• Docket Number: A052638,Nos. A051808,s. A051808
• Citation: 1 Cal.Rptr.2d 265,235 Cal.App.3d 1016
• Parties: Marylyn S. RICE, Plaintiff and Respondent, v. DEAN WITTER REYNOLDS INC. et al., Defendants and Appellants; Ronald Reinhold, Defendant and Respondent. Ronald REINHOLD, Cross-complainant and Respondent, v. DEAN WITTER REYNOLDS INC. et al., Cross-defendants and Appellants.
• Court: California Court of Appeals Court of Appeals

Page 265

1 Cal.Rptr.2d 265

235 Cal.App.3d 1016

Marylyn S. RICE, Plaintiff and Respondent, v. DEAN WITTER REYNOLDS INC. et al., Defendants and Appellants;

Ronald Reinhold, Defendant and Respondent.

Ronald REINHOLD, Cross-complainant and Respondent, v. DEAN WITTER REYNOLDS INC. et al., Cross-defendants and Appellants.

Nos. A051808, A052638.

Court of Appeal, First District, Division 3, California.

Oct. 31, 1991.

Rehearing Denied Dec. 2, 1991.

Review Denied Feb. 11, 1992.

Crosby, Heafey, Roach & May, Eric G. Wallis, Paul D. Fogel, Oakland, for defendants and appellants.

Merrill & Arnone, William J. Arnone, Jr., Ross B. Jones, William S. Snell, Santa Rosa, for plaintiffs and respondents.

WHITE, Presiding Justice.

Dean Witter Reynolds Inc. (Dean Witter), and James Sherbourne ¹ appeal after the trial court denied their petition to compel arbitration in a dispute arising out of a brokerage agreement. The trial court denied arbitration because the plaintiff, Marylyn S. Rice, alleged in her complaint that Dean Witter and a codefendant, Ronald Reinhold, had obtained the brokerage agreement by fraud. We reverse an order imposing sanctions for the filing of a frivolous motion, but otherwise affirm the judgment.

I FACTS

Mrs. Rice is a 75-year-old woman in poor health. In her verified complaint, she alleged that beginning in 1981, her then son-in-law, codefendant Reinhold, represented to Mrs. Rice that he was a sophisticated businessman. Over time, Mrs. Rice came to trust Reinhold's integrity and business judgment. Eventually, she opened a checking account on which Reinhold was an authorized signatory so he could assist in managing her personal and business affairs. Because of this, Mrs. Rice claims a fiduciary relationship existed between her and Reinhold.

Sometime in 1981, Reinhold needed a $25,000 loan for various business ventures. Mrs. Rice agreed to make the loan. At Reinhold's request, Mrs. Rice went with him to the Santa Rosa Dean Witter office to secure the loan. There, she met James Based on the representations of both Sherbourne and Reinhold, Mrs. Rice intended and believed she was merely executing papers necessary to loan Reinhold $25,000. In fact, the "Customer's Agreement" Mrs. Rice signed ostensibly permitted Dean Witter to sell her stock "for any reason whatsoever" if Dean Witter deemed it necessary for its protection. In addition, the Customer's Agreement contained a clause requiring Mrs. Rice to arbitrate any controversy arising out of or relating to the contract. ²

Sherbourne, a Dean Witter broker, who was a personal friend and business associate of Reinhold. Both Sherbourne and Reinhold knew Mrs. Rice was unsophisticated in business and had no experience with securities investments. Relying on Sherbourne's and Reinhold's professional [235 Cal.App.3d 1021] advice and representations, Mrs. Rice signed documents placing 1,332 shares of Chevron Corporation (Chevron) stock, which she had inherited in 1968, into a margin account with Dean Witter; acting on the defendants' advice, Mrs. Rice also borrowed $25,000 against those shares.

Mrs. Rice further alleged that Reinhold and Sherbourne misrepresented or concealed the true nature of the documents she had signed. She did not understand the true nature of the documents placed before her, and would not have signed them had she known their true nature and effect. In particular, she would not have assented to the provision permitting Dean Witter to sell her stock, and would not have waived her right to a jury trial.

In 1982 Mrs. Rice authorized Reinhold to deposit 460 shares of Pacific Gas and Electric stock into the Dean Witter account, and to liquidate those shares and purchase new shares of Chevron stock. Later, at Reinhold's direction, Mrs. Rice deposited another 1,332 shares of Chevron stock into the Dean Witter account.

Between 1981 and 1988, Reinhold made numerous unauthorized withdrawals from the Dean Witter account and speculated in the account by making unauthorized purchases and sales. Mrs. Rice alleged on information and belief that Sherbourne knowingly participated in these unauthorized activities. Eventually, Reinhold completely liquidated the Dean Witter account, selling all of the Chevron stock.

In order to keep the unauthorized withdrawals and speculation secret, Reinhold intercepted Mrs. Rice's account statements and deposited funds with Dean Witter to match the dividend that should have been paid on the Chevron stock; Dean Witter then remitted funds in the amount of the declared dividend to Mrs. Rice. By managing the account in this manner, defendants concealed the sale of the Chevron stock from Mrs. Rice.

In March of 1988, Mrs. Rice's daughter was in the process of obtaining a divorce from Reinhold; because of this, Mrs. Rice removed Reinhold from all of her business affairs and bank accounts. However, Mrs. Rice did not discover her Chevron stock had been sold until October of 1988, when she did not receive a dividend check.

Based on these and other facts, Mrs. Rice filed a complaint against Dean Witter, Sherbourne, and Reinhold for fraud, breach of fiduciary duty, negligence, breach of contract, and other causes of action. Dean Witter and Sherbourne answered with a petition to compel arbitration pursuant to the arbitration clause in the Customer's Agreement signed by Mrs. Rice. Mrs. Rice opposed arbitration on the grounds that the Customer's Agreement was obtained by While the first petition to compel was pending, Reinhold answered the complaint and filed a cross-complaint against Dean Witter and Sherbourne for apportionment of fault. After the court denied the first arbitration petition, Dean Witter filed a second petition, this time against Reinhold to compel arbitration on his cross-complaint. Reinhold opposed the petition on the ground he had never entered into any written agreement with Dean Witter. The trial court denied this second petition, and ordered Dean Witter to pay Mrs. Rice $750 as a sanction for filing a frivolous motion. ³

fraud in the inception and because fraud "permeated" the entire contract. After a hearing, the trial court denied Dean Witter's petition to compel arbitration against Mrs. Rice, but did not specify which fraud theory it was relying on. The court noted that it would deny the petition under any standard of review that might be applicable; in other words, the court determined that Mrs. Rice's complaint and supporting allegations of fraud were sufficient to survive a demurrer, and were also sufficient to raise a triable issue of fact on the issue of fraud so as to survive summary judgment.

Dean Witter and Sherbourne filed timely appeals from the orders denying the petitions to compel arbitration, and the matters have been consolidated on appeal. The orders denying arbitration are appealable under Code of Civil Procedure section 1294, subdivision (a).

II DISCUSSION

The present case is governed by the Federal Arbitration Act (9 U.S.C. § 1 et seq.) ("the Act"). (Strotz v. Dean Witter Reynolds, Inc. (1990) 223 Cal.App.3d 208, 212, fn. 3, 272 Cal.Rptr. 680, review den. Nov. 14, 1990, and cert. den. (1991) 499 U.S. 948, 111 S.Ct. 1417, 113 L.Ed.2d 469; Main v. Merrill Lynch, Pierce, Fenner & Smith, Inc. (1977) 67 Cal.App.3d 19, 24-25, 136 Cal.Rptr. 378; 9 U.S.C. § 2.) Generally, under the Act, arbitration is strongly favored, and "any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration...." (Moses H. Cone Hospital v. Mercury Constr. Corp. (1983) 460 U.S. 1, 24-25, 103 S.Ct. 927, 941, 74 L.Ed.2d 765; Thorup v. Dean Witter Reynolds, Inc. (1986) 180 Cal.App.3d 228, 233-234, 225 Cal.Rptr. 521.)

Nevertheless, despite the policy in favor of arbitration, the Act specifically states that an arbitration clause is enforceable unless there are "grounds as exist at law or in equity for the revocation of any contract." (9 U.S.C. § 2, emphasis added.) "Thus state law, whether of legislative or judicial origin, is applicable [to arbitration clauses] if that law arose to govern issues concerning the validity, revocability, and enforceability of contracts generally." (Perry v. Thomas (1987) 482 U.S. 483, 493, fn. 9, 107 S.Ct. 2520, 2527, fn. 9, 96 L.Ed.2d 426, emphasis in original; see also Main v. Merrill Lynch, Pierce, Fenner & Smith, Inc., supra, 67 Cal.App.3d at p. 33, fn. 5, 136 Cal.Rptr. 378.)

In California, two distinct state law theories have emerged which permit a litigant to avoid an arbitration agreement on the ground of fraud. The first--commonly called "fraud in the inception"--requires the litigant to show that the fraud went to the inception or execution of the agreement, so that the promisor did not in fact voluntarily assent to any part of the purported contract of which the arbitration clause is a part.

The second theory--commonly known as the "permeation doctrine"--is not as well defined. Generally, under this theory, the litigant seeking to avoid arbitration must prove the fraud so permeated the contract and the relationship between the parties that it vitiated the entire agreement.

As we explain below, all California courts which have addressed the issue agree that fraud in the inception is a valid ground for avoiding arbitration. However, the courts are divided on the validity of the permeation doctrine.

A. Fraud in the Inception.

We first consider whether the order denying arbitration with respect to Mrs. Rice may be sustained on the ground of fraud in the inception. We conclude that it may be sustained on this ground.

We begin our analysis with Prima Paint v. Flood & Conklin (1967) 388 U.S. 395, 87 S.Ct. 1801, 18 L.Ed.2d 1270. In Prima Paint, the United States Supreme Court held that an arbitration clause is severable from the principal contract in which it is located. Consequently, claims of fraud which may vitiate the principal contract do not necessarily affect the agreement to arbitrate. Based on this reasoning, the Supreme Court...