On May 4, 2009 the United States Supreme Court decided Arthur Andersen LLP v. Wayne Carlisle, ___ U.S. ___ (2009), holding that a nonsignatory to a contract containing an arbitration clause may invoke Section 3 of the Federal Arbitration Act — which authorizes courts to stay litigation in favor of arbitration —  if state contract law allows it to enforce the contract.  The case is significant in its own right and one we intend to discuss in a subsequent post.  It further undermines the rationale of ReliaStar because the Court makes what may be  its strongest statement to date about state contract law governing the scope, validity, and  revocability of arbitration agreements falling under the Federal Arbitration Act:  

Neither [Section 2 nor 3 of the FAA].  .  .  purports to alter background principles of state contract law regarding the scope of agreements (including the questions of who is bound by them).  Indeed [Section] 2 explicitly retains an external body of law governing revocation (such grounds ‘as exist at law or in equity’).  And we think [Section] 3 adds no substantive restriction to [Section] 2′s enforceability mandate.  State law, therefore, is applicable to determine which contracts are binding under [Section] 2 and enforceable under [Section] 3 if that law arose to govern issues concerning the validity, revocability, and enforceability of contracts generally.  .  .  . 

Slip op. at 6-7 (citations, quotations and footnote omitted; emphasis in original). 

The “scope of agreement” question addressed by ReliaStar concerned the scope of the parties’ agreed prohibition on fee shifting.  Applicable New York rules of contract interpretation and construction required that agreement to be enforced as written.  The dictum in Arthur Andersen underscores that the ReliaStar majority should have analyzed the contract like the New York Court of Appeals would have analyzed any other contract, concluded it was clear and unambiguous, and enforced it accordingly.

We recently reported on ReliaStar Life Ins. Co. v. EMC National Life Co., ___ F.3d ___, ___ (2009) (Raggi, J.) (blogged here), in which the United States Court of Appeals for the Second Circuit held that an arbitration panel was authorized to award under the bad faith exception to the American Rule attorney and arbitrator fees to a ceding company in a case where the parties had agreed that “[e]ach party shall bear the expense of its own arbitrator.  .  .  and related outside attorneys’ fees, and shall jointly and equally bear with the other party the expenses of the third arbitrator.”  This post takes a critical look at ReliaStar.  

The Second Circuit is one of the most influential and respected  Circuit Courts of Appeal in the United States, yet on occasion even this prestigious court renders a decision that is open to question.  ReliaStar is one of those decisions.  The majority opinion lost sight of what the parties agreed about the arbitrators’ power to award attorney fees.  Rather than adhere to the plain meaning of the parties’ agreement as required by New York  law, the Court construed an unambiguous limitation on arbitral authority to mean something other than what it said. 

No doubt that the Court believed that its decision would encourage resort to arbitration by construing arbitral authority broadly.  But the Court would have done a far better job encouraging resort to arbitration had it simply enforced the parties’ agreement as written.  One of the most attractive features of arbitration is that parties get to dictate how they want their dispute decided, including, among other things, how best to allocate the costs, fees and expenses of deciding it.   But that feature falls by the wayside if courts cannot be relied upon to enforce arbitration agreements as written. 

Discussion 

Background

The question before the Court was one of arbitrability:  Did the arbitrators have the power to award attorneys fees for EMC’s alleged bad faith conduct in the arbitration?  It turned on what the contract had to say about attorney fees.  State law governed the interpretation of the arbitration clause, including the question of whether it was reasonably susceptible to more than one interpretation.  See First Options of Chicago, Inc. v. Kaplan, 514 U.S. 938,  944 (1995); Mastrobuono v. Shearson Lehman Hutton, Inc., 514 U.S. 52, 62-63 & n.9 (1995).  If the clause was ambiguous under applicable state law, then federal law required that the ambiguity in its scope be resolved in favor of arbitration.   See 514 U.S. at 62.

The parties agreed that New York law, “and to the extent applicable the Federal Arbitration Act,”  would “govern the interpretation and application” of their agreement.  For many years the New York Court of Appeals (New York’s highest court) has adhered to what is known as the “plain meaning” rule of contract interpretation.  The theory behind the plain meaning rule is that the most persuasive indication of what the parties intended their written contract to mean is embodied in the words, phrases and sentences they used.    

Here is what the New York Court of Appeals has to say about the plain meaning rule:        

A familiar and eminently sensible proposition of law is that, when parties set down their agreement in a clear, complete document, their writing should as a rule be enforced according to its terms.  Evidence outside the four corners of the document as to what was really intended but unstated or misstated is generally inadmissible to add to or vary the writing.  That rule imparts stability to commercial transactions by safeguarding against fraudulent claims, perjury, death of witnesses.  .  .  infirmity of memory .  .  . [and] the fear that the jury will improperly evaluate the extrinsic evidence.  .  .  . 

W.W.W. Associates, Inc. v. Giancontieri, 77 N.Y.2d 157, 162-63 (1990) (citations and quotations omitted).   

The key phrase that the ReliaStar Court had to analyze stated “[e]ach party shall bear the expense of its own arbitrator.  .  .  and related outside attorneys’ fees, and shall jointly and equally bear with the other party the expenses of the third arbitrator”   (the “Fee and Expense Provision”).   Under the plain meaning rule, there is no reasonable interpretation of this unqualified provision, but that: 

1. Each party “bears the expense of its own arbitrator. . .fees”;
2. Each party “bears the expense of its own. . . outside attorneys’ fees”; and
3. Each party “shall jointly and equally bear with the other party the expenses of the third arbitrator.”

There are no qualifications or exceptions stated in these simple risk allocation rules and they are not susceptible to construction.   As the dissent observed, the Fee & Expense Provision is “no more susceptible to construction than is Article II, Section I of the U.S. Constitution which provides that no person shall be eligible to be President ‘who shall not have attained to the Age of thirty five years.’”  Slip op. at 17. 

When the majority considered what the parties intended by the plain and unambiguous words they used, they focused not on the said, but the unsaid.   According to the majority, the Fee and Expense provision “simply states the general American Rule that each party will bear its own attorney fees and extends that principle to apply also to the fee of the arbitrator selected by each party.”  Slip op. at 11.  The Court found that the provision said nothing about how fees were to be allocated in the event a party acted in bad faith and it interpreted this understandable silence to mean that the parties intended to incorporate into their contract the bad faith exception to the American Rule applicable in federal courts. 

Analysis

The Court’s reasoning and findings cannot withstand scrutiny under New York rules of contract interpretation.  First, the Court should have determined whether or not the Fee & Expense Provision was ambiguous as written, without regard to its supposed purpose or the reason for its inclusion.  The provision might have been agreed upon for any number of reasons, and even if there were extrinsic evidence of what the parties’ intended, that evidence would be irrelevant.  The only relevant consideration was what the parties said.  The majority’s speculation about what the parties meant or intended but did not say was besides the point where, as here, the language they used was clear and unqualified.   

Second, the Court violated New York contract interpretation rules by determining that the parties’ failure to address fee shifting in the event of bad faith effectively created an ambiguity in the Fee & Expense Provision.  To ascertain whether a contract is ambiguous, courts are required by New York law to focus on what is said, not what is omitted:     

An omission or mistake in a contract does not constitute an ambiguity [and].  . . the question of  whether an ambiguity exists must be ascertained from the face of an agreement without regard to extrinsic evidence.

Reiss v. Financial Performance Corp., 97 N.Y.2d 195, 199 (2001) (citations and quotations omitted).   

The Fee & Expense Provision is unqualified; by its terms it applies whether or not one of the parties acted in bad faith.  Expressly stating that the parties intended the rule against fee shifting to apply where a party acted in bad faith would not have broadened the provision’s scope or made it any clearer than it already was.  Having already used unqualified language, there was simply no reason the drafters would or should have believed that it was necessary to say more to ensure that the arbitrators would not be permitted to shift fees under any circumstances.  

Third, the Court violated New York contract interpretation rules by effectively adding a “bad faith exception” to the unqualified Fee & Expense Provision.  New York law generally forbids courts from adding implied terms to the parties’ contract under the guise of interpretation or construction:   

Even where a [contractual] contingency has been omitted, we will not necessarily imply a term since courts may not by construction add or excise terms, nor distort the meaning of those used and thereby make a new contract for the parties under the guise of interpreting the writing. 

Reiss, 97 N.Y.2d at 199 (citations and quotations omitted).   While implying a term may be appropriate under certain limited circumstances, New York courts “will not imply a term where the circumstances surrounding the formation of the contract indicate that the parties, when the contract was made, must have foreseen the contingency at issue and the agreement can be enforced according to its terms.”  97 N.Y.2d at 199. 

There was no dispute that the parties knew or should have known at the time of drafting that a party might arbitrate in bad faith.  That is one of the risks parties undertake when they agree to arbitrate and they can choose to allocate that risk as they see fit.  The Court’s reasoning assumed the parties were aware that there was a possibility the other might not arbitrate in good faith.  One of the key predicates for the Court’s decision was that the Fee & Expense Provision was simply a restatement of the American Rule and that “bad faith was a well-recognized exception to the American Rule.  .  .  .”  Slip op. at 13. 

There was likewise no legitimate dispute that the Fee & Expense Provision could be enforced as written.   The provision was clear and unambiguous and all it required the parties to do was bear their own attorney and party-appointed arbitrator fees, and split the umpire’s fee, irrespective of the outcome of the dispute, and irrespective of whether one party alleged the other arbitrated in bad faith.   

In any event, even if New York rules of contract interpretation and construction allowed the Court to look behind the plain meaning of the Fee & Expense Provision to ascertain the parties’ intent, the Court looked askew.   The Court assumed, without explanation, that the Fee & Expense Provision was intended to incorporate the federal version of the American Rule, including the bad faith exception to that federal rule.  But the parties agreed their contract would be interpreted according to New York Law, and the American Rule as articulated by the New York courts does not feature a bad faith exception:  “attorney’s fees are incidents of litigation and a prevailing party may not collect them from the loser unless an award is authorized by agreement between the parties, statute or court rule.”   Hooper Associates, Ltd. v. AGS Computers, Inc., 74 N.Y.2d 487, 491 (1989).     While there is a New York court rule authorizing courts to award attorney fees against a party that litigates in bad faith, that rule does not purport to authorize arbitrators to award attorney fees for bad faith.  The only statute even arguably applicable is Section 7513 of  New York’s Civil Practice Law and Rules, which establishes a presumption that arbitrators do not have the authority to award attorney fees unless the parties otherwise agree.  See New York Civ. Prac. L. & R. 7513; Synergy Gas Co. v. Sasso, 853 F.2d 59, 65 (2d Cir. 1988),

Finally, the breadth of the arbitration clause did not create an ambiguity when read together with the Fee & Expense Provision.  New York rules of contract interpretation provide that specific contract provisions trump general ones.  See, generally, Katz v. Feinberg, 290 F.3d 95, 96 (2d Cir. 2002) (per curiam).  The arbitration clause’s broad grant of authority was a general provision, which made no reference whatsoever to attorney fees, arbitrator fees, or any other form of relief.  By contrast, the Fee & Expense Provision specifically and unambiguously dealt with the subject of attorney and arbitrator fees.  Just as an insurance policy’s broad grant of coverage is subject to an unambiguous exclusion, so is an arbitration clause’s broad grant of authority subject to a specific, unambiguous provision limiting that authority. 

It seems to us that the majority of the ReliaStar Court may have been motivated more by a desired result than by applicable law and the parties’ agreement.  Given that the preeminent purpose of the Federal Arbitration Act is to enforce the parties’ arbitration agreement as written, ReliaStar may be one of those rare Second Circuit decisions that warrant rehearing and reversal en banc.

On a related matter, I am pleased and honored to note that Victoria has invited me to guest blog for Disputing this Monday, April 27, 2009.  My post will propose some solutions to the problems that the Arbitration Fairness Act of 2009 will likely create in disputes between commercial entities.  Readers may recall that we discussed those problems in considerable detail in our multi-part post on the Arbitration Fairness Act entitled “What Does the Arbitration Fairness Act of 2009 Have to Say About Commercial and Industry Arbitration Involving Sophisticated Parties?” (available here).  Our preferred solution would be that Congress not enact the Arbitration Fairness Act in the first place, but the post is written on the hopefully  mistaken assumption that Congress decides to jump onto the anti-arbitration bandwagon. 

Speaking of the anti-arbitration bandwagon, keep your eyes on the blogosphere this coming week, because Wednesday, April 29, 2009, is Arbitration Fairness Day (blogged here and here), which will be celebrated by a press conference on Capitol Hill in support of the Arbitration Fairness Act and other anti-arbitration legislation.  There will no doubt be many complaints by persons who perceive themselves as “victims” of arbitration, and who assume (correctly or incorrectly) that they would have fared better in court.  But we also expect to see level-headed posts calling for restraint, explaining the importance of identifying problems with empirical – not anecdotal – evidence, and advocating narrowly-tailored solutions to the extent that pervasive problems are identified.  Let’s not throw the proverbial baby out with the bathwater.  

Finally, early this coming week we expect to post our critical analysis of the Second Circuit’s recent decision in ReliaStar Life Ins. Co. v. EMC National Life Co., ___ F.3d ___ (2d Cir. 2009) (blogged here), in which the Court held that an arbitration panel in a reinsurance case was authorized to award attorney fees for a party’s alleged bad faith conduct in the arbitration, even though the parties agreed that each would bear its own attorney fees.  As we shall see, even a court as highly-respected and influential as the Second Circuit can occasionally render decisions that are open to question, and Judge Pooler’s dissent in that case is recommended reading.  We wonder if the decision would withstand review en banc.     

Stay tuned.  .  .  .   

On April 9, 2009 the United States Court of Appeals for the Second Circuit decided a case that may significantly expand the power of arbitrators to award attorney and arbitrator fees in cases involving reinsurance and other contracts.  The Court held that an arbitration panel was authorized to award under the bad faith exception to the American Rule attorney and arbitrator fees to a ceding company in a case where the parties had agreed that “[e]ach party shall bear the expense of its own arbitrator.  .  .  and related outside attorneys’ fees, and shall jointly and equally bear with the other party the expenses of the third arbitrator.”  ReliaStar Life Ins. Co. v. EMC National Life Co.,  ___ F.3d ___, ___ (2009) (Raggi, J.).  This post briefly discusses the majority and dissenting opinions.  Our critical analysis will be provided in a subsequent post. 

Facts

In December 1997 ReliaStar Life Insurance Co. (“ReliaStar”) entered into a two coinsurance agreements with EMC National Life Co. (“EMC”), one reinsuring business in force as of January 1, 1998, another reinsuring business written on or after January 1, 1998 (the “Reinsurance Agreements”).  In life reinsurance parlance, the term “coinsurance” refers to a form of proportional reinsurance, and should not be confused with its direct insurance counterpart (which, in any event, has various meanings depending on the type of direct insurance involved).  

The Reinsurance Agreements contained broad, identical arbitration clauses, which required arbitration “[i]n the event of any dispute or differences arising hereafter between the parties with reference to any transaction under or relating in any way to this Agreement.  .   .  .”  Section 10.3 of the arbitration agreements (the “Fee and Expense Provision”) said that “[e]ach party shall bear the expense of its own arbitrator.  .  . and related outside attorneys’ fees, and shall jointly and equally bear with the other party the expenses of the third arbitrator.”  Section 10.4 contained a choice-of-law clause, which said “[a]ny arbitration instituted pursuant to this Article shall be held in New York, New York, or another site mutually agreed upon by the parties and the laws of the State of New York and to the extent applicable, the Federal Arbitration Act, shall govern the interpretation and application of this Agreement.” 

The parties submitted to arbitration a dispute concerning the alleged termination of the Reinsurance Agreements.  After discovery and a hearing, the panel issued an interim award finding that the Reinsurance Agreements remained in force and directing EMC to pay Reliastar more than $21 million in overdue balances, plus interest.  A majority of the panel, without explanation, awarded ReliaStar attorney and arbitrator fees and costs. 

The parties agreed that EMC could move for reconsideration of the fee and cost ruling and, if necessary, challenge it in court.  After further briefing, a majority of the panel entered a final award in favor of Reliastar (the “Final Award”), requiring EMC to pay arbitrator and attorney fees in the amount of $3,169,496, and costs in the amount of $691,903.75 (the “Fee and Cost Ruling).  The majority explained that it awarded fees because EMC’s conduct in the arbitration was allegedly “‘lacking in good faith.’”  Slip op. at 5.

Reliastar  petitioned the United States District Court for the Southern District of New York for an order confirming the Final Award and EMC counter-petitioned for an order vacating the Fee and Cost Ruling.  The District Court vacated the Fee and Cost Ruling and confirmed the balance of the Final Award.  

The Majority Opinion

The Second Circuit reversed the District Court’s order vacating the Fee and Cost Ruling.  The Court explained its reasoning in two steps. 

First, the Court said that the parties’ broad arbitration clause conferred upon the panel the “inherent authority.  .  . to sanction a party that participates in the arbitration in bad faith and that such a sanction may include an award of attorney’s or arbitrator’s fees.”  For this conclusion the Court relied on Synergy Gas Co. v. Sasso, 853 F.2d 59, 65-66 (2d Cir. 1988), and the Ninth Circuit’s decision in Todd Shipyards v. Cunard Line, Ltd., 943 F.2d 1056, 1064 (9^th Cir. 1991), both of which found arbitrators were authorized to award attorney fees against parties that had allegedly arbitrated in bad faith.  The Court explained that the arbitrators’ power under a broad arbitration clause to award fees and costs was necessary to ensure the effectiveness of arbitration as a dispute resolution mechanism:    

[T]he underlying purposes of arbitration, i.e., efficient and swift resolution of disputes without protracted litigation, could not be achieved but for good faith arbitration by the parties.  Consequently, sanctions, including attorney’s fees, are appropriately viewed as a remedy within an arbitrator’s authority to effect the goals of arbitration. 

Slip op. at 10-11. 

Second, the Court concluded that the Fee and Expense Provision did not limit the panel’s broad authority to award arbitrator and attorney fees as a sanction for bad faith conduct.  Ostensibly applying New York rules of contract interpretation, the Court said that the Fee and Expense Provision “simply states the general American Rule that each party will bear its own attorneys fees and extends that principle to apply also to the fee of the arbitrator selected by each party.”  Slip op. at 11.  But the Court found that the provision said nothing about how fees were to be allocated in the event a party acted in bad faith.  The Court therefore construed the Fee and Expense Provision to limit the panel’s authority to shift fees and expenses only in cases where the parties arbitrated in good faith.  Because the broad grant of authority in the arbitration clause authorized the arbitrator to award fees and costs in situations where the arbitrators determined one of the parties acted in bad faith, construing the limitation as applicable only where the parties acted in good faith meant that the arbitrators had the authority to award fees and costs to ReliaStar.     

The Court concluded that “because the [arbitration] agreement[s] in this case conferred broad authority on the arbitrators, because inherent in such authority is the power to sanction bad faith conduct, and because bad faith is a well-recognized exception to the American Rule for attorney’s fees, we conclude that the simple statement of that rule in [the Fee and Expense Provision].  .  . is insufficient by itself to swallow the exception.”  Slip op. at 13.  The Court said its holding did not preclude parties from limiting a panel’s authority to award fees and costs, provided “they explicitly and clearly state that intent as part of their agreement to arbitrate.”   Slip op. at 14. 

The Court rejected EMC’s argument that the Court’s construction would render the Fee and Expense Provision superfluous in that the American Rule would be applicable even in the absence of the provision.  According to the Court, “[p]arties to commercial arbitration agreements may choose explicitly to reference the American Rule for any number of reasons unrelated to the scope of the arbitrators’ sanction authority.”  The Court said the parties might have chosen to restate the American Rule because:  (a) not all arbitrators are attorneys, and thus may not be familiar with the American Rule; and (b) some arbitrators may hail from “English Rule” jurisdictions “in which the prevailing party’s fees are routinely paid by an unsuccessful opponent.”  Slip op. at 13. 

The Dissenting Opinion

Dissenting Judge Pooler disagreed with much of the majority’s reasoning.  The dissent raised three key points, among others. 

First, the Fee and Expense Provision was unambiguous and should not have been the subject of “construction” by the majority.  According to Judge Pooler, the Fee and Expense Provision ”is no more susceptible to construction than is Article II, Section I of the U.S. Constitution which provides that no person shall be eligible to be President ‘who shall not have attained to the Age of thirty five years.’”  Slip op. at 17. 

Second, the majority erred by construing the arbitration clauses’ broad but general grant of authority as a limitation on the specific Fee and Expense Provision.  Citing Katz v. Feinberg, 290 F.2d 95, 96 (2d Cir. 2002) (per curiam), the dissent said that “the majority’s conclusion contradicts this Court’s recognition of the dominance of specific over general arbitration provisions.”  Id.  (quotation omitted)  The Fee and Expense Provision was a specific provision that dealt directly with the parties’ responsibility for attorney and arbitrator fees, whereas the arbitration clauses’ broad grant of authority was a general provision that should not, according to the dissent, have been interpreted to override the specific one.    

Third, the dissent rejected as ”pure surmise” the majority’s characterization of the Fee and Expense Provision as a “boilerplate” restatement of the American Rule.  According to the dissent, the ”Court ha[d] no basis upon which to conclude that the parties’ inclusion of [the Fee and Expense Provision].  .  .in their agreement was a matter of little consequence to them.”  Slip op. at 23-24.  The dissent explained that the parties may have intended the Fee and Expense Provision to discourage litigants from vigorously pursuing questionable claims: 

the explicit provision for the American Rule in an arbitration agreement might be a consideration in a party’s strategic approach to an arbitration proceeding.  .  .  .  [A] party may believe that its position in the dispute to be arbitrated is unlikely to prevail and knowing that it will bear its own attorney’s fees might inform its attorneys to refrain from exerting undue efforts on the case. 

Slip op. at 24.  Incorporation of the bad faith exception to the American Rule would not, of course, be necessary to accomplish that goal.

Critical analysis to follow.  .  .  .