The article is reprinted below with permission, and I would like to thank Elaine Song, a member of the New York Law Journal’s editorial staff, for her assistance and work in getting this published in New York’s leading legal trade publication.  

Reprinted with permission from the May 18, 2011 edition of the New York Law Journal© 2010 ALM media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382, reprints@alm.com or visit www.almreprints.com:

Outside Counsel

Arbitrator Evident Partiality Standard Under Scrutiny in ‘Scandinavian Re’

Philip J. Loree Jr. ContactAll Articles

New York Law Journal

May 18, 2011

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Philip J. Loree Jr.

Section 10(a)(2) of the Federal Arbitration Act (FAA) authorizes federal district courts to vacate arbitration awards “where there was evident partiality…in the arbitrators….”¹ Just as 28 U.S.C. §455 imposes impartiality requirements on federal judges, so too does Section 10(a)(2) on arbitrators.

To implement Section 10(a)(2)’s arbitral impartiality standards, courts have imposed on neutral arbitrators a duty to disclose circumstances that establish evident partiality. The scope of the duty to disclose relationships and interests that disqualify a neutral on evident partiality grounds, and what types of interests and relationships can establish evident partiality, are topics muddled by unclear, semantically malleable standards, which sometimes baffle judges, arbitrators, and in-house and outside counsel.

The pending appeal in Scandinavian Reinsurance Co. v. Saint Paul Fire & Marine Ins. Co.² presents the U.S. Court of Appeals for the Second Circuit with an opportunity to provide additional, meaningful guidance on arbitral impartiality standards, including arbitrator disclosure obligations. There the district court vacated a final arbitration award on evident partiality grounds even though none of the arbitrators had personal or financial relationships with the parties or interests in the outcome. The district court said the award had to be vacated because two of the arbitrators did not disclose to the parties facts about their involvement in an allegedly related proceeding—facts that would have no bearing on whether a similarly situated federal judge was impartial under much stricter judicial impartiality standards.

The question the court will decide is whether FAA Section 10(a)(2) authorized the district court to vacate the award under these circumstances. The answer should be “no,” and here’s why.

The District Court Decision

Scandinavian Re arose from a petition to vacate a final award issued by three experienced, well-known and respected industry arbitrators appointed to resolve a reinsurance dispute. The district court vacated the award because two arbitrators (one neutral, one party-appointed) did not disclose their temporally overlapping service on another arbitration panel hearing a case the district court characterized as concerning: (a) a common witness; (b) “similar” issues; (c) “similar” contract terms; (d) “the same type of reinsurance business”; and (e) a party that was the successor-in-interest to reinsurance business the prevailing party in the Scandinavian Re arbitration had assumed. (The parties dispute the accuracy of these findings, but, as we shall see, that doesn’t matter.)

The district court held that the arbitrators’ undisclosed, overlapping service in the other arbitration created “a material conflict of interest” establishing evident partiality:

[T]he Scandinavian Re Arbitration and the [other arbitration] were presided over by two common arbitrators, overlapped in time, shared similar issues, involved related parties, included…a common witness that supported interpreting [the agreement in the other arbitration] as written but interpreting the Scandinavian Re Agreement in light of Scandinavian Re’s intent at the time it entered into the agreement. Additionally, [another witness] was employed by [a party in the other arbitration which had purchased reinsurance business originally assumed by the prevailing party in the Scandinavian Re arbitration] at the time she appeared as a witness in the Scandinavian Re Arbitration. By participating in both [arbitrations, the arbitrators] placed themselves in a position where they could receive ex parte information about the kind of reinsurance business at issue in the Scandinavian Re Arbitration, be influenced by recent credibility determinations they made as a result of [the common witness'] testimony in [the other arbitration], and influence each other’s thinking on issues relevant to the Scandinavian Re Arbitration. By failing to disclose their participation in the [other arbitration], [the two arbitrators] deprived Scandinavian Re of an opportunity to object to their service on both arbitration panels and/or adjust their arbitration strategy….³

Analysis

The case turns on whether the Scandinavian Re arbitrators met arbitral impartiality standards, which are more demanding than judicial impartiality standards.⁴ While federal judges are disqualified for partiality “in any proceeding in which [their] impartiality might reasonably be questioned”—a/k/a the “appearance of bias” standard—in the Second Circuit “an arbitrator is disqualified [for evident partiality] only when a reasonable person, considering all of the circumstances, ‘would have to conclude that [the] arbitrator was partial to one side.’”⁵

Conventional wisdom suggests the Second Circuit should simply determine whether “a reasonable person…would have to conclude” the arbitrators were partial. But the Second Circuit can (and should) decide Scandinavian Re under explicitly defined standards set forth by statute and interpreted by U.S. Supreme Court and other federal courts: the judicial impartiality standards.

Chief Judge Frank H. Easterbrook of the U.S. Court of Appeals for the Seventh Circuit has demonstrated that initially considering whether arbitrators met judicial impartiality standards can greatly simplify the resolution of many evident partiality (and certain contractual, arbitrator-qualification) questions, because doing so not only avoids the philosophical debate and policy-oriented analysis that the “reasonable person would have to conclude” test invites, but in many cases, including Scandinavian Re, can provide added assurance about the validity of the outcome. For if arbitrators satisfy judicial impartiality standards, they necessarily satisfy arbitral ones, which are less demanding.⁶

What Are the Judicial Standards? The statute, 28 U.S.C. Section 455, sets forth the judicial impartiality standards that a federal judge must meet in each case over which he or she presides. Section 455(a) describes a “catchall,” “appearance of bias” impartiality standard: “(a) Any justice, judge, or magistrate judge of the United States shall disqualify himself in any proceeding in which his impartiality might reasonably be questioned.”⁷ Section 455(b) sets out specific circumstances under which a judge is disqualified from hearing a case because of actual bias or prejudice or certain personal, financial or professional relationships or interests that are presumed to conflict with the parties’ interest in having an impartial decision maker.⁸

Judges who do not meet these demanding judicial impartiality standards in any given case are obligated to recuse themselves, that is, to step aside and let another judge hear the matter. If they do not do so, and an appellate court rules they should have, then their orders and judgments may be vacated.

Were the ‘Scandinavian Re’ Arbitrators Disqualified Under §455(b)? The best way to assess impartiality under §455 is to consider first whether the arbitrators—were they federal judges—would have been disqualified on §455(b) grounds. The only §455(b) ground that might provide even a barely plausible basis for challenging impartiality in a case like Scandinavian Re is §455(b)(1), which requires judges to disqualify themselves “[w]here [they have]…a personal bias or prejudice concerning a party, or personal knowledge of disputed evidentiary facts concerning the proceeding.”⁹ But the Scandinavian Re arbitrators did not violate subsection 455(b)(1).

In Liteky v. United States,¹⁰ the Supreme Court explained that predispositions judges reach based on information obtained in an adjudicative capacity do not evidence Section 455(b)(1) “bias” or “prejudice,” except in extraordinary circumstances. The Court said the terms “bias” and “prejudice” “connote a favorable or unfavorable disposition or opinion that is somehow wrongful or inappropriate, either because it is undeserved, or because it rests upon knowledge that the subject ought not to possess…or because it is excessive in degree….”¹¹ Under the so-called “extrajudicial source doctrine,” alleged “bias” or “prejudice” generally cannot be based on knowledge obtained from participation in judicial proceedings, or on predispositions reasonably formed as a result, because there is nothing wrongful or inappropriate about judges having such knowledge or predispositions.¹²

Knowledge obtained from other proceedings; judicial opinions reached during those proceedings concerning applicable law and its application to facts; and judicial views formed during those proceedings concerning a party’s or witness’ credibility or character may cause a judge to be favorably or unfavorably disposed to a particular position, party or witness. But absent “deep-seated favoritism or antagonism that would make fair judgment impossible,” those predispositions are not “wrongful” or “inappropriate” and thus do not establish bias or prejudice.¹³

Assuming for argument’s sake that the district court’s factual findings were accurate, at most the Scandinavian Re arbitrators served in two proceedings featuring a common witness, some similar issues and contract terms, the same type of reinsurance business, and a related party. Even if there were no “extrajudicial source doctrine,” those facts would hardly suggest §455(b)(1) “bias” or “prejudice.”

But assuming (in the absence of evidentiary support) the arbitrators’ service in the other arbitration influenced their thinking in the Scandinavian Re arbitration, there is nothing wrongful or inappropriate about a judge—or by extension, an arbitrator—having or using in proceeding B knowledge or experience properly obtained in an adjudicative capacity from proceeding A.¹⁴ And nobody—including the district court judge—says that the arbitrators’ participation in the other arbitration resulted in “deep-seated favoritism or antagonism that would make fair judgment impossible.”¹⁵

The Scandinavian Re arbitrators also had no “personal knowledge of disputed evidentiary facts concerning the proceeding,” Section 455(b)(1)’s other basis for disqualification. Perhaps the arbitrators had already heard in one proceeding testimony on factual issues common to both, including testimony from a common witness. Perhaps they were already familiar with the relevant contract wording, which allegedly was similar.

But that doesn’t mean they obtained personal knowledge of the facts established or advocated in the other arbitration and thus could testify as fact witnesses in that arbitration, let alone in the Scandinavian Re arbitration. No one claims they were involved in or had personal knowledge of the disputed transactions; whatever knowledge they had was obtained solely in an adjudicative capacity.

Were the ‘Scandinavian Re’ Arbitrators Disqualified Under §455(a)? The only remaining question is whether the arbitrators were disqualified under §455(a)’s catchall, “appearance of bias” standard. Liteky provides an easy answer: A judge’s “impartiality” cannot “reasonably be questioned” where, as in Scandinavian Re, the alleged impartiality is based on knowledge obtained or opinions or views formed by the judge in the ordinary course of legitimately discharging his or her adjudicative responsibilities in another proceeding.¹⁶

Was There Any Legitimate Basis for the District Court’s Decision? The answer is “no.” Even if the strict judicial impartiality standards applied to the Scandinavian Re arbitrators, they satisfied them, and that necessarily means they satisfied the more lenient ones imposed by §10(a)(2).

The district court’s conclusion that the arbitrators had a “material conflict of interest” was therefore misplaced. The district court said the arbitrators “placed themselves in a position where they could receive ex parte information about the kind of reinsurance business at issue in the Scandinavian Re arbitration, be influenced by recent credibility determinations they made as a result of [the common witness'] testimony in [the other arbitration], and influence each other’s thinking on issues relevant to the Scandinavian Re Arbitration.”¹⁷ But a decision maker cannot have a “conflict of interest” unless he or she has a personal or financial interest in the outcome of the matter that conflicts with the parties’ interest in the decision maker’s impartiality.¹⁸ Liteky forecloses any argument that a decision maker’s discharge of legitimate adjudicative functions in matter A can create an “interest” in the outcome of related matter B, let alone a conflicting one.¹⁹

The risk that the arbitrators might “influence each other’s thinking on” allegedly similar, common issues likewise does not create a conflict of interest or otherwise establish evident partiality. That risk is present to some degree in appellate courts that use rotating, three-judge panels, and is particularly high in the U.S. Supreme Court, where the same nine justices generally hear each case. But nobody thinks that federal judges or Supreme Court justices must recuse themselves in matter B simply because they served together on the Court when it heard related matter A, and thus might influence each other’s thinking in matter B.

But Didn’t the Arbitrators Fail to Disclose Their Service on the Other Arbitration Panel? Some may think that the Second Circuit should affirm the district court because the arbitrators did not disclose their involvement in the other arbitration. They may think that the arbitrators’ failure to disclose their service amounted to evident partiality because it allegedly evidenced some deceptive motive on the arbitrators’ part that somehow spoiled the award. Alternatively, some may, like the district court judge, think that the arbitrators’ nondisclosure somehow “deprived Scandinavian Re of an opportunity to object to their service on both arbitration panels and/or adjust their arbitration strategy,”²⁰—even though an evident-partiality conclusion does not follow from that doubtful premise.

These arguments are misplaced for several reasons, but it is enough to say that accepting them would impose on arbitrators impartiality standards far more onerous than those federal judges must meet.

In the Second Circuit, courts may vacate awards for evident partiality where arbitrators fail to disclose a “material relationship with…a party” or a material interest—financial or personal—in the outcome of the arbitration.²¹ There is nothing controversial about that, for an arbitrator’s material relationship with a party or person or material financial interest in the outcome would establish partiality under both judicial and arbitral impartiality standards.

But in Scandinavian Re the undisclosed circumstances provided no basis for disqualification under Sections 455(a) or (b), which means that not even a federal judge would have been obligated to disclose them.²² The Scandinavian Re arbitrators were not required to disclose anything that a similarly situated federal judge would not have to disclose, and the Second Circuit should so rule.

Philip J. Loree Jr. is a partner at Loree & Loree in Manhasset.

Endnotes:

1. 9 U.S.C. §10(a)(2).

2. No. 09 Civ. 9531(SAS), 2010 WL 653481 (S.D.N.Y. Feb. 23, 2010).

3. Scandinavian Reinsurance Co. v. Saint Paul Fire & Marine Ins. Co., No. 09 Civ. 9531(SAS), 2010 WL 653481, at *8 (S.D.N.Y. Feb. 23, 2010), appeal pending No. 10-910-cv (2d Cir.).

4. See Applied Indus. Materials Corp. v. Ovalar, 492 F. 3d 132, 137 (2d Cir. 2007); Morelite Constr. Corp. v. New York City Dist. Council Carpenters Benefit Fund, 748 F.2d 79, 83-84 (2d Cir. 1984).

5. Ovalar, 492 F.3d at 137 (quoting Morelite, 748 F.2d at 84 (emphasis added)).

6. See Trustmark Ins. Co. v. John Hancock Life Ins. Co. (U.S.A.), No. 09-3682, 2011 WL 285156 (7th Cir. Jan. 31, 2011) (Easterbrook, C.J.); Sphere Drake Ins. Co. v. All American Life Ins. Co., 307 F.3d 617 (7th Cir. 2002) (Easterbrook, J.).

7. 28 U.S.C. §455(a).

8. 28 U.S.C. §455(b).

9. 28 U.S.C. §455(b)(1).

10. 510 U.S.540, 550 (1994) (Scalia, J.).

11. See 510 U.S. at 550 (emphasis in original).

12. 510 U.S. at 550.

13. 510 U.S. 550-51 & 555-56 (citations omitted).

14. See 510 U.S. at 550.

15. 510 U.S. at 555.

16. 510 U.S. at 552.

17. 2010 WL 653481 at *8.

18. See, generally, Trustmark, 2011 WL 285156, at *3.

19. See Liteky, 510 U.S. at 550-51 & 552-55; Trustmark, 2011 WL 285156, at *3.

20. See 2010 WL 653481, at *8.

21. Applied Indus. Materials, 492 F.3d at 137 (material financial relationship with a party); see also Pitta v. Hotel Assoc. of New York City, 806 F.2d 419, 423-24 (2d Cir. 1986) (material personal interest in the outcome); Morelite, 748 F.2d at 84-85 (father-son relationship with a party).

22. See Sphere Drake, 307 F.3d at 622.

Regular readers have heard us preach about the importance of knowing arbitration law cold (here), understanding and identifying when an arbitration award is final (here), and being keenly aware of Federal Arbitration Act deadlines (here).  The United States Court of Appeals for the Seventh Circuit recently decided a case that illustrates these points well.  See Board of Trustees of the University of Illinois v. Organon Teknika Corp. LLC, ___ F.3d ___, slip op. (7^th Cir. July 27, 2010) (Easterbrook, C.J.). 

The Court held that, in the circumstances, an arbitration award was final notwithstanding a provision in the award that said the arbitrator reserves his right to change his mind.  But there is more to it than that. 

B.   Background

 Organon Teknika Corp. LLC (“Teknika”) is a subsidiary of Merck & Co, Inc. and licenses from the University of Illinois (“the University”) certain intellectual property rights necessary to manufacture a cancer drug.  The royalty is tied to Teknika’s sale price for the drug and the contract allows Teknika to sell to its affiliates. 

Recognizing that Teknika’s affiliate sales could reduce royalties in the event Teknika offered insider prices, the contract allows the University to reopen its royalty rate if Teknika charges its affiliates prices less than it would charge unrelated buyers in arms’-length transactions.  The contract contains an arbitration agreement that requires an arbitrator to determine, based on comparable transactions, whether Teknika is charging its affiliates arms’-length prices.   Because the issue of arms’-length pricing can repeatedly arise throughout the life of the license, the clause necessarily contemplates the possibility that the same pricing issue may have to be determined on various occasions, all based on contemporaneous and comparable sales to affiliates and non-affiliates.       

The University concluded that Teknika’s sales to its affiliates were not at arms’-length prices and demanded arbitration.  The parties selected an arbitrator who was a member of an intellectual-property-asset-management consulting firm.  He heard evidence concerning 39 allegedly comparable transactions, all of which were supposedly negotiated at arms’-length.  The University argued that they were not comparable transactions. 

The arbitrator selected four of these as benchmarks, found they had been negotiated at arms’-length, and concluded that they showed that the University was not entitled to a royalty-rate adjustment.  He entered an award closing the proceeding without changing the royalty rate.  A cover letter accompanying the award said it was “final,” and the arbitrator’s firm sent a “final” invoice for his services. 

But the award said:

The foregoing opinions and conclusions contained in this report are based on the documents, information and research undertaken as of the date of this report.  I reserve the right to revisit my analysis and amend my conclusions, should additional information become available for review. 

The University waited six months without seeking arbitral reconsideration or judicial review.  It then asked the arbitrator to reconsider, seizing on the proviso quoted above.  It argued that two of the four benchmark transactions had not been negotiated at arms’-length. 

The arbitrator asked his firm’s lawyers whether he could reconsider the award, and the lawyers told him he could, provided both parties agreed.  He sought consent from the parties and Teknika refused. 

The University moved in federal district court to compel arbitration, requesting an order compelling Teknika to resume with the arbitration.  Teknika responded that it had honored its obligation to arbitrate, the arbitration was over, the University lost, and that Federal Arbitration Act Section 12’s 90-day (actually three-month) period to vacate or modify the award had elapsed. 

In a move that took both parties for surprise, the district court said there was no dispute to resolve because the arbitrator had not made a final award.  The matter therefore remained before the arbitrator, leaving the court with nothing to do but dismiss Teknika’s action without prejudice. 

That left things in a state of semi-stasis.  Teknika had prevailed, but was troubled by the terms of the district court’s order, which stated the award was not final.  The University had lost, but might have been able to persuade the arbitrator to render a revised award on terms more favorable to Teknika than the original, perhaps without Teknika’s participation in the proceeding. 

So Teknika, technically the prevailing party, appealed.  The University, technically the losing party, did not. 

In a characteristically terse, well-written and well-reasoned opinion, Chief Judge Frank H. Easterbrook, joined by Circuit Judges William J. Bauer, and David F. Hamilton, reversed the district court and declared that the arbitration was over.      

C.   The Seventh Circuit’s Opinion

The Court initially had to resolve an appellate jurisdiction problem.  A prevailing party can’t appeal from a judgment in its favor on the ground it did not agree with the court’s opinion.  But the Court said Teknika could appeal this one. 

Teknika had a problem with the terms of the judgment, not the language of the opinion.  Teknika wanted a judgment dismissing the University’s claim with prejudice, conclusively resolving the royalty dispute, but what it got was one dismissing the University’s action without prejudice.  Armed with that judgment, the University could resume its suit against Teknika when it saw fit, or perhaps even persuade the arbitrator to modify his award despite Teknika’s continuing refusal to participate in the arbitration.  “No matter[,]” said the Court, for “[i]t was enough to say that Teknika is aggrieved by the terms of the judgment as well as the language of the opinion and is therefore entitled to appellate review.”  Slip op. at 5 (citations omitted). 

Turning to the merits, the Court held that the “district court plainly erred in thinking that [the arbitrator’s] award was not final.”  The award

resolves the parties’ dispute; it was accompanied by a cover letter calling it the final decision; the parties paid their final bills; nothing further happened for six months – and neither side suggested to the other that something should have been happening to get the proceeding wrapped up.  It had been wrapped up already. 

Slip op. at 5-6 (citations omitted; emphasis in original). 

The language in the arbitrator’s opinion contemplating possible revision of the award did not impugn its finality.  The Court said that language was “the arbitral equivalent of Fed. R. Civ. P. 60(b)(2), which allows a judgment to be reopened to consider ‘newly discovered evidence that with reasonable diligence, could not have been discovered in time to move for a new trial under Rule 59(b).’”  Slip op. at 6 (quoting Fed. R. Civ. P. 60(b)(2)).  But just as the ever-present risk of Rule 60(b)(2) relief does not render a judgment non-final, so too the arbitrators’ reference to his right to reconsider the award did not render the award non-final: 

No one thinks that the possibility of reopening a district court’s judgment under Rule 60(b)(2) six months after its entry makes the judgment non-final and hence precludes an appeal.  Likewise no one should think that the equivalent language in the arbitrator’s opinion makes the decision non-final. 

Slip op. at 6 (citations omitted). 

The Court noted that “[t]he parties have regaled us with discussions of the ‘functus officio doctrine’ and other technicalities of arbitration law, but none of them matters[,]” because “[t]he situation is as simple and straightforward as we have described it.”  Slip op. at 6. 

Having drawn an analogy to Rule 60(b)(2), the Court had to deal with a timing issue.  While Rule 60(c)(1) sets a one-year deadline on a Rule 60(b)(2) application, the arbitrator imposed no deadline on a request for reconsideration.  The Court said the default rule was not Rule 60(c)(1)’s one-year deadline, but Federal Arbitration Act Section 12’s  90-day (actually three-month) deadline for a party to move to vacate or modify an award.  The parties, noted the Court, “did not supersede that rule by contract[:]”  “They bargained for a final and conclusive decision, not for perpetual arbitration.”  Slip op. at 6. 

Because the University waited six-months before commencing an action to compel arbitration, its “request came too late.”  So, as Chief Judge Easterbrook succinctly put it, “[t]his arbitration is over.”  Slip op. at 7. 

D.   Analysis

Teknika shows that courts resolve doubts in favor of finality.  And it shows that litigants need to assume that courts will do exactly that. 

We obviously do not know all of the details about this case, let alone what motivated each party’s conduct in connection with it.  We also have the benefit of 20/20 hindsight – something the parties obviously did not.  But the result might have been different had the University treated the award as final, and not waited six months to seek arbitral relief. 

Courts tend to resolve doubts in favor of finality for at least two reasons.  First, finality of awards is necessary to ensure that arbitration works.  One of the avowed purposes of the Federal Arbitration Act is to enable parties to resolve disputes in a speedy and efficient manner.  When awards that otherwise appear to be final and conclusive are deemed non-final for technical reasons, disputes are not resolved, let alone in a timely and efficient manner.        

Second, parties almost always agree that awards should be “final and binding,” and judicial interpretations of the Federal Arbitration Act generally seek to enforce the parties’ arbitration agreement.  Just as the parties in Teknika bargained “for a final and conclusive decision, not for perpetual arbitration [,]” so it is with most other parties that agree to arbitrate.   The Court’s decision enforced that bargain. 

The principal reason that litigants should assume that courts will resolve doubts in favor of finality is that finality determines whether time limits for judicial review have begun to run.  Federal Arbitration Act Sections 9, 10, and 11 all have been held applicable only to final awards (or awards intended to be final, but for some technical reason are not).  The reason is that these judicial-review provisions contemplate the possibility that a court will enter a final judgment confirming the award, and a judgment confirming a non-final award would not conclusively resolve the rights and obligations that are the subject of the award any more than the non-final award did.  Such a judgment would therefore not be final.  

Parties – like the University – who assume that an award is not final, and forgo seeking judicial review, risk being time-barred if they let the applicable limitation period expire before seeking review.   If there are doubts about whether an award is final, then the safer course is to treat it like it is, and act accordingly.  

We conclude with a couple of other observations and a caveat.  We wonder why Teknika did not cross-move to confirm the award in response to the University’s motion to compel arbitration.  While that would likely not have changed the outcome in the district court, a denial of a motion to confirm without prejudice would have provided a firmer basis for appellate jurisdiction, and the end result of the appeal would have been a judgment confirming the award, which probably would also have stated that it was too late to seek reconsideration.  Perhaps that’s just a picayune point of Federal Arbitration Act practice and procedure; in all likelihood Teknika’s rights will be as fully protected as they would have been had it cross-moved to confirm.  Things would probably have proceeded a little more smoothly had the cross-motion been made, but we say that solely with the benefit of 20/20 hindsight, and not knowing what (if anything) motivated Teknika not to cross move.    

We were also somewhat surprised that the Court deemed Section 12’s three-month time limit for certain types of judicial review to be the applicable limitation period for arbitral review, particularly when that period has nothing to do with reconsideration of an award  — something a court has no power to grant.  We suspect it was because the Court chose not to address the functus officio question of whether reconsideration by the arbitrator would have been proper in the circumstances — despite what the award said – and so needed an (elapsed) time limit to rely upon, so that functus officio would not – as the Court put it — “matter.” Section 12 supplied a limitation period by analogy that allowed the Court to dispose of the case while avoiding nettlesome functus officio questions. 

But even though Section 12 was, as we read it, intended solely to set a time limit on seeking certain types of judicial relief, it provided an acceptable analogue for filling a gap in the Federal Arbitration Act.  If a party is time-barred from seeking judicial relief that might result in a modified award or a remand to the arbitrator, then it at least arguably follows that a party should likewise be precluded from seeking arbitral relief from a final award.  In any event, as discussed in more detail below, there may be cases where state law would provide an even better analogue. 

As the previous sentence implies, our caveat is “beware of state law.”  The Court in Teknika suggested that the University could have made a timely request to the arbitrator for reconsideration, provided it was made within the three-month period provided by Federal Arbitration Act Section 12.  Apparently there was no potentially applicable state law better suited to fill the gap. 

Even where an arbitration is governed by the Federal Arbitration Act, and the parties have not agreed that state arbitration law applies, a court might look to state law for a more specific gap filler than Federal Arbitration Act Section 12.  New York State’s arbitration law provides, for example, that an application to the arbitrators to modify an award must be made “within twenty days after delivery of the award to the applicant. .  .  .”  See New York Civ. Prac. L & R § 7509.  Although this rule permits modification only to the extent a court could grant it pursuant to an application for modification made under New York Civ. Prac. L & R. § 7511(c) – Section 7511(c) authorizes modification on limited grounds similar to those set forth in Federal Arbitration Act Section 11 and, like Section 11, does not authorize an application for reconsideration – it would still be a better analogue for a default rule than Section 12.  For Section 12 sets the time limit for applying to a court to vacate or modify an award, whereas CPLR 7509 expressly sets a time limit for making an application for modification to an arbitrator.  Section 12 would therefore arguably not preempt Section 7509, and a New-York-based court faced with a situation like that in Teknika might find that it supplied a better default rule. 

Since state law may (like CPLR 7509) impose a time limit shorter than three months on applications to arbitrators to modify or reconsider awards, to make reasoned strategy decisions, counsel faced with an issue like that presented in Teknika must have a grasp on what state arbitration law has to say (if anything) about this subject.

Lecture over and class dismissed (with prejudice, of course…). 

[Editor’s Note:  For a different analysis of Teknika, and one more critical of the Court's than ours, see our friend Marc Goldstein’s excellent post here.] 

In Part I of this two-part post (here) we discussed the background and procedural history of Gulf/Transatlantic and how New York’s Appellate Division, First Department resolved the issues of:  (a) the amount of reinsurance accepted by Gerling; and (b) whether the trial court should have granted Gerling’s motion for summary judgment on Gulf’s reformation claim.  This Part II covers the remaining three issues whether:  (a) the 1998 First Union Policy “attached” to the 1999 Treaty; (b) Gerling reinsured the policies Gulf issued to a subsidiary of the General Electric Company; and (c) Gerling established a question of material fact concerning whether it was entitled to rescind the 1999 Treaty.    

Discussion

A.     Did a three-month stub period of the 1998 First Union Corporation Policy “attach” to the 1999 Treaty? 

Gerling sought a declaration that the policy issued to First Union Corporation (the “First Union Policy”) was not covered by the 1999 Treaty, and Gulf sought a declaration that Gerling was “obligated to indemnify Gulf under the 1999 treaty for Gerling’s share of [a settlement Gulf entered into with First Union and for which it sought partial reimbursement under].  .  .  the 1999…Treaty.”  Slip op. at 13.  Both parties moved for partial summary judgment on this claim, and the trial court granted partial summary judgment in favor of Gerling and denied partial summary judgment in favor of Gulf.  The Court held that the trial court should have denied both parties’ summary judgment motions on this claim because neither party met its burden on its motion. 

Effective January 1, 1996 Gulf issued a twelve-month policy to First Union (the “1996 First Union Policy”).  Gulf issued two subsequent policies effective January 1, 1997 (the “1997 First Union Policy”), and January 1, 1998 (the “1998 First Union Policy”).  Gulf and First Union reached an agreement to extend coverage for three months into 1999 under the same terms of the 1998 First Union Policy pending negotiations, but neither Gulf nor Gerling presented any evidence whether the agreement was oral or written, or cited “any evidence bearing on the question of whether the agreement, as opposed to the coverage, was effective as of a date in 1998, as of.  .  .  January 1, 1999 or as of a later time and date in 1999.”  Slip op. at 13.   

The 1999 Treaty was “’[e]ffective January 1, 1999 at 12:01 a.m., Eastern Standard Time, to January 1, 2000 at 12:01 a.m. Eastern Standard Time, as respects losses occurring on policies attaching during the term’“  Slip op. at 12 (emphasis in original; quoting 1999 Treaty).  The “Business Covered” article said that Gulf ceded to its reinsurers a “’quota share participation of the net retained insurance liability of [Gulf] on each risk insured under new and renewal policies becoming effective at and after 12:01 a.m., Eastern Standard Time, January 1, 1999, as respects losses occurring at and after said date covering business classified by [Gulf] as Automobile Residual Value Insurance’”  Slip op. at 12. (emphasis in original; quoting 1999 Treaty).  “Policies” were defined as “’[Gulf's] binders, policies and contracts providing insurance and reinsurance on the business covered under this Agreement.’” Slip op. at 12 (emphasis in original; quoting 1999 Treaty).  The Treaty’s choice-of-law clause provided that “’[t]his Agreement shall be governed by and construed according to the laws of the State of New York.’”  Slip op. at 12 (emphasis in original; quoting 1999 Treaty).

While the Treaty did not define the verb “attaching,” the Court said that “[i]ts meaning.  .  .  seems clear from the above-quoted language of Article I of the treaty, and the parties appear to be in agreement that a policy, be it a “new” or a “renewal” policy, “attach[es]” during the term of the treaty if it becomes effective during the treaty’s term.”  Slip op. at 12.  Thus, concluded the Court, “[r]egardless of whether the agreement is characterized as an ‘extension,’ a ‘new’ or a ‘renewal’ policy, the decisive question is whether that policy attached — i.e., became effective — during the term of the [T]reaty.”  Slip op. at 15-16.  And the resolution of that question turned on whether First Union and Gulf intended “that the agreement become effective on a date during the term of the” Treaty.  Slip op. at 16. 

The problem for both Gerling and Gulf was that neither came forward with any evidence as to what First Union’s and Gulf’s intent was as respects when the parties intended the agreement to extend the term of the policy to be effective:

[I]f Gulf and First Union agreed in 1998 to extend the 1998 policy and intended their agreement to be effective in 1998, Gerling would be entitled to summary judgment.  But if Gulf and First Union agreed in 1999 to extend the 1998 policy, or agreed in 1998 to such an extension but intended their agreement to be effective in 1999, Gulf would be entitled to summary judgment (putting aside, of course, Gerling’s claim that it is entitled to rescission of the 1999 treaty [See Section C., below]).  As neither party alerts us to any evidence presented to Supreme Court bearing on when the agreement was reached or when it was intended to be effective, neither party met its burden and each party’s motion for partial summary judgment should have been denied.

Slip op. at 16.  

B.      Did Gerling agree to reinsure Gulf’s Section B coverage in 1998? 

The Treaties contained two separate coverage types:  Section A, which consisted of RVI policies Gulf issued to various insureds; and Section B, which consisted solely of the RVI policies Gulf issued to a subsidiary of the General Electric Company.  The issues we have discussed thus far have applied to both coverage sections, so we have not yet had occasion to distinguish between the two. 

But Gulf contended that there was an oral agreement between Gerling and Gulf under which Gerling agreed to reinsure Gulf’s section B coverage during the period August 1, 1998 until and including December 31, 1998.  Gulf contended this was a separate agreement from the 1999 Treaty, and therefore proof of its existence was not barred by the integration clause in the 1999 Treaty.  Gerling moved for partial summary judgment on Gulf’s claim, which the trial court granted, and which the Court affirmed. 

The Court did not have to address Gulf’s claim that the agreement was separate from the 1999 Treaty, because it found that Gulf failed to meet its burden to establish the existence of a material issue of fact warranting the denial of summary judgment.  See Slip op. at 17-18.   

Under New York law, said the Court, “’[t]o create a binding contract, there must be a manifestation of mutual assent sufficiently definite to assure that the parties are truly in agreement with respect to all material terms.’”  Slip op. at 17  (quoting Re  Express Indus. & Term. Corp. v New York State Dept. of Transp., 93 N.Y.2d 584, 589 (1999) (here)).   And to defeat summary judgment on a claim predicated on the existence of an oral agreement, the party opposing summary judgment must “’set forth such necessary evidentiary details as when, where or by whom the alleged oral agreement was made or the substance of the conversations.’”  Slip op. at 17 (quoting Apache-Beals Corp. v Intl. Adjusters, Ltd., 59 A.D.2d 1032, 1033 (4^th Dep’t 1977), aff’d, 46 N.Y.2d 888 (1979) (here)). 

Gulf’s evidentiary submissions did not meet this burden, and the Court affirmed the trial court’s grant of partial summary judgment.  Gulf relied on a March 29, 1999 fax from the broker to Gerling’s underwriter which purported to “confirm,’ among other things, coverage under Section B  effective August 1, 1998,” but the fax did not “identify when, where or by whom Gerling agreed to such coverage,” and the underwriter “did not respond to the fax or to a subsequent letter” from the Broker “enclosing for [the underwriter’s] signature an I & L contract for Section B coverage only for the period from August 1, 1998 through December 31, 1998.”  Slip op. at 17 (quotations omitted).  Gerling also relied on other facts, “including Gerling’s receipt of a premium from Gulf consistent with participation by Gerling on Section B coverage for the last five months of 1998.”  Slip op. at 17-18.  While those facts might have established an implied contract, Gulf’s claim was based on an oral contract, and they  did not establish the existence of such a contract.  See slip op. at 17-18.

C.     Did Gerling establish that there was a question of material fact as to whether it was entitled to rescind the 1999 Treaty?     

Rescission was one of the grounds on which Gerling opposed Gulf’s motion for summary judgment concerning Gerling’s indemnification obligations under the 1999 Treaty.  The trial court ruled there was a material question of fact as to whether Gerling was entitled to rescind the 1999 Treaty.  The Court affirmed, albeit on different grounds. 

For the benefit of readers not already familiar with the law governing rescission of reinsurance contracts, a reinsurer need not prove actual – or even constructive – fraud or mutual mistake to rescind a reinsurance contract.  What sets reinsurance contracts apart is the duty of utmost good faith (uberrimae fidei):   To establish a prima facie case for rescission, a reinsurer need only show that pre-contract the cedent failed to disclose material facts concerning the original risk of loss.  Even an innocent nondisclosure may suffice.  See, e.g., Union Indemnity Ins. Co. v. American Centennial Ins. Co., 89 N.Y.2d 94, 106-07 (1996) (copy here).   For a more thorough recitation of the applicable legal principles, and cites to other key cases, see slip op. at 18. 

Gerling’s rescission defense concerned events surrounding the First Union policy, which was discussed in Section A., above.  As discussed, there is a question of fact as to whether that policy was ceded to the 1999 Treaty in the first place.  But Gerling’s rescission defense is predicated on different facts. 

Gerling adduced evidence that, when Gulf solicited Gerling’s participation in the 1999 Treaty, Gulf failed to disclose that L&M – Gulf’s managing general agent (“MGA”) – “was seeking a 360% increase in the premium rate on.  .  .  the First Union policy, even though, in response to inquiries from.  .  .  Gerling’s underwriter, Gulf stated that it was too early in the program to seek premium adjustments from its insureds.”  Slip op. at 18-19.  It was undisputed that:  (a) the First Union Policy – due to expire on December 31, 1998 – accounted for approximately one-half the premium reported under the reinsured RVI program; (b) “L&M was seeking … a substantial premium increase;” and (c) Gerling was not informed of the request prior to agreeing to participate in the 1999 Treaty.  Slip op. at 19. 

The crux of Gulf’s position was that there was no evidence that Gulf knew, at the time of placement, that L&M was requesting a substantial increase in premium for the First Union policy, and that L&M’s knowledge cannot be imputed to Gulf because L&M was acting not as an agent, but as an independent contractor of Gulf.  In support Gulf cited the agency agreement between L&M and Gulf, which expressly recited that L&M acted as an independent contractor,  not an employee of Gulf. 

The Court held that L&M’s knowledge could be imputed to Gulf.  It recited New York’s common-law definition of an agency relationship – one that “results from a manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and the consent by the other to act.”  Slip op. at 19 (quotations and citations omitted).  While it did not discuss the terms of the Gulf/L&M agency agreement, it said that “a review” of it “makes clear” that “the true relationship between Gulf and L&M with respect to Gulf’s RVI program is that of principal and agent.”  Slip op. at 19.  The Court also rejected Gulf’s fallback argument that there can be no imputation of knowledge from agent to principal for the purposes of a reinsurance nondisclosure claim, noting that “[n]o case cited by Gulf purports so to hold or even to suggest that the common-law rule imputing the knowledge of an agent to the principal is not applicable in the reinsurance context,” and that Gulf provided no “justification for such an exception” or any attempt to “reconcile it with the duty of utmost good faith owed by reinsureds.”  Slip op. at 19-20.   

The Court held that Gerling satisfied its burden to defeat Gulf’s motion for summary judgment, and that the materiality of the nondisclosure presented a question of fact for trial.  Slip op. at 20.

Today we look at a reinsurance case recently decided by the New York Supreme Court, Appellate Division, First Department, New York’s intermediate appellate court for cases originating in New York County (Manhattan) and certain other counties in the New York metropolitan area.  We would not characterize Gulf Ins. Co. v Transatlantic Reins. Co., ___ A.D.3d ___,  2009 NY Slip Op. 06788 (1^st Dep’t Oct. 1, 2009) (copy here), as a ground-breaker, but it involves a number of interesting  issues, including the interpretation and construction of a quota share treaty, course of performance, reformation and rescission. 

Substantive reinsurance cases are a relatively rare breed to begin with (especially in recent years), and cases that discuss a broad range of issues in some depth are rarer still.  That makes Gulf/Transatlantic worthy of some attention, especially to those interested in learning a few reinsurance law basics.  Hat tip to my friend and former colleague James P. Tenney for bringing the case to our attention.

 A few caveats are in order.  First, one of the reasons we do not see that many substantive reinsurance cases arising out of reinsurance treaties (as opposed to facultative certificates) is because arbitration clauses have historically been the norm in the treaty context.  Disputes like those in Gulf/Transatlantic are therefore more commonly resolved in arbitration.  That may change in the future as attitudes about the desirability of arbitration as a method to resolve reinsurance disputes appear to be in flux (let’s hold that thought for another day). 

Second, as most reinsurance lawyers know (or quickly learn), courts usually decide reinsurance cases according to the strict rules of law, while arbitration panels generally do not, particularly when there is an honorable engagement clause in the contract.  (See our discussion of honorable engagement clauses, here.)   Never assume that the outcome of a reinsurance case in arbitration is going to mirror one a court would reach, although courts and arbitrators may occasionally reach the same or similar conclusions based on the same set of facts.          

Third, given the number of issues raised in the case, and their somewhat technical nature, we thought it best simply to discuss what they were, how they arose and how the Court ruled on them, rather than engaging in a critical analysis or providing our thoughts on how a typical arbitration panel might have decided them.  We simply attempt to make the opinion a little easier for reinsurance professionals and others interested in the subject to digest.   

Part I of this two-part post sets forth the background, and deals with two issues, both of which relate to the amount of reinsurance accepted by the reinsurer.  One involves contract interpretation, the other, reformation.  Part II of this post will tackle three issues:  one involving whether a stub period of a policy was reinsured by one of the treaties, one concerning whether the reinsurer agreed to reinsure both coverage types specified in parts A and B of the treaty, and another concerning whether the reinsurer’s rescission claim raised a question of fact sufficient to defeat summary judgment.  

Background

Beginning in 1996 Gulf Insurance Company (“Gulf”) wrote automobile residual value insurance (“RVI”) policies.   Gulf obtained reinsurance for these policies, including a series of quota share treaties in which various reinsurers participated.  As is frequently the case, each treaty was evidenced by a treaty wording, and an interest & liabilities agreement (“I & L”), which set forth each reinsurers’ participation in the treaty.  Gerling Global Reinsurance Corporation of America (“Gerling”) (n/k/a “GLOBAL Reinsurance Corporation of America”) participated only in the treaties effective 1999, 2000, and 2001. 

In March 2000 a Gulf policyholder, First Union Corporation (“First Union”), commenced a coverage action against Gulf, claiming $418 million was due it under its RVI policy.  In 2003 Gulf and First Union settled the coverage action for $266 million and Gulf billed its 1996, 1997 and 1998 reinsurers for what it claimed were their respective shares of the settlement.  Gerling was not billed because it did not participate in any of those treaty years.  The reinsurers refused to pay and Gulf commenced an action in Supreme Court, New York County (New York County’s trial court of general jurisdiction) to collect the disputed reinsurance balances.

In March 2004 Gulf billed a portion of the settlement to reinsurers participating in treaties in later years, including the treaty effective 1999 in which Gerling participated.  Gerling refused to pay and Gulf commenced an action against it in Supreme Court, New York County.  Gerling, in turn, commenced a separate action in the same court seeking rescission of the treaties effective 1999, 2000 and 2001, and, in the alternative, certain declaratory relief.  Pretrial proceedings in these two actions were consolidated. 

After discovery, the parties filed cross-motions for summary judgment.  The issues raised by the motions for summary judgment, and their resolution by the trial and appellate courts, are discussed in detail in this two-part post (in the order in which they were addressed by the Court).      

Discussion

A.  What Amount of Reinsurance did Gerling Accept? 

A key issue informing the resolution of the summary judgment motions was whether Gerling’s percentage participation in the 1999 and 2000 Treaties, as stated in the I & Ls, was intended to be a percentage participation of a 45% quota share of Gulf’s gross liability under the applicable RVI policies, or simply a percentage participation of Gulf’s gross liability under those policies.  The Court held that Gerling accepted 6.5% of 45% of Gulf’s gross liability under the policies reinsured by the Treaties, not 6.5% of 100% of that gross liability. 

Most versed in reinsurance law and practice would correctly observe that this holding was uncontroversial.  But there was nevertheless some support for Gulf’s position based on the maxim “loss follows premium.” 

 Let’s take a look at what the Treaties and I & Ls provided as respects Gerling’s participation.  As the 1999 and 2000 Treaties were identical, we need only consider the 1999 Treaty wording and I & L (collectively, “the Treaty”).  The applicable “Business Covered” section of the Treaty wording said that “[t]he Company [Gulf] shall cede to the Reinsurer [defined to include all participating reinsurers collectively] and the Reinsurer shall accept from the Company a 45% quota share participation of the net retained insurance liability of the Company on each risk insured.”  “Net retained insurance liability” was defined as “the remaining portion of the Company’s gross liability on each risk reinsured under this Agreement after deducting recoveries from all reinsurance, other than the reinsurance provided hereunder and the reinsurance provided in the Company Retention Article.”  The “Company Retention Article” said that “[t]he Company will maintain for its net account a 55% participation in the business reinsured hereunder.  However, at its discretion, the Company may purchase facultative reinsurance.”

Let’s pause briefly here to deal with a wrinkle in the contract language that did not affect the outcome, but which might otherwise cause confusion.   The definition of “net retained insurance liability” set forth above suffered from what presumably was a scrivener’s error.  It provided for the deduction of “recoveries from all reinsurance, other than the reinsurance provided hereunder and the reinsurance provided by the Company Retention Article.”   Slip op. at 4 (emphasis added).  Where, as here, Gulf’s retention was expressed on a pro-rata basis (55%), not deducting inuring facultative reinsurance for the purposes of calculating net retained insurance liability would result in Gulf effectively receiving additional quota share reinsurance on loss that was already reinsured 100% by inuring facultative reinsurance.  The parties therefore agreed that “net retained insurance liability” simply meant “the remaining portion of the Company’s gross liability.  .  .  after deducting recoveries from all reinsurance, other than the reinsurance provided hereunder.”     

Turning back to the rest of the contract, the I & L stated that “[Gerling] shall have a 6.50% participation … in the Interests and Liabilities of the Reinsurer as set forth in the Agreement attached hereto entitled Quota Share Reinsurance Agreement.”  The Treaty wording said “Gulf shall cede to the Reinsurer and the Reinsurer shall accept from [Gulf] a 45% quota share participation of [Gulf's] net retained insurance liability … on each risk insured.”  These two documents, taken together, showed that Gerling accepted a 6.5% participation in the 45% quota share of Gulf’s net retained insurance liability.  The Court said that whether or not Gulf had inuring reinsurance, “[t]he crucial and unambiguous fact is that Gerling has a 6.5% participation in the 45% quota share and that quota share cannot be equal to 100% of Gulf’s net retained insurance liability.”  Slip op. at 7.  

The premium provisions of the I & L buttressed this conclusion.  They stated that “[Gulf] shall pay [Gerling] 6.50% of all premiums due … the Reinsurer in accordance with the provisions of the Agreement [the Treaty] attached.”  (emphasis added)  The Treaty wording, in turn, stated that “[Gulf] shall pay to the Reinsurer 45% of [Gulf's] original gross net written premium … in respect to its net retained insurance liability.”  And the Treaty defined “original gross net written premium” as “gross written premium less returns, cancellations, inuring excess of loss reinsurance and facultative reinsurance, if any.” 

So putting aside for the moment any extrinsic evidence, the I & L and Treaty wording provided that Gerling was entitled to a 6.5% share of 45% of the “original gross net written premium.”  That, in turn, meant that Gerling accepted a 6.5% share of “a 45% quota share participation of the net retained insurance liability of the Company on each risk insured.”  Slip op. at 6-7.  

But the extrinsic evidence arguably cast matters in a different light.  First, Gulf had not procured any inuring reinsurance.  Second, Gulf paid Gerling – and Gerling accepted without objection — 6.5% of 100% of the “original gross net written premium.”  Third, as Gulf pointed out, “when all of the reinsurers’ individual participations under their I & L contracts were added up (TRC 12.5%; XL 11.25%; Odyssey 11.25%; and Gerling 10%), they total the 45% share of Gulf’s gross liabilities that the .  .  . reinsurers agreed collectively to accept under the [Treaty].”  Slip op. at 5.  

Gerling explained “’that its acceptance of the [higher amounts of premium] was based upon its mistaken acceptance of the broker’s representations to its bookkeeping department that the amounts were correct.’”  Slip op. at 6 (quoting trial court).  Gerling also pointed out that “because the premium was received after — not contemporaneously with — execution of the contract documents, its receipt and related documents of its bookkeepers ‘do not reflect any interpretation of treaty wordings.’”  Slip op. at 6 (quoting trial court) (emphasis added). 

While Gulf’s extrinsic evidence was consistent with Gulf’s position that Gerling accepted a 6.5% participation of Gulf’s gross liability under the reinsured RVI policies, it contradicted what the Court found to be the clear and unambiguous provisions of the I & L and Treaty wording.  New York law does not permit consideration of extrinsic evidence to vary the terms of clear and unambiguous contract language.  Because the I & L and Treaty provisions were unambiguous, the Court found that the conflicting extrinsic evidence was irrelevant.  Slip op. at 7 (citation omitted).  Accordingly, the Court held that the trial court “correctly concluded that the relevant provisions of the 1999 and 2000 treaties and I & L contracts unambiguously state Gerling’s percentage participation as a percentage of all risk assumed by the reinsurers.”  Slip op. at 8.  

 B.  Did the Trial Court Properly Grant Summary Judgment on Gulf’s Reformation Claim?

In the event it lost on the amount of reinsurance accepted issue, Gulf sought, in the alternative, reformation of the Treaties to provide that Gerling accepted a 6.5% share of Gulf’s gross liability under the reinsured policies.  The predicate for reformation was mutual mistake.  The trial court granted Gerling’s motion for summary judgment, but the Court reversed, finding that Gulf had adequately established its burden to show that there was a material issue of fact precluding summary judgment.  Slip op. at 12.  

Given its finding that the Treaties clearly and unambiguously provided that Gerling accepted a 6.5% share of 45% of Gulf’s gross liability, the Court had to square this case with two prior New York Court of Appeals decisions holding that a party resisting summary judgment of a claim for reformation of a clear and unambiguous contract between sophisticated parties must come forward with “unequivocal and persuasive evidence of mutual mistake”  Slip op. at 8, 8-10; see Chimart Assoc. v Paul, 66 N.Y. 2d 570 (1986) (here);  Backer Mgt. Corp.v Acme Quilting Co, 46 N.Y. 2d 211 (1978). 

Gulf was required to show that the mutual mistake existed at the time the contract was executed.  But the Court found that, while “[h]ow the parties perform a contract necessarily is manifested after execution of the contract…,” “their [subsequent] performance is highly probative of their state of mind at the time the contract was signed.”  Slip op. at 10.   The Court acknowledged that “neither Gulf’s course-of-performance evidence nor the Gerling ‘Account Instructions’ conclusively establish mutual mistake.”  Slip op. at 11.  And if Gerling’s version of the events was “accepted, Gulf’s course-of-performance evidence could be viewed as equivocal,” because “the interpretation of a contract manifested by a party’s performance ‘must be the conscious action of a responsible agent of the party against whom the interpretation is urged[.]’”  Slip op. at 11 (quoting Jansen v United States, 344 F.2d 363, 369 (Ct. Cl. 1965)): 

 Gerling countered Gulf’s evidence with an affidavit from Alice Belkin, an assistant secretary and account analyst in Gerling’s accounting department who was involved in reviewing and booking premiums and losses reported to Gerling by Gulf through its broker, Guy Carpenter. According to Ms. Belkin, she recorded in Gerling’s books premium and loss experience relating to the reinsurance agreements with Gulf in accordance with assurances she received from Guy Carpenter, not on the basis either of any review by her of the terms of the treaties and I & L contracts or of discussions with Gerling underwriters knowledgeable about those terms. Referring to Ms. Belkin’s affidavit, and apparently accepting the truth of its factual assertions, Supreme Court wrote that “Gerling explains that its acceptance of the [higher amounts of premium] was based on its mistaken acceptance of the broker’s representations to its bookkeeping department that the amounts were correct.”

Slip op. at 11.  

But, for the purposes of summary judgment, the trial court should have taken Gulf’s version of the facts as true, and not effectively have ruled that Gerling’s evidence was more credible than Gulf’s: 

The trier of fact might have a favorable impression of Ms. Belkin’s credibility.  But it also might regard testimony in accordance with those factual assertions as a deus ex machina, appearing too suddenly and conveniently after Gulf ceded the First Union claim to its reinsurers. Gulf contends, and we agree, that from all the evidence it submitted, a fact finder reasonably could conclude that a multibillion dollar reinsurance company does not collect the premium and pay losses for more than three years without any internal controls whatsoever to ensure that the substantial amounts it receives and pays are consistent with the terms of the underlying contracts.  As a panel of the Third Department stated in a similar context, “we think it cannot be said on this record that a reasonable person could by no rational process find the evidence of mutual mistake to be clear, positive and convincing.  Summary judgment on affidavits should not be granted where there is any doubt as to the existence of triable issues of fact.

Slip op. at 11-12 (citations omitted). 

Accordingly, the Court reversed the trial court’s grant of summary judgment, holding that “Gulf was not required to come forward with incontrovertible proof of mutual mistake. It met the heavy burden it was required to shoulder of coming forward with ‘unequivocal evidence of mutual mistake’ in evidentiary form.”  Slip op. at 12. 

In Part II we discussed the remaining three issues considered by the Court, so stay tuned.  .  .  .

On May 29, 2009 American Express filed a petition for a writ of certiorari in the American Express Merchants’ Litigation, in which the United States Court of Appeals for the Second Circuit held that a provision in an arbitration agreement forbidding class action arbitration was invalid and unenforceable under the circumstances of that case.  See Re American Express Merchants’ Litigation,  554 F.3d 300 (2d Cir. 2009), petition for cert. filed (08-1473) (May 29, 2009).  (A copy of the Second Circuit decision is here, and the Supreme Court Docket sheet is here.)   Opposition papers are due June 29, 2009. 

If the United States Supreme Court were to hold in Stolt-Nielsen that arbitrators cannot order class action arbitration where the arbitration clause is silent on that point, then it would seem that an arbitration clause expressly forbidding class action arbitration should necessarily be valid and enforceable.   Even if the Court were to hold that the arbitrators in Stolt-Nielsen had the power to order a class action arbitration –  even though  the contract was concededly silent on the point – that would still beg the question whether a class action arbitration can be authorized where the contract clearly and unambiguously forbids it.  Hopefully the Court will take the opportunity to bring well-reasoned clarity into this extremely important area of arbitration law by granting certiorari in the American Express Merchants’ Litigation.  If certiorari is granted, next year could yield not one, but two landmark arbitration decisions.

We shall keep readers informed of developments as and when they occur.

The Second Circuit and other courts have recognized that signatories may enforce under Sections 3 and 4 of the Federal Arbitration Act  arbitration agreements against non-signatories whenever common-law principles of contract and agency would permit such enforcement, and that non-signatories may enforce arbitration agreements against signatories at least under an estoppel theory, and possibly under other theories of contract and agency.  See, e.g., Ross v. American Express Co., 547 F.3d 137, 143 & n.3 (2d Cir. 2008); Ross v. American Express Co., 478 F.3d 96, 99 (2d Cir. 2007); Astra Oil Co. v. Rover Navigation, Ltd., 344 F.3d 276, 279-80 & n.2 (2d Cir. 2003); Thomson-CSF, S.A. v. American Arbitration Assoc., 64 F.3d 773, 776-80 (2d Cir. 1995).  The Second Circuit likewise allows interlocutory appeals from the denial of  Section 4 motions to compel arbitration, or Section 3 motions to stay litigation in favor of arbitration, brought by or against non-signatories.  See, generally, 478 F.3d at 99.

Certain other circuits have held that nonsigatories may not invoke Section 3 or 4 based on an estoppel theory, or at least cannot appeal on an interlocutory basis the denial of an estoppel-based Section 3 or 4 application.  See, e.g., DSMC Inc. v. Convera Corp., 349 F.2d 679, 683-84 (D.C. Cir. 2003) (then Roberts, J.); Re Universal Service Fund Tel. Billing Practice Litigation v.Sprint Communications Co., 428 F.3d 940, 945 (10^th Cir. 2005) (limiting holding to whether Court of Appeals had appellate jurisdiction at interlocutory stage).  These Courts have relied on Section 3′s and 4′s requirement that the relief sought must be “under” a written agreement to arbitrate, and their determination that an estoppel claim by a non-signatory is not one “under” a written agreement to arbitrate.    

Arthur Andersen:  Issues and Holding

On May 4, 2009, in Arthur Andersen LLP v. Carlisle, ___ U.S. ___ (2009) (Scalia, J.), the United States Supreme Court resolved the circuit split in favor of the courts permitting non-signatories to avail themselves of Federal Arbitration Act Sections 3 and 4.  There were two issues before the Court:

1. Whether the federal appellate courts have jurisdiction under Federal Arbitration Act Section 16(a) to review denials of stays of litigation requested by litigants who were not parties to the arbitration agreement; and
2. Whether Federal Arbitration Act Section 3 can ever mandate a stay sought by a nonsignatory to an arbitration agreement.

The Court held that federal appellate courts have jurisdiction to review appeals from denials of stays sought by non-signatories and that Section 3 can mandate a stay where applicable state law allows the enforcement of an agreement by or against a non-signatory.   Justice Souter dissented in an opinion joined by Chief Justice Roberts and Justice Stevens. 

Facts and Procedural History

Arthur Andersen was an appeal from a Sixth Circuit decision dismissing for lack of jurisdiction an appeal of a denial of a motion for a stay brought by a non-signatory to an arbitration agreement on an estoppel theory.  The plaintiffs had hired Arthur Andersen to provide tax and accounting advice concerning how to minimize their tax liabilities arising out of their sale of their construction-equipment company.  Andersen introduced the plaintiffs to Bricolage Capital, LLC, which referred them to a well-known law firm for legal advice.  Bricolage and the plaintiffs entered into investment-management agreements containing broad arbitration clauses.  These relationships and agreements resulted in plaintiffs investing in a tax shelter scheme, which the Internal Revenue Service ultimately disapproved, and which resulted in the plaintiffs investing in stock warrants that turned out to be worthless.  For a period, the IRS offered conditional amnesty to others who had invested in like schemes, but Andersen and the law firm allegedly did not timely inform the plaintiffs of this option, which resulted in plaintiffs settling with the IRS and paying all back taxes, penalties and interest.    

Plaintiffs filed suit in the Eastern District of Kentucky against Andersen, the law firm, Bricolage and others, and the defendants — other than Bricolage and its employees — moved to stay the litigation based on the arbitration agreements in Bricolage’s contracts, even though they were not signatories to those contracts (Bricolage also moved for a stay but subsequently filed for bankruptcy, which mooted its application).  The District Court denied the non-signatories’ motions.  On appeal to the United States Court of Appeals for the Sixth Circuit, the Court dismissed the appeal for want of jurisdiction because the appellants were not signatories to the Bricolage agreements. 

Appellate Review under Federal Arbitration Act Section 16(a)

Federal Arbitration Act Section 16(a) provides that “an appeal may be taken from an order.  .  . refusing a stay of any action under Section 3 of this title.”  (emphasis added).  The Arthur Andersen Court pointed out that the Sixth Circuit, and other courts that have withheld enforcement by non-signatories, reasoned that stay motions premised on an equitable estoppel theory “seek to expand (rather than simply vindicate) agreements” to arbitrate and thus are not cognizable under Section 3.  Slip op. at 3.  They are, therefore, not “under Section 3″ for the purposes of Federal Arbitration Act Section 16(a), and thus not subject to interlocutory appeal. 

But the Arthur Andersen Court rejected this reasoning, holding that Section 16(a) expressly authorizes interlocutory appeals of motions denying Section 3 stays, irrespective of whether the moving party was a signatory to the arbitration agreement.  Jurisdiction over an appeal, said the Court, “‘must be determined by focusing on the category of order appealed from, rather than upon the strength of the grounds for reversing the order.”  Slip op. at 4 (quoting Behrens v. Pelletier, 516 U.S. 299, 311 (1996)).  And Section 16(a) “unambiguously makes the underlying merits irrelevant, for even the utter frivolousness of the underlying request for a § 3 stay cannot turn a denial into something other than ‘an order.  .  . refusing a stay of any action under section 3.  .  .  .”  Slip op. at 4. 

Non-Signatories’ Right to Invoke Federal Arbitration Act Section 3

The Court also held that a non-signatory to a written arbitration agreement can successfully invoke Section 3 if state law would allow it to enforce an ordinary contract under the same circumstances: 

Section 2 – the FAA’s substantive mandate – makes written arbitration agreements ‘valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.’  That provision creates substantive federal law regarding the enforceability of arbitration agreements, requiring courts ‘to place such agreements upon the same footing as other contracts.’  Section 3, in turn, allows litigants already in federal court to invoke agreements made enforceable by §2.  That provision requires the court, ‘on application of one of the parties,’ to stay the action if it involves an ‘issue referable to arbitration under an agreement in writing.’ 

Neither provision purports to alter background principles of state contract law regarding the scope of agreements (including the question of who is bound by them).  Indeed §2 explicitly retains an external body of law governing revocation (such grounds ‘as exist at law or in equity’).  And we think §3 adds no substantive restriction to §2′s enforceability mandate.  ‘[S]tate law,’ therefore, is applicable to determine which contracts are binding under §2 and enforceable under §3 ‘if that law arose to govern issues concerning the validity, revocability, and enforceability of contracts generally.’  Because ‘traditional principles’ of state law allow a contract to be enforced by or against nonparties to the contract through ‘assumption, piercing the corporate veil, alter ego, incorporation by reference, third-party beneficiary theories, waiver and estoppel,’ the Sixth Circuit’s holding that nonparties to a contract are categorically barred from §3 relief was error. 

Slip op. at 5-7 (emphasis in original; citations and footnotes omitted). 

The Court rejected the argument that, under Section 3, claims by nonparties to enforce an arbitration agreement are not “referable to arbitration under an agreement in writing” because they seek to bind a signatory to an obligation beyond that signatory’s obligation to arbitrate with other signatories.  See Slip op. at 7; 9 U.S.C. § 3 (emphasis supplied).  The Court pointed out that Section 3 provided otherwise: 

Perhaps that would be true if §3 mandated stays only for disputes between parties to a written arbitration agreement.  But that is not what the statute says.  It says that stays are required if the claims are ‘referable to arbitration under an agreement in writing.’  If a written arbitration provision is made enforceable against (or for the benefit of) a third party under state contract law, the statute’s terms are fulfilled. 

Slip op. at 7. 

Analysis and Conclusion

The Court’s opinion is significant for at least four reasons.  First, it reaffirms in no uncertain terms that questions concerning the validity, scope and enforceability of an agreement to arbitrate are governed by state law applicable to contracts generally.  The only exception is that an ambiguity in the scope of the agreement itself must be resolved in favor of arbitration. 

Second, the Court reaffirmed what a number of courts have taken for granted, namely, that Section 3 stays may be sought by non-signatories on an estoppel theory, provided that applicable state law would authorize the enforcement of the agreement on that ground under the same circumstances.  Had the Court ruled otherwise, it would have interpreted the Federal Arbitration Act less expansively than its plain language permits.  We suspect the Court was particularly reluctant to depart from a textual analysis simply to reduce the number of appeals in Federal Arbitration Act satellite litigation.  For more than 20 years, the Court’s arbitration jurisprudence has focused on enforcing arbitration agreements to the same extent as contracts generally, and Arthur Andersen is no exception.    

Third, the Court’s broad pronouncement strongly suggests that a non-signatory may enforce an arbitration agreement against a signatory on contract and agency grounds other than estoppel, including assumption, piercing the corporate veil, alter ego, incorporation by reference, and third-party beneficiary theories.  Prior to the Court’s decision, whether a non-signatory could avail itself of a theory other than estoppel was an open question in the Second Circuit.  See 547 F.3d  at 143 n.3. 

Fourth, although the Court did not address Section 4 motions to compel arbitration, its reasoning is equally applicable in that context.  Federal Arbitration Act Section 4 provides, in pertinent part: 

A party aggrieved by the alleged failure, neglect, or refusal of another to arbitrate under a written agreement for arbitration may petition any United States district court which, save for such agreement, would have jurisdiction under Title 28, in a civil action or in admiralty of the subject matter of a suit arising out of the controversy between the parties, for an order directing that such arbitration proceed in the manner provided for in such agreement.  .  .  . 

9 U.S.C. § 4 (emphasis supplied) 

Not unlike Section 3, Section 4 does not require the petitioner or movant to be a signatory to a written agreement to arbitrate, but merely that there be an “alleged failure, neglect, or refusal of another to arbitrate, under a written agreement” to arbitrate.  Section 4 says that “[a] party .  .  .  . may petition any United States district court.  .  .  .”, and one might argue that “party” means “party to the arbitration agreement”, not “party to a Section 4 proceeding.”  But the Andersen Court eschewed that interpretation.  See Slip op. at 6 n.4.

In any event, limiting Section 4′s availability to formal parties to written arbitration agreements would frustrate the pro-enforcement policy of the Federal Arbitration Act.  Sections 3 and 4 are designed to work together in appropriate cases as a dual enforcement mechanism:  If one unwilling to arbitrate brings suit in federal court, then Section 3 enables the other to obtain a stay of litigation, and Section 4 enables that other to compel arbitration in the same action, assuming that the Section 4 movant has been aggrieved by the other litigant’s failure to proceed to arbitration and is not in default itself.   

Denying that dual enforcement mechanism in cases involving non-signatories would make arbitration agreements less enforceable than ordinary contracts.  Consider the position of A, a non-signatory, seeking to enforce an agreement against B, a signatory.  A would be unable to move to compel B to arbitrate, which would force it to bring suit against B.  Or if B happened to bring suit against A first, A’s only recourse would be a motion for a stay.  If the stay was granted, B could refuse to proceed to arbitration despite the stay, which would effectively force A to choose between moving to vacate the stay, and proceeding with the litigation, or leaving the stay in place and not vindicating its contractual rights under state law.