Over a year ago we ran a Reinsurance Nuts & Bolts feature entitled “Aggregate Extension Clauses”  (here).  To our considerable surprise, that article was, and remains, one of our more popular ones. 

At the close of the article we said (tongue in cheek):  “If you, the reader, have gotten this far, then perhaps you would like to delve into a discussion of ‘Aggregate Extraction Clauses.’  But these clauses – which conjure up some of the more frightening scenes from Marathon Man (1976) – are better left for another day.  .  .  . ”  Brace yourselves, for we fear that day has arrived.  .  .  .        

B.   What is an Aggregate Extraction Clause? 

To put aggregate extraction clauses in context a very brief review of aggregate cover and aggregate extension clauses is in order.  As discussed in our aggregate extension clause feature (here), policies covering on an aggregate basis are designed to insure principally against the risk that the frequency of relatively small (i.e., low severity) losses will exceed an expected level during a given period.  That’s why products liability risks are frequently written on an aggregate basis – i.e., to protect against the high-frequency, low-severity “Coca-Cola-type”  losses discussed by the English Court of Appeal in Yasuda Fire & Marine Co. of Europe Ltd v. Lloyd’s Underwriting Syndicates No. 209, 356 & Ors., [1998] Lloyd’s Rep. LR. 343 (C.A.). 

The existence and amount of aggregate coverage is determined by aggregating together all losses occurring within a specified period, irrespective of their severity.  That aggregate amount is subject to an aggregate deductible and frequently an aggregate limit.   

Reinsuring aggregate cover on an excess of loss basis presents problems because the amount of each loss or occurrence is generally not high enough to exceed the retention of the excess of loss treaty.  Over a period, however, the accumulated loss covered by the policy might well exceed the retention of the excess of loss treaty were it deemed to arise from a single occurrence.   

We explained in our prior article (here) that the aggregate extension clause effectively extends the aggregate cover of the underlying policy into the excess of loss treaty.   Instead of subjecting each individual loss or occurrence to a separate retention and limit, it allows the aggregation of losses or occurrences when the original policy is written on an aggregate basis.   

The aggregate extraction clause deals with the special problems that may arise when losses covered on an aggregate basis arise out of a single occurrence that has also caused loss under one or more policies that were not written on an aggregate basis.  If – as is sometimes the case — the loss arising out of a single occurrence is of relatively high severity, then it is not the type of loss that either the aggregate policy or the aggregate extension clause was principally designed to cover.   And when the relatively severe loss is lumped into the aggregate cover provided by the reinsurance contract, it eats up capacity that was designed principally to accommodate high frequency, low severity losses. 

At the same time, the cedent is deprived of the ability to accumulate the single-occurrence aggregate-loss with non-aggregate losses on other reinsured policies arising out of the same occurrence.   Thus, while the cedent may get the benefit of clash cover protection on single-occurrence, non-aggregate losses arising out of multiple, non-aggregate policies, it loses that benefit in situations where a portion of the loss arising out of the occurrence is covered on an aggregate basis.   (An excess of loss contract provides clash cover when a single occurrence under the treaty is subject to a single retention and limit, irrespective of the number of original policies that respond to the occurrence.  This type of cover reinsures against the accumulation of net retained liability under multiple, original policies arising from the same occurrence.)   

The aggregate extraction clause addresses both of these problems.   It allows the cedent to extract from aggregate reinsurance coverage a single-occurrence-based loss on policies written on an aggregate basis and combine it with other losses on non-aggregate policies that arise out of the same occurrence.  Brokers and Reinsurance Markets Association (“BRMA”) clause 4A is an example of an aggregate extraction clause: 

As regards liability incurred by the Company for losses on a policy or policies covering on an aggregate basis, the Company shall be permitted to extract from such aggregate policy or policies the amount of loss sustained by it arising from one loss occurrence in order that such loss can be added to the Company’s losses from the same occurrence on [an]other policy or policies, if any.

For the purposes of this Article, the amount of loss from one occurrence on an aggregate policy shall be deemed to be that percentage of the aggregate loss to the Company that the total loss from the particular occurrence bears to the total aggregate losses to the insured or company on the business protected by such aggregate policy. 

To operate the clause requires the following: 

1.  There must be liability incurred by the Company for losses under a policy covering on an aggregate basis;  

2.  Some of that loss (in 1., above) must arise out of a single occurrence for the purposes of the reinsurance contract;

3.  The cedent must have also incurred liability for loss or losses under one or more other original policies that do not provide cover on an aggregate basis; and

4.  Those losses (referred to in 3., above) must arise out of the same occurrence as the aggregate loss referred to in 2., above.  

When all these requirements are met, the cedent may remove from aggregate coverage the loss referred to in 2., above, and combine it with the losses referred to in 3., above. 

Typically, the loss extracted from aggregate reinsurance coverage will be of relatively high severity compared to the other losses falling under the reinsurance contract’s aggregate coverage.   Otherwise there would likely be little reason for the cedent to exercise the aggregate extraction option. 

The second paragraph of the clause provides a formula for determining the amount of aggregate loss deemed to arise out of the single occurrence.  To calculate that amount, our hypothetical ceded-claims person would divide the total amount of loss arising from the occurrence under all reinsured policies by the “total aggregate losses to the insured or company on the business protected by such aggregate policy,” multiply the result by 100, and multiply the resulting percentage figure by the total amount of aggregate loss on the aggregate policy.  The product would equal the amount of loss under that aggregate policy deemed to arise out of the single occurrence and therefore subject to aggregate extraction.  

And that, in a nutshell, is what an aggregate extraction clause is and does.  .  .  .

Part III.A of the evident partiality segment of this series discussed the parties’ reasonable expectations of neutrality.  Today we consider how those expectations are enforced. 

“Evident partiality” challenges typically arise out of one of two scenarios.  First, there are “presumed bias” cases in which the arbitrator’s relationship to the parties or the controversy would lead a reasonable person to conclude that the arbitrator was biased, even though the challenger cannot prove actual bias.    Second, there are evident partiality challenges based on allegations of actual bias.  For example, suppose a neutral said on the record during the proceedings prior to deliberations:  ”Party A, frankly I have distrusted your company’s business motives for many years, but hearing your witnesses’ testimony has simply confirmed what I’ve suspected all along.”  While the chances of an arbitrator making such a statement (let alone on the record) are exceedingly slim to non-existent, it would provide the basis for an evident partiality challenge (which would probably succeed) based on proof of actual bias. 

The difference between “presumed” and “actual” bias is simply one of proof.  One is based on circumstantial evidence and the other on direct evidence.  Our focus will be on “presumed bias” cases, because they arise with greater frequency.  Actual bias is very difficult to prove, and if it or something approaching it can be established, then that proof would in any (or most any) event meet the standards necessary to establish evident partiality.   

Enforcement of the Parties’ Expectations of Neutrality Through the Disclosure Process

There are three procedural problems with presumed bias cases.  First, courts generally cannot entertain an evident partiality challenge until the arbitrators issue a final award and the challenging party makes a timely motion to vacate, and the Federal Arbitration Act does not expressly provide procedures designed to ensure the parties’ expectations of neutrality are protected during the arbitrator selection process or any other time prior to a final award.  Second, the selection process is the juncture at which the parties’ expectations of neutrality are most vulnerable to frustration and the period during which the parties are best positioned to protect those expectations.  Third, the arbitrators themselves have the most ready access to the information the parties need to protect their expectations of neutrality. 

To protect the parties’ expectations of neutrality during the selection process, the United States Supreme Court imposed the now-familiar requirement that arbitrators disclose at the outset of the proceedings non-trivial conflicts of interest (such as ongoing business relationships with one of the parties) and any other relevant information bearing on the arbitrator’s ability to meet the parties’ expectations of neutrality.   See Commonwealth Coatings Corp. v. Continental Cas. Co., 393 U.S. 145 (1968).  At least two circuits have added to that disclosure requirement an affirmative duty on the part of a neutral arbitrator to investigate when there is reason to believe a nontrivial conflict might exist.  See Applied Materials Indus. Corp. v. Ovalar Makine Ticaret ve Sanayi, A.S., 492 F.3d 132, 138 (2d Cir. 2007) (2d Cir. 2007); New Regency Productions,  Inc. v. Nippon Herald Films, 501 F.3d 1101, 1111 (9th Cir. 2007). 

A neutral arbitrator’s failure to disclose a conflict of interest of which he or she is deemed to have knowledge can result in vacatur of an award on evident partiality grounds without any showing that the arbitrator was actually biased or that the award resulted from bias.  Indeed, as the Seventh Circuit observed, if an arbitrator unduly frustrates a party’s access to information pertinent to whether he or she has the requisite degree of neutrality, there may be grounds for vacatur based not only on evident partiality, but also on the arbitrator exceeding his or her powers: “[f]ailure to comply with a[n] [express or implied] contractual requirement designed to facilitate the search for an acceptable neutral might imply that the neutral exceeded his authority, spoiling the award under 9 U.S.C. § 10(a)(4).”  Sphere Drake Ins. Co. v. All American Life Ins. Co., 307 F.3d 617, 623 (7th Cir. 2002), reh’g denied, Nov. 4, 2002, cert. denied, 538 U.S. 961 (2004).   

The flip side of the disclosure rule is that it provides an opportunity for the parties to vet and waive at the outset conflicts of interest that might otherwise provide the basis for a losing party to challenge the award.  If the arbitrator discloses a potential conflict, and a party fails to object, that party usually waives its right to challenge a later award based on the disclosed conflict.  See, e.g., Kiernan v. Piper Jaffray Cos. 137 F.3d 588, 593-94 (8th Cir. 1998); Cook Indus. v. Itoh & Co., 449 F.2d 106, 107-08 (2d Cir. 1971), cert. denied, 405 U.S. 921 (1972).   

Early vetting coupled with the waiver rule reduces the risk that time and expense will be invested in a proceeding that yields an award subject to vacatur.   Before the parties know the outcome of the arbitration, they are more likely to consider a potential conflict to be trivial and waive it.  But if undisclosed and not discovered until after an award has been issued, the losing party may understandably perceive the potential conflict to be more serious than it was, and move to vacate the award.  The motion may not be successful, but it may not be utterly frivolous either, and the parties and the court will end up incurring time and money costs. 

Disclosure by Appointed Arbitrators

At least in reinsurance arbitrations, appointed arbitrators are generally expected to disclose their relationships with the parties even though they are usually expected to be, at least to some degree, partial to the appointing party.  Whether or not these disclosures are required by Commonwealth Coatings is an open question and at least one circuit has suggested the answer is “no.”  See Winfrey v. Simmons Foods, Inc., 495 F.3d 549, 552 (8^th Cir. 2007). 

Because the parties’ expectations of party-appointed arbitrator neutrality are not very high (absent contract language or agreed arbitration rules to the contrary), party-appointed arbitrator disclosures  will ordinarily not yield anything to support a successful evident partiality challenge.  And a  party-appointed arbitrator’s nondisclosures will generally not deprive the other party of information relevant to arbitrator selection, since appointed arbitrators are unilaterally and privately selected by the appointing party, and the other party generally has no say in matter as long as the arbitrator is otherwise qualified to serve. 

But at least one important purpose is arguably served by party-arbitrator disclosure.  The information the appointed-arbitrators disclose may be useful to their colleagues – especially the neutral – in determining what to make of the positions taken by the arbitrators in deliberations.  A failure to disclose that information might, in appropriate circumstances, establish that the arbitrator exceeded his powers under Section 10(a)(4) of the FAA.  Cf. Sphere Drake, 307 F.3d at 623 (“We have not been given any reason to think that umpire Huggins wanted more information from [party-appointed arbitrator] Jacks in order to know what to make of Jacks’ arguments during deliberations.”); Winfrey, 495 F.3d at 552 (“Simmons presents no evidence indicating that Butler’s partiality deceived or misled the other two arbitrators.”). 

Asserting Evident Partiality

In presumed bias cases there are typically two scenarios that give rise to a motion to vacate.  First, an arbitrator may disclose a conflict of interest that one of the parties considers indicative of evident partiality.  Assuming that a party timely objects to the conflict, the arbitrator does not voluntarily step down, the arbitrators make an award adverse to the objecting party, and the party timely moves to vacate, then the objecting party can legitimately challenge the award on evident partiality grounds.   

Second, an arbitrator may fail to disclose an actual or potential conflict of interest, which is subsequently discovered by one of the parties who promptly objects.  That party may also legitimately move to vacate the award based on evident partiality grounds.     

Establishing Evident Partiality:  Applicable Standards

Whether the case involves disclosure or nondisclosure, the potential conflict and its surrounding circumstances must be assessed to determine whether the award should be vacated.  Defining a workable standard to assess evident partiality challenges is difficult, and perhaps impossible.  The circuits have formulated various “tests” running the gamut from “a reasonable person, considering all the circumstances, would have to conclude” the arbitrator was partial, to a standard which, for all intents and purposes, permits vacatur where the alleged conflict creates an “appearance of bias.”  Compare Schmitz v. Zilveti,  20 F.3d 1043, 1047-48 (9^th Cir. 1994) (adopting “reasonable impression of partiality” test which it construed as functional equivalent of “appearance of bias”) with Ovalar,  492 F.3d at 137-38 (“[A]rbitrator is disqualified only when a reasonable person, considering all of the circumstances, would have to conclude that an arbitrator was partial to one side;” test satisfied where the “arbitrator knows of a material relationship with a party and fails to disclose it.”); see also Philip J. Loree Jr. & Costas Frangeskides,  Arbitration Practice and Procedure in U.S. and U.K. Reinsurance Disputes: Is the Grass any Greener on the Other Side of the Pond?, AIRROC Matters, Vol. 4 No. 1, at 24, 42-43 n.21-22 (Spring 2008) (Part 1) (citing cases) (copy available here). 

None of these “tests” is a consistently useful indicator of the outcome of a given case.  Reasonable people applying the tests may reach different conclusions based on the same facts, and outcomes may be influenced by fact-dependant policy considerations.  The relative strictness or laxity of a test, however, may indicate how predisposed a circuit might be toward granting relief on evident partiality grounds. 

But irrespective of how each test may be worded, whether the parties’ expectations of neutrality have been thwarted is a significant, underlying, and sometimes unspoken, consideration.  For example, as discussed in Part III.A, when the parties use tripartite arbitration without agreeing on whether, and if so, to what extent, the party-appointed must be neutral, disinterested or independent, then a court will likely conclude that the parties expected the party-appointed arbitrators to be non-neutral and (a) conclude vacatur is inappropriate even if the arbitrator would be deemed evidently partial were he or she a neutral; (b) require the challenging party to show prejudice resulting from the evident partiality; or (c) figure into the evident partiality calculus the parties’ diminished expectations of partiality.  (See Part III.A., here, and cases cited.) 

One important caveat is that a conflict remains a conflict whether or not it is disclosed, and irrespective of what the arbitrator’s subjective state of mind might be.  Suppose a neutral arbitrator owned a 25% equity interest in one of the parties, a closed corporation.  The neutral discloses the conflict and says his ownership will not affect his ability to act as a neutral.  And suppose that the neutral firmly believes what he says despite his rather significant financial interest in the matter over which he is asked to preside.  One of the parties objects, the panel rules against the objecting party, and – although no one can prove or disprove it – the umpire acts completely impartially and gives the losing party the benefit of every doubt.   Under these facts the party challenging the award would have a strong (some might say surefire) motion to vacate under the law of every (or virtually every) circuit. 

Conversely, failure to disclose a potential conflict does not provide a basis for an evident partiality challenge unless the potential conflict turns out to be an actual conflict or something awfully close to one.  We hedge here because there may be relationships between an arbitrator and a party that are material to the evident partiality calculus, but which, in and of themselves, may not qualify as actual conflicts.  The United States Court of Appeals for the Second Circuit indicated that the test for evident partiality can be satisfied where the arbitrator “knows of a material relationship with a party and fails to disclose it,” because “[a] reasonable person would have to conclude that an arbitrator who failed to disclose under such circumstances was partial to one side.”  See Ovalar, 492 F.3d at 137-38.  That suggests to us that the Second Circuit (and perhaps other circuits) will place some weight on the circumstances surrounding the non-disclosure itself in determining whether, based on all of the circumstances, the test for evident partiality is satisfied.

We hope we have provided you with some useful, general information concerning evident partiality.  In Part IV. of this series we address Federal Arbitration Act Section 10(a)(3), which authorizes vacatur where a party was prejudiced by an arbitrator’s procedural misconduct.

In this Part III of our Nuts & Bolts feature on vacating arbitration awards (Parts I and II  here and here) we consider the second statutory ground for vacating an award under the Federal Arbitration Act:  “where there was evident partiality…in the arbitrators…” 9 U.S.C. 10(a)(2).  What constitutes “evident partiality” or arbitral bias has been the subject of numerous judicial decisions setting forth various standards and applying them to a wide range of fact patterns.  The decisions are not easy to reconcile (some may, indeed, be irreconciliable) and generally the standards are of limited utility in practice.  Matters are complicated by judicially-created rules concerning disclosure of potential conflicts of interest and the consequences that may or may not flow from a breach of those rules.  To say “evident partiality” is an elusive subject understates the case.       

 But “evident partiality” may be easier to grasp if we focus not on abstract standards or ethics, but on the parties’ reasonable expectations of neutrality in the circumstances.  Surprisingly, many courts address the subject of “evident partiality” without expressly discussing this important consideration, even when it appears to have been a significant part of the decision-making calculus.  Others have expressly used the parties’ agreement and attendant expectations of neutrality as a guidepost. 

 Understanding the parties’ reasonable expectations of partiality is only half the battle.  One must also understand the related topic of how those expectations are enforced through judicially-created rules governing disclosure and waiver of conflicts of interest, and the relevance of those rules to a motion to vacate an award under Federal Arbitration Act Section 10(a)(2).   

In this Part III.A. our focus is on the parties’ reasonable expectations of neutrality.  Part III.B. will cover the enforcement of those expectations.   

The Parties’ Reasonable Expectations of Neutrality

The principal purpose of the Federal Arbitration Act is to enforce arbitration agreements as written.  See, e.g., First Options of Chicago, Inc. v. Kaplan, 514 U.S. 938, 947 (1995).  Parties are largely free to structure their arbitration agreements as they see fit, and that freedom extends to selecting the decision makers, establishing their qualifications, and agreeing on how impartial they should be.  See Merit Ins. Co. v. Leatherby Ins. Co., 714 F.2d 673, 679 (7th Cir.), cert. denied, 464 U.S. 1009 (1983) (Posner, J.) (“parties … choose their method of dispute resolution, and can ask no more impartiality than inherent in the method they have chosen.”) (citation omitted). 

While the Federal Arbitration Act deems “evident partiality” a ground for vacating an award, the Act does not define the term or establish a baseline standard of impartiality that must be met by every arbitrator.  This contrasts starkly with the English Arbitration Act 1996, which imposes on all arbitrators effectively the same standards of impartiality applicable to English judges.  See, generally, Arbitration Act 1996 § 33(1).    

What constitutes “evident partiality” is  assessed according to a sliding scale of sorts, depending on the parties’ agreement and the surrounding circumstances.  For example, parties may agree to use only neutral arbitrators or a combination of non-neutral and neutral arbitrators.  Or other qualifications may be imposed, such as a requirement that the arbitrators be “disinterested” in the outcome and not be under the “control” of one of the parties. 

Where the parties intend one or more of the arbitrators should be neutral, then that desire for neutrality should be enforced.  In the absence of express qualifications attempting to define the degree of neutrality required, the degree of neutrality will be determined by what the parties would reasonably expect in light of the realities of the marketplace.  

Where the parties’ agreement authorizes non-neutral arbitrators, courts either find that the parties have waived by consent the “evident partiality” ground for vacatur, or impose a more rigorous test for demonstrating evident partiality than that applicable to a neutral arbitrator.  For example, the court might require the challenger to show that bias “prejudicially affected the award” or simply figure into the mix the parties’ diminished expectations of neutrality.  See, generally, Sphere Drake Ins. Co. v. All American Life Ins. Co., 307 F.3d 617, 620 (7th Cir. 2002), reh’g denied, Nov. 4, 2002, cert. denied, 538 U.S. 961 (2004) (“evident partiality” ground can be waived by consent); Winfrey v. Simmons Foods, Inc., 495 F.3d 549, 552 (8th Cir. 2007) (requiring a showing of prejudice); Nationwide Ins. Co. v. Home Ins. Co., 429 F.3d 640, 645-46 & 648-49 (6^th Cir. 2005), reh’g en banc denied  Feb. 16, 2006 (figuring into the mix the parties’ diminished expectations of impartiality). 

Tripartite Arbitration:  Party-Appointed Arbitrators  

In industry arbitration – including reinsurance arbitration – whether or not the arbitration is tri-partite or before a single arbitrator may inform the parties’ expectations of partiality.  If a single arbitrator is used, then the presumption is the parties intended the arbitrator to be a neutral, albeit one not subject to the rigorous standards of neutrality applicable to federal judges (more on that later).  

But typically arbitration agreements in reinsurance contracts and other industry arbitration agreements call for tripartite panels.  In reinsurance arbitrations, each party typically appoints an arbitrator and the party-appointed arbitrators attempt to agree on an umpire or select one by lot drawing, coin toss, Dow Jones pick or like tie-breaking procedure.  Unless the arbitration agreement provides otherwise, courts generally presume that the parties intended their appointed arbitrators to act as advocates of a sort: 

 [I]n the main party-appointed arbitrators are supposed to be advocates. In labor arbitration a union may name as its arbitrator the business manager of the local union, and the employer its vice-president for labor relations.  Yet no one believes that the predictable loyalty of these designees spoils the award. (Emphasis in original; citations omitted).

 Sphere Drake, 307 F.3d at 620.   

The New York Public Personnel Blog (Public Employment Law Press) recently reported on a rather extreme example of this principle in a case governed by New York State arbitration law, which authorizes vacatur for evident partiality of an arbitrator “appointed as a neutral.”  According to the post, a New York intermediate appellate court held that evident partiality was not established even where a party-appointed arbitrator testified in favor of the appointing party’s position at the arbitration hearing.   The court said that New York’s arbitration law did not authorize vacatur based on a party-appointed arbitrator’s evident partiality and party-appointed arbitrators may, in any event, be partial.  (Post here) 

The theory behind the tripartite structure is that it provides the best of two worlds: (a) two experienced and knowledgeable industry professionals, each of whom acts as an advocate of sorts on behalf of its appointing party; and (b) an equally experienced and knowledgeable umpire, who either casts the tie-breaking vote or brokers a consensus.  The reinsurance industry’s general acceptance of an advocacy role for party-appointed arbitrators is evidenced by the common practice of panels (usually with the parties’ consent) authorizing ex parte contact between party-appointed arbitrators and their appointing parties. 

Although courts will (absent contract language to the contrary) ordinarily assume that the parties intended party-appointed arbitrators to play an advocacy role, in the reinsurance industry there is a fair amount of disagreement concerning the degree of partiality permissible.  For example, there are some who believe that robust advocacy is appropriate, while others believe the party-appointed arbitrator should strive to give the appointing party the benefit of the doubt, but ultimately decide the matter according to the evidence and applicable law, custom and practice.  Others may have different views.  

For its part, the ARIAS-US Code of Conduct, Canon II, commentary, urges party-appointed arbitrators “to act in good faith with integrity and fairness,” “not allow their appointment to influence their decision on any matter before them,” and “make all decisions justly.”  The ARIAS-US commentary, however, is not binding on the parties (unless they so agree) and there is disagreement within the industry as to whether the standards embraced by Canon II’s commentary should be followed in practice. 

The upshot is that the line between the acceptable and unacceptable is both difficult to draw and blurry.  Checks on rampant partisanship are not imposed by the courts but by economic considerations:  Party-appointed arbitrators that overstep what other panel members perceive to be proper ethical boundaries risk diminished credibility, influence, and effectiveness, which in turn, may result in fewer appointments.  

The use of partisan arbitrators, which continues in reinsurance industry arbitration, appears to have fallen out of favor in less specialized forms of commercial arbitration.  Rule 17 of the American Arbitration Association’s Commercial Arbitration Rules reverses the presumption that party-appointed arbitrators should be non-neutral.  Rule 17 says “Any arbitrator shall be impartial and independent and shall perform his or her duties with diligence and in good faith, and shall be subject to disqualification for:”  

(i) partiality or lack of independence,

(ii) inability or refusal to perform his or her duties with diligence and in good faith, and

(iii) any grounds for disqualification provided by applicable law.

Rule 17 further provides that “The parties may agree in writing.  .  .  that arbitrators directly appointed by a party pursuant to Section R-12 shall be nonneutral, in which case such arbitrators need not be impartial or independent and shall not be subject to disqualification for partiality or lack of independence.”   The AAA rules vest in the AAA the power to “determine whether the arbitrator should be disqualified under the grounds set out above, and shall inform the parties of its decision, which decision shall be conclusive.” 

Tripartite Arbitration:  Umpires or Neutral Arbitrators

Umpires and neutrals are held to higher standards of impartiality.  Parties expect them to be fair, objective, open-minded in deliberations and not predisposed to rule in favor of either party before hearing the evidence.  They are supposed to be impartial, but are nevertheless not held to the same rigorous, statutory standards of impartiality applicable to United States federal judges.  See Sphere Drake, 307 F.3d at 621; Morelite Constr. Corp. v. New York City Dist. Council Carpenters Benefit Fund, 748 F.2d 79, 83 (2d Cir. 1984); see, generally, 28 U.S.C. § 455 (disqualification standards for federal judges). 

 By not requiring neutrals to comply with judicial standards of partiality courts balance the parties’ expectations with the realities of the marketplace.  Particularly in industry arbitration, sought-after arbitrators often have many years of industry experience, which may inform their perspectives on issues important to the industry.  Intra-industry issues can pit one segment of the industry against another, and a qualified neutral may have experience in one or both of these segments.  Some degree of institutional predisposition comes with the territory, and does not necessarily disqualify the neutral.  And as industry insiders, arbitrators may know the lawyers and the parties socially and professionally, but those relationships generally do not disqualify the arbitrator from service.  These practical realities demand what Judge Posner aptly termed a “tradeoff between impartiality and expertise” – the parties bargained for dispute resolution by an industry expert and the benefit of that expertise carries with it the burdens of greater entanglement with the parties, the industry and the issues.  Indeed, if courts required the industry arbitrators — or even commercial arbitrators without an industry-specific focus — to shed or be free from this proverbial baggage, then qualified umpire candidates would be hard to come by.  See Leatherby,  714 F.2d at 679 (“people who arbitrate do so because they prefer a tribunal knowledgeable about the subject matter of their dispute to a generalist court with its austere impartiality but limited knowledge of the subject matter.”) 

Stay tuned for Part III.B, which will focus on how courts enforce the parties’ expectations of neutrality through the disclosure and vetting process and Federal Arbitration Act Section 10(a)(2).

Section 10(a)(1) is an excellent expression of how Section 10 is designed to provide relief in situations where putting a court’s  imprimatur on an award would deprive one of the parties of the benefit of its freely-bargained-for arbitration agreement.   It says that corruption, fraud, or undue means in the procurement of an award, whether perpetrated by the arbitrators or a party, spoils the award (assuming the aggrieved party timely moves to vacate).  There is nothing particularly controversial about that; we suspect few would contend that parties who agree to arbitrate impliedly consent to arbitration resulting in an award procured through outright chicanery.    

The burden for obtaining relief under Section 10(a)(1) is heavy.  Fraud and corruption are serious allegations, to say the least.  And “undue means” has been construed to be a bird of the same feather:  Like fraud and corruption it requires “proof of intentional misconduct” or “bad faith,” and “connotes behavior that is immoral if not illegal. . . .”  See, e.g., PaineWebber Group, Inc. v. Zinsmeyer Trusts P’ship,  187 F.3d 988, 991 (8th Cir. 1999) (quotations and citations omitted).   Given the gravity of all of this, three requirements must generally be satisfied to make out a claim under Section 10(a)(1):  “(1) clear and convincing evidence of fraud [, corruption or undue means][;] (2) that the fraud [, corruption or undue means] materially relates to an issue involved in the arbitration[;] and (3) that due diligence would not have prompted the discovery of the fraud [corruption or undue means] during or prior to the arbitration.”   Int’l Bhd. of Teamsters, Local 519 v. United Parcel Serv., Inc., 335 F.3d 497, 503 (6th Cir. 2003); see, e.g., Bonar v. Dean Witter Reynolds, Inc., 835 F.2d 1378, 1383 ( 11th Cir .1988).

Section 10(a)(1) says that the “award” must be “procured” by the fraud, corruption or undue means, and that suggests a causal nexus between the proscribed conduct and the award.  While the conduct must “materially relate to an issue in the arbitration,” must it also be outcome determinative?  In other words, must the party seeking relief show that the award would have been different but for alleged fraud, corruption or undue means, or is it enough to show that it tainted the proceedings simply because it related materially to one of the issues at stake? 

The circuits are split on this point.  Some courts require the challenger to show that the corruption, fraud or undue means “caused the award to be given.”  See, e.g.,  A.G. Edwards & Sons, Inc. v. McCullough, 967 F.2d 1401, 1403 (9^th Cir. 1992).  Others say that the challenger is not required to “establish that the result of the proceedings would have been different had the fraud [, corruption, or undue means]  not occurred.”  See, e.g., Bonar, 835 F.2d at 1383.   

Section 10(a)(1) is probably the least commonly invoked ground for vacating an arbitration award.  That said, it provides an important safety valve to address rare, but extremely important cases where an award is the product of  corruption, perjured testimony or other egregious misconduct, and where the challenger was unable to address the problem before the arbitrators. 

The next installment of this series shall address a more commonly invoked ground for vacatur:  evident partiality.

An arbitration award is effectively a contract resulting from a contract.  Two parties agree to appoint arbitrators, submit their dispute to arbitration and abide by the award.  The parties ordinarily consent to entry of judgment on the award, and it can be confirmed under Section 9 of the Federal Arbitration Act (or a state law equivalent when the Federal Arbitration Act doesn’t apply).  Alternatively it may be enforced through the plenary and summary  procedures applicable to ordinary contracts (subject to any special rules governing arbitration awards).  

So what happens when things go awry — or at least seem to have gone awry — and the arbitration award is or appears to be fundamentally unfair, divorced from the contract or the result of fraud, bias, or some form of prejudicial misconduct on the part of the arbitrators?  Section 10 of the Federal Arbitration Act provides a safety net in the form of a motion or petition  to vacate the award.  (State arbitration statutes and law applicable in actions to enforce arbitration awards generally provide similar recourse, but our focus here is on the Federal Arbitration Act.)

The United States Supreme Court recently declared that Section 10(a) of the Federal Arbitration Act sets forth the exclusive grounds for vacating a commercial  arbitration award (we are not concerned here with awards under 5 U.S.C. § 590, which are governed by 9 U.S.C. § 10(b)).  See Hall Street Assoc. v. Mattel, Inc., 128 S. Ct. 1396, 1404 (2008).  And make no mistake, these grounds are exceedingly narrow; section 10 of the Federal Arbitration Act authorizes vacatur only where: 

1.  The award was procured by corruption, fraud, or undue means;

2.  [T]here was evident partiality or corruption in the arbitrators, or either of them;

3.  [T]he arbitrators were guilty of misconduct in refusing to postpone the hearing, upon sufficient cause shown, or in refusing to hear evidence pertinent and material to the controversy; or of any other misbehavior by which the rights of any party have been prejudiced; or

4.  [T]he arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made.

9 U.S.C. § 10(a). 

While the principal purpose of the Federal Arbitration Act is to enforce the parties agreement as written, see, e.g., First Options of Chicago, Inc. v. Kaplan, 514 U.S. 938, 947 (1995), we see the flip side of that purpose expressed in Section 10(a).  Section 10(a) addresses situations where  putting a court’s  imprimatur on an award would deprive one of the parties of the benefits of its freely-bargained-for arbitration agreement.  Judge Posner put it well when he said:

It is tempting to think that courts are engaged in judicial review of arbitration awards under the Federal Arbitration Act, but they are not. When parties agree to arbitrate their disputes they opt out of the court system, and when one of them challenges the resulting arbitration award he perforce does so not on the ground that the arbitrators made a mistake but that they violated the agreement to arbitrate, as by corruption, evident partiality, exceeding their powers, etc. – conduct to which the parties did not consent when they included an arbitration clause in their contract. That is why in the typical arbitration . . . the issue for the court is not whether the contract interpretation is incorrect or even wacky but whether the arbitrators had failed to interpret the contract at all, for only then were they exceeding the authority granted to them by the contract’s arbitration clause.

Wise v. Wachovia Sec., LLC, 450 F.3d 265, 269 (7th Cir.) (citations omitted), cert. denied, 549 U.S. 1047 (2006).

As we shall discuss in detail in subsequent posts, each of the grounds specified in Section 10(a) implicates whether the arbitration award deprived the party of the benefit of its arbitration agreement.   Indeed, the first question a party should consider before investing time and expense in a motion or petition to vacate is whether it has reasonable grounds for asserting that the award effectively violated the agreement to arbitrate.  If the answer is “yes,” and the alleged violation falls within the scope of Section 10(a), then the party may have a good faith basis for vacating the award. 

In subsequent parts of this post we shall take a closer look at each of the grounds for vacating an award….

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.  .  .  .

The power of arbitrators appointed to resolve a particular dispute or disputes is defined by the submission, not the arbitration agreement. The scope of the agreement to arbitrate tells us only what must be submitted to arbitration. It is the submission itself that “serves not only to define, but to circumscribe the authority of the arbitrators.” Ottley v. Schwartzberg, 819 F.2d 373, 376 (2d Cir. 1987) (here).   

As the United States Court of Appeals for the Fifth Circuit explained, a predispute arbitration agreement generally is “not self-executing” — “[b]efore arbitration can … proceed, it is necessary for the parties to supplement the agreement to arbitrate by defining the issue to be submitted to the arbitrator and by explicitly giving him the authority to act.”  Piggly Wiggly Operators’ Warehouse Inc v. Piggly Wiggly Operators’ Warehouse Independent Truck Drivers Union, 611 F2d 580 (5th Cir. 1980) (here).  The disputes presented to the panel for resolution without objection constitute the submission, which may be embodied in a formal submission agreement or determined from the arbitration demand in conjunction with the arguments and contentions made by the parties during the proceeding.

The submission is effectively a delegation of authority to one or more particular arbitrators to resolve one or more particular issues.  And once arbitrators have ruled on those issues, their authority is exhausted; they have no authority to hear any further disputes between the parties unless the parties delegate to them that further authority. See, generally, U.S. v. American Soc’y of Composers, Authors and Publishers, 32 F.3d 727, 732-33 (2d Cir. 1994) (here); Ottley, 819 F.2d at 376.

The scope of the delegated authority may be broader or narrower than the scope of the arbitration agreement, or it may be coextensive with it. The parties may, for example, agree to arbitrate all disputes between them, but if they empanel arbitrators to resolve only a subset of those disputes, then the arbitrators’ authority is limited to that subset of disputes. And parties that have agreed to arbitrate only a subset of potential disputes can nevertheless submit other disputes to the arbitrators, which will have the authority to resolve them. See, generally, Ottley, 819 F.2d at 376; see also Rocket Jewelry Box, Inc. v. Noble Gift Packaging, Inc., 157 F.3d 174, 177 (2d Cir. 1998) (here); Trade & Transport, Inc. v. Natural Petroleum Charterers Inc., 931 F.2d 191, 195 (2d Cir. 1991) (here).

For example, in the reinsurance context, a dispute may arise over a claim or series of claims, a party may demand arbitration of those claims, and a panel may be appointed to resolve the dispute.  Midstream in the proceeding disputes may arise over different claims.  The empanelled arbitrators have the authority to resolve those disputes only if the parties agree to submit them to the panel (they may be impliedly submitted if one party asserts them in the arbitration and the other party contests them without a reservation of rights).  

Those additional claims – not the subject of the original demand for arbitration – must, of course be arbitrated if they fall within the scope of the arbitration clause.  But the empanelled arbitrators cannot force the parties to submit them in the ongoing proceeding.  A new arbitration must be commenced, perhaps with new panel members. 

Issues concerning what was submitted to the arbitrators can also arise in other contexts.  One example is what happened in KX Reinsurance Co. v. General Reinsurance Corp., 08 Civ. 7807 (SAS), 2008 WL 4904882 (S.D.N.Y. Nov. 18, 2008) (Scheindlin, J.), where the Court held that the panel exceeded its authority when, after resolving all the issues the parties submitted, the panel nevertheless retained jurisdiction to hear future disputes between the parties. You can read more about that case here.

As is true with most rules, there is an exception.  Some arbitration agreements are self-executing in that they provide that the parties are to submit all disputes to a particular arbitrator or permanent arbitration panel.  Under such a self-executing arbitration agreement, the permanent arbitrator or panel generally has the authority to resolve additional disputes arising in the course of the proceedings, or to retain jurisdiction to hear future disputes, as long as the arbitration clause requires the parties to submit those disputes.   

In view of how the submission limits the authority of the empanelled arbitrators, parties need to give careful thought to the scope of the demand for arbitration, and the relief requested.  Sometimes a proverbial ounce of prevention is worth a pound of cure.

I remember when I first heard the term “aggregate extension clause.”  I was a couple of years out of law school and just getting my feet wet in reinsurance law and practice.  Naturally, I had no idea of what an aggregate extension clause was or, for that matter, why someone would want to call something an “aggregate extension clause” in the first place, unless the principal objective was to confuse the reader.  I envisioned some densely worded, obtuse, complex and hopelessly confusing provision designed to accomplish some obscure yet important purpose, the relevance of which was surely beyond my ken.  I decided  that I could read up on the clause, or ask a colleague about it, but I feared that the explanation – written or oral – would be at least as difficult to decipher as the clause itself, and probably more so.  So I did my best to avoid even having to think about aggregate extension clauses — let alone deal with them — for as long as possible.  

Eventually, of course, I had to face my fears and grapple with the seemingly elusive concept of “aggregate extension.”  I quickly learned that my initial assessment was only partly correct:  aggregate extension clauses are indeed densely worded, but the purpose of the clause is far more straightforward than I once assumed.  Once I learned a little bit about the clause, I realized (or at least thought) that I could impress – or perhaps awe – my less experienced colleagues with it, and might even be able to use it to show my more experienced colleagues that I knew something about reinsurance.   While I can’t say I obtained as much mileage out of my newfound knowledge as I expected,  I am nevertheless glad that I invested a little time into learning about aggregate extension clauses.    

In this Reinsurance Nuts & Bolts post we briefly discuss in very simple and basic terms what an aggregate extension clause is, and what it does.  We also provide the reader with an example of some of the operative wording of an aggregate extension clause.  Our discussion is not intended to be comprehensive; if anything, it is oversimplified.  But it should give the reader a basic understanding of the topic.   

Extending the Concept of Aggregate Cover into the Excess of Loss Treaty

Excess of loss reinsurance agreements typically provide cover on an each and every loss or each and every occurrence basis.  They provide reinsurance for each loss or occurrence in an amount in excess of a specified retention per loss or occurrence up to a specified limit per loss or occurrence.  Excess of loss treaties often cover a wide range of the cedent’s underlying policies, and their retentions and limits are frequently set to respond to losses of moderate to high severity (of course, some are specifically designed to address catastrophic losses or low severity losses).  Losses or occurrences that do not meet the retention (sometimes referred to as the attachment point) are not covered. 

All of this works quite well when the underlying insurance contract provides insurance on an each and every loss or each and every occurrence basis for losses of moderate to high severity.  But it does not work well when the underlying insurance is written on an aggregate basis. 

Aggregate cover is generally designed to insure against the risk that there will be a higher frequency of low severity losses than the insured expects.  The dollar amount of an individual loss or occurrence does not determine whether the contract provides cover or the dollar amount of the cover.  The existence and amount of cover is determined by aggregating together all losses occurring within a specified period, irrespective of their severity.  The aggregate amount is subject to an aggregate deductible and frequently an aggregate limit.  The risk insured is that the frequency of relatively small losses will exceed an expected level during the period, although larger losses may also fall within the scope of the cover.   

Reinsuring aggregate cover on an excess of loss basis presents problems because the amount of each loss or occurrence is generally not high enough to exceed the retention of the excess of loss treaty.   Over  a period, however, the aggregate amount of loss covered by the policy may well exceed the retention of the excess of loss treaty if the aggregate amount of loss were deemed a single loss or occurrence for the purposes of the treaty.  

The aggregate extension clause effectively extends the aggregate cover of the underlying policy into the excess of loss treaty.  Instead of subjecting each individual loss or occurrence to a separate retention and limit, it allows the aggregation of losses or occurrences when the underlying cover is written on an aggregate basis. 

Aggregate extension clauses come in various forms and may be interpreted in various ways.  Here is the relevant portion of an aggregate extension clause used in the London Market, which was construed by the English Court of Appeal (Civil Division) in Yasuda Fire & Marine Co of Europe Ltd v. Lloyd’s Underwriting Syndicates No. 209, 356 & Ors., [1998] Lloyd’s Rep. LR. 343 (C.A.) (available here): 

As regards liability incurred by the reinsured for losses on risks covering on an aggregate basis, this agreement shall protect the reinsured excess of the amounts as provided for herein in the aggregate any one such aggregate loss up to the limit of indemnity as provided for herein in all any one such aggregate loss.

Notwithstanding that this agreement is effected on a losses occurring during the period basis, all aggregate original policies coming within the scope of this agreement shall be covered on a risks incepting during the period basis.  Furthermore, where an original aggregate policy is issued for limits relevant to an overall period greater than 12 months with an inception date during the period of this agreement then such original policy shall be covered hereunder for the whole of its period notwithstanding any annual resignature. Long term policy periods with annual limits are to be treated as each annual period being a separate policy with the anniversary date being regarded as the inception date.   .   .   .   

In Yasuda the English Court of Appeal (Civil Division) explained the purpose and intent behind aggregate extension clauses. Yasuda illustrates that the key purpose of an aggregate extension clause is “to provide effective reinsurance where the reinsured is covering aggregated losses exceeding certain limits” by “carr[ying] through into the reinsurance policy the same principle of aggregation as exists in the original policy which has been written ‘on an aggregate basis:’”

The aggregate extension clause has been in existence in one form or another for some 60 years.  It is a standard clause in the sense that it is one of the clauses with a more or less standard wording which is then incorporated into reinsurance contracts.  The … [most] important [purpose of the aggregate extension clause] is to provide effective reinsurance where the reinsured is covering aggregated losses exceeding certain limits. The classic example used to illustrate this is drawn from the products liability field and what are called ‘Coca Cola losses’.  A producer such as Coca Cola sells large numbers of articles each of which involves a small product liability risk, as for example from the bursting of a defective bottle.  Statistically in any given year there will be an anticipated number of claims which the producer has to pay.  The producer is concerned not only that any one of these claims may substantially exceed the norm but also the number of claims that have to be paid in any given period may exceed the norm.  Therefore the producer may take out products liability insurance which covers him against the risk of having to payout more than a certain sum in the aggregate in respect of such claims.   This is a simple and uncontroversial example of an insurance covering the assured ‘on an aggregate basis’.  Similarly, it provides an uncontroversial illustration of the operation of the aggregate extension clause in a reinsurance policy.  Under the ‘Coca Cola’ type of cover, once the aggregate excess has been reached, the original insurer becomes liable to pay every claim that comes in during the relevant period (possibly subject to an overall policy limit). The aggregate extension clause enables the original insurer to pass on those liabilities, in the aggregate, to the reinsurer.  It carries through into the reinsurance policy the same principle of aggregation as exists in the original policy which has been written ‘on an aggregate basis’.

Id. (emphasis added; citations omitted)

Aggregate Limits and an Aggregate Retention do not Necessarily Mean the Underlying Cover was Written on an Aggregate Basis

One important thing to keep in mind about aggregate extension clauses is that they come into play only when the underlying insurance is written on an aggregate basis.  That the underlying policy has aggregate limits and even an aggregate deductible does not necessarily mean that the cover is written on an aggregate basis.  As the English Court of Appeal in Yasuda pointed out, the underlying cover is not written on an aggregate basis where the insured’s right to recover is predicated on each individual loss or occurrence satisfying a deductible or retention, even where the underlying cover also contains an aggregate deductible and an aggregate limit: 

In the present cases the question arising under the  aggregate extension clause has to be considered in relation to the original policies issued by the reinsured all of which included terms imposing an each and every claim excess and limit.  Thus, as part of the establishment of the original assured’s right to recover from the reinsured, the original assured had to demonstrate that each individual claim exceeded the excess or ‘retention’ figure stipulated.  If it did not, then no claim could be made under the original cover against the reinsured.  If it did, the right of recovery of the original assured was then confined to the amount of the excess but was subject also to a per claim limit. It is thus an essential feature of the cover provided by the reinsured to those it was insuring that each claim satisfy an each and every loss criterion.  Whatever else one may think, this is the antithesis of providing cover on an aggregate basis.  .  .  . 

.  .  .  . 

The argument of Yasuda and the other reinsureds is that notwithstanding the each and every loss clauses in the original cover, there were other features of the cover provided by one or more of the original insurance policies, which nevertheless justified the conclusion that the original cover was provided on an aggregate basis.  Thus, consistently with their arguments to which I have earlier referred, Yasuda rely upon the fact that the original cover was in all cases subject to an overall limit, maybe with a right of reinstatement and was in most cases also subject to an aggregate retention which had to be exceeded before any claim could be made under that cover.  They rightly point out that such provisions would be expected to be features of cover on an aggregate basis. Thus, in the Coca Cola type policy to which I have referred earlier, the claims qualify for recovery under the policy because they in the aggregate exceed a certain level.  It is a feature of that type of policy that the risk which is being insured is one which deals with the aggregation of claims and is not concerned with their individual size.  But this serves to demonstrate that the feature upon which the reinsured seek to rely in the present cases does not suffice to demonstrate that the cover was ‘on an aggregate basis’.  It leaves unanswered the question whether it is then necessary to look at each individual claim and ask whether it individually exceeds a certain limit.  If it is necessary to do this, then it no longer remains possible to say that the cover is on an aggregate basis:  it is on an each and every claim basis.

.  .  .  . 

In the relevant policies of original insurance, once the aggregate retention has been exceeded, the claim still has to be looked at on an individual basis to see whether it individually exceeds a certain sum and, if it does, the right to recover from the original insurer is defined by reference to a per claim excess and limit.  Where that is the case, the basis of cover is not on an aggregate basis: it is upon an each and every loss basis.  I do not accept the argument of the reinsureds that any element of aggregation trumps the other features of the cover. It is the basis of the  cover which has to be looked at.  This may involve an evaluation of the features or characteristics of the cover but it does not permit one element of aggregation to be pointed out and the remainder of the features of the cover to be ignored. I accept the submission of the reinsurers that cover which requires criteria to be applied to each and every loss and imposes an each and every loss excess and limit cannot be said to be cover provided on an aggregated basis.

Id.   

If you, the reader, have gotten this far, then perhaps you would like to delve into a discussion of ”Aggregate Extraction Clauses.”  But these clauses – which conjure up some of the more frightening scenes from Marathon Man (1976) – are better left for another day.  .  .  .

In today’s Nuts & Bolts post we take a brief look at honorable engagement clauses, which are sometimes referred to as “honorable undertaking” clauses.  Honorable engagement clauses are, for practical purposes, a species of choice of law clause.   Generally, they confer upon arbitration panels a degree of freedom to depart from the strict rules of law and evidence, and to interpret the contract as an honorable engagement rather than literally according to its terms.  They are premised on the now arguably outmoded historical concept that a reinsurance contract is more than a contract, but an honorable undertaking, a deal that  is closed when the parties shake hands over a cocktail (or three), and one by which the parties are honor-bound to abide.  They also recognize that reinsurance is an arcane business with its own peculiar set of customs, practices and norms, and that, if the parties so agree, arbitrators should be reasonably free to apply these norms in deciding a case, even if a court faced with the same facts would or could not. 

Honorable engagement clauses are more common in older reinsurance contracts than in those written today.  But many reinsurance disputes arise out of long-tail asbestos or environmental claims arising out of decades-old contracts, a great many of which contain these clauses.  And the clauses can have some significant implications in those disputes.

Some Examples of Honorable Engagement Clauses

Honorable engagement clauses are typically found within the arbitration clause itself, but occasionally appear in a separate clause.  Some contracts contain both honorable engagement clauses and ordinary choice-of-law clauses, which designate a particular jurisdiction’s law as governing.    

Honorable engagement clauses come in various types and may be interpreted in various ways.  We shall focus on examples found in the Brokers and Reinsurance Market Association (“BRMA”) arbitration clause wordings, which are available, along with other BRMA standard clauses, here. 

BRMA arbitration clauses 6C, 6E and 6I contain the following honorable engagement clauses, which one might term “classic.”  Each confers upon the arbitration panel a good deal of latitude in interpreting the contract and departing from otherwise applicable law: 

BRMA 6 C

The arbitrators shall interpret this Contract as an honorable engagement and not as merely a legal obligation; they are relieved of all judicial formalities and may abstain from following the strict rules of law.

BRMA 6 E

All arbitrators shall interpret this Contract as an honorable engagement rather than as merely a legal obligation.  They are relieved of all judicial formalities and may abstain from following the strict rules of law. They shall make their award with a view to effecting the general purpose of this Contract in a reasonable manner rather than in accordance with a literal interpretation of the language.

 BRMA 6 I

The arbiters and the umpire are relieved from all judicial formalities and may abstain from the strict rules of law, interpreting this Contract as an honorable undertaking rather than as a merely legal obligation. 

 When honorable engagement clauses are contained in contracts that also contain choice-of-law clauses, interpretive tension may result.  The honorable engagement portion of the arbitration clause says that the arbitrators do not have to apply the “strict” rules of law, but the choice of law provision says that a particular body of law nevertheless applies: 

BRMA 6 J

The Arbiters shall consider this Contract as an honorable engagement rather than merely as a legal obligation and they are relieved of all judicial formalities and may abstain from following the strict rules of law.  .  .  . 

Any arbitration proceedings shall take place at a location mutually agreed upon by the parties to this Contract, but notwithstanding the location of the arbitration, all proceedings pursuant hereto shall be governed by the law of the state in which the Company has its principal office.

Certain honorable engagement clauses relieve the interpretive tension by saying that the choice-of-law provision supplies the governing law only to the extent that the arbitrators look to the law for guidance:

 BRMA 6 L

The panel shall be relieved of all judicial formality and shall not be bound by the strict rules of procedure and evidence. Unless the panel agrees otherwise, arbitration shall take place in  (City, State),  but the venue may be changed when deemed by the panel to be in the best interest of the arbitration proceeding. Insofar as the arbitration panel looks to substantive law, it shall consider the law of the State of __________.  .  .  .  The panel shall interpret this Contract as an honorable engagement rather than as merely a legal obligation and shall make its decision considering the custom and practice of the applicable insurance and reinsurance business as promptly as possible following the termination of the hearings. 

Closely related to honorable engagement clauses are clauses that might more accurately be referred to as “custom and usage” or “custom and practice” clauses.  These clauses may relieve the arbitrators from following strict judicial formalities and rules of evidence and procedure, but do not necessarily authorize them to refrain from following applicable law.   They do, however, command the arbitrators to make their decision with regard to applicable custom, practice and usage, and in that sense they are not unlike honorable engagement clauses.  Sometimes they, too, appear in contracts containing choice-of-law clauses.  Here are some examples: 

BRMA 6 P

The Board shall make a decision and award with regard to the terms expressed in this Agreement, the original intentions of the parties to the extent reasonably ascertainable and the custom and usage of the property and casualty insurance and reinsurance business, which decision and award shall be in writing and shall state the factual and legal basis for the decision and award.  .  .  .  

 BRMA 6 R

The Panel shall be relieved from applying the strict rules of evidence and/or procedure and shall make its decision based on the custom and practice of the insurance and reinsurance business with a view toward effecting this Contract in a reasonable manner. 

 BRMA 6 A

The arbitrators shall not be obliged to follow judicial formalities or the rules of evidence except to the extent required by governing law, that is, the state law of the situs of the arbitration as herein agreed; they shall make their decisions according to the practice of the reinsurance business. 

BRMA 6 B

The board shall make its decision with regard to the custom and usage of the insurance and reinsurance business.  The board shall issue its decision in writing based upon a hearing in which evidence may be introduced without following strict rules of evidence but in which cross-examination and rebuttal shall be allowed. 

 BRMA 6 F

The Arbitrators or Umpire as the case may be shall determine any reference in accordance with current reinsurance market practice pertaining during the period of this Contract.  .  .  .

The Court of Arbitration shall take place in New York and the law applicable to both the aforesaid Contract and this arbitration clause shall be the law of New York State.

Here is an example of a custom and usage clause with a choice of law clause that could be interpreted as authorizing the arbitrators to depart from otherwise applicable substantive law (as opposed to simply evidence and procedural law):    

BRMA 6 O

The panel shall be relieved of all judicial formality and shall not be bound by the strict rules of procedure and evidence. Unless the panel agrees otherwise, arbitration shall take place in  (City,  State) , but the venue may be changed when deemed by the panel to be in the best interest of the arbitration proceeding. Insofar as the arbitration panel looks to substantive law, it shall consider the law of the State of _________.  .  .  .

 The panel shall make its decision considering the custom and practice of the applicable insurance and reinsurance business as promptly as possible following the termination of the hearings.   .  .  . 

Some Key Points to Remember

There are at least three important points to keep in mind about honorable engagment and custom and usage clauses, and this list is not intended to be exhaustive.  First, while the clauses may confer varying degrees of discretion upon arbitrators to depart from the strict rules of law and to eschew strict interpretation of the contract language, they are not limitless in scope.  While the limits of the authority they confer will depend upon the wording of the clause and that of the rest of the contract — and those limits may, indeed, be blurry — the arbitrators’ decision must have a colorable basis in the contract and the applicable law.  In considering whether the award has a colorable basis, however, some interesting questions may arise concerning whether the interpretation of the honorable engagement clause itself is a question of arbitrability, which ordinarily a court must decide, or a question for the arbitrators, which the court must review deferentially like any other arbitrator determination.      

Second, honorable engagement clauses may have important implications on how each side presents its case to the arbitrators.  They can provide affirmative support for arguments that may lack support in the contract or applicable law, but which are based on equity and fairness, or on what the advocating party believes the arbitrators will consider the applicable customs, practices, and norms of the reinsurance industry.  By the same token, the party opposing such an argument must be prepared to deal with the implications of the honorable engagement clause, and to argue that its position is supported not only by the elusive concept of “honorable engagement,” but also by the terms of the contract and applicable law.  To the extent that one party may sense that the other has the better side of the ”honorable engagement” debate, that party may be able to assert legitimately that the clause cannot be interpreted to permit the result advanced by the other party, and to reserve its rights to challenge an award based on that interpretation. 

Third, these clauses can have important implications for Federal Arbitration Act satellite litigation.  For example, if an award is challenged on the ground that the arbitrators exceeded their authority by manifestly disregarding the law or by rendering a decision that did not draw its essence from the reinsurance contract, the honorable engagement clause may provide the party defending the award with a powerful argument for rejecting the challenge.  While the other party may argue that the clause is not broad enough to justify the award, it will have to demonstrate that the interpretation of the scope of the honorable engagement clause raises a question of arbitrability that must be determined by the court.  Otherwise, if there is even a colorable basis for the arbitrators’ interpretation of the clause itself, the reviewing court will have no choice but to accept it, even if it would have interpreted the clause differently.  And even if the court interprets the clause de novo, it may find it broad enough to authorize the award.