In this part IV of our Nuts & Bolts vacatur feature, we focus on Section 10(a)(3) of the Federal Arbitration Act, which provides in pertinent part (with bracketed numbering and text added for convenience): 

[An arbitration award may be vacated:]

where the arbitrators were guilty [(1)] of misconduct [(a)] in refusing to postpone the hearing, upon sufficient cause shown, or [(b)] in refusing to hear evidence pertinent and material to the controversy; or [(2)] of any other misbehavior by which the rights of any party have been prejudiced[.]

Section 10(a)(3) might be referred to as a procedural due process provision, and courts sometimes suggests it defines the level of due process that must be present in an arbitration for a court to confirm the award without violating constitutional due process requirements.   We do not find that line of reasoning to be particularly helpful, and its validity is debatable.  But Section 10(a)(3) certainly prescribes a baseline level of procedural protection to parties who agree to arbitrate without expressly specifying procedural protections.  And it imposes a no-harm-no-foul rule:  procedural misconduct or misbehavior — including not following agreed procedural rules — does not undermine an award unless the misconduct or misbehavior prejudiced the challenging party.   

II.  Grounds for Vacatur under Section 10(a)(3)

Section 10(a)(3) says a court for may vacate an arbitration award for “misconduct” or “misbehavior.”  It specifies only two types of misconduct:  “refusing to postpone the hearing, upon sufficient cause shown” and “refusing to hear evidence pertinent and material to the controversy.”  But it contains a catch-all provision that authorizes vacatur when the arbitrators are “guilty.  .  .  of any other misbehavior by which the rights of any party have been prejudiced.”    We have discussed in a prior posts the Ninth Circuit’s recent decision rejecting certain Section 10(a)(3) challenges to a reinsurance arbitration award.  (Post here.)

The key to Section 10(a)(3) is whether the challenging party has been denied a “fundamentally fair hearing” or has otherwise been prejudiced.  And in evaluating whether that standard has been met, courts assume that when parties agree to arbitrate they trade-off some of the procedural “niceties” that apply in court.  So what might be considered the denial of a fundamentally fair hearing in court might be considered fair in arbitration.  For example, parties in arbitration are not entitled to the same discovery rights they might have in court, arbitrators are generally not bound to follow procedural and evidentiary rules strictly, and arbitrators generally have a great deal of leeway to formulate their own procedural rules, provided they do not conflict with the parties’ agreed rules (if any).       

A. Misconduct:  “Refusing to Postpone the Hearing Upon Sufficient Cause Shown”

An arbitrator’s refusal to grant a continuance can be a ground for vacatur, provided the party requesting it showed the arbitrator “sufficient cause” for it to be granted.  But this ground for vacatur is no panacea for those seeking to delay the day of reckoning, and arbitrators should not consider it as such.    

When courts evaluate claims premised on this ground, they usually accord the arbitrators a great deal of deference in determining what is “sufficient cause shown.”  Courts are not likely to deem “sufficient cause” was shown when the need for a continuance was the fault of the party that unsuccessfully sought it.  

But when the denial of a continuance prejudiced the challenging party, and the need for it was not of the challenger’s own making, then courts may grant relief.  For example, if a party who otherwise acted prudently could not produce an important witness at the hearing because the arbitrators denied a continuance, then this branch of Section 10(a)(3) may authorize a court to vacate the award.  The key questions are whether the arbitrator acted arbitrarily and whether the challenging party was prejudiced as a result.          

B.  Misconduct:  “Refusing to Hear Evidence Pertinent and Material to the Controversy” 

When parties agree to arbitrate, the law presumes they intended that the arbitrators would allow them to present material and pertinent evidence supporting their position.  That does not mean that a party is entitled to present cumulative testimony or seek the broad discovery permitted by the Federal Rules of Civil Procedure. 

If arbitrators exclude evidence which, if admitted and credited, would have justified a different outcome, then a court may grant relief.  Again, the touchstone is prejudice:  would the outcome have been different had the arbitrator admitted and credited the evidence?  Even if the outcome would not necessarily have been different, was the challenging party afforded a fundamentally fair hearing even though the arbitrators would not hear the proferred evidence?  

Burlage v. Superior Court of Ventura Cty., 178 Cal. App. 4th 524 (2d Dist. Oct. 20, 2009), rev. denied, No.  S178328 (Cal. Sup. Ct. Jan. 21, 2010), is an excellent example of the type of case where relief for excluding material evidence was warranted and granted.  As explained in prior posts (here and here), a seller and buyer entered into a contract to purchase land.  Seller knew that the land — including a swimming pool and a fence — encroached on an enjoining property but did not tell buyer.  A dispute arose between the parties concerning the encroachment, and buyer claimed that seller had defrauded it.  The dispute was submitted to arbitration as required by the arbitration agreement in the contract of sale. 

After the escrow closed, but before the arbitration hearing, the title insurer paid the adjoining landowner $10,950 for a lot-line adjustment that gave buyer title to the encroaching land.  But despite this buyer sought damages for alleged diminution in value of the property, and for the cost of moving the pool and fence that were situated on previously encroaching land that buyer now owned because of the lot-line adjustment. 

Seller sought to introduce evidence of the lot-line adjustment, and buyer moved to exclude it.  Buyer said that damages must be ascertained from the date of the escrow closing, a contention the seller disputed.  The arbitrator granted the motion, ruling that damages were to be fixed as of the date of the escrow closing, and excluded evidence of the effect of the lot-line adjustment had on buyer’s damages claim. 

At the hearing buyer’s experts testified that, as of the date of the closing, it would have cost approximately $100,000 to fix the problem.  The arbitrator’s prior ruling precluded the seller from rebutting that expert testimony by showing either:  (a) that there were no damages; or (b) that damages were limited to the amount of money the title company paid to fix the encroachment problem.  After the hearing the arbitrator ruled that:  (a) seller knew that the pool and fence encroached on adjoining land; (b) seller did not disclose this fact to buyer; and (c) the encroachment materially affected the property’s value.  The arbitrator awarded buyer $552,750 in compensatory damages, $250,000 in punitive damages, and $732,570 in costs and attorney fees. 

The trial court vacated the award and the Court of Appeal, Second District, affirmed 2-1.  The court held that the evidence the seller sought to introduce was material, its exclusion was prejudicial and vacatur was therefore warranted under California’s version of Section 10(a)(3), Cal. Civ. Code § 1286.2(a)(5):  

What could be more material than evidence that the problem was “fixed” and there are no damages?  Yet, the Burlages presented expert testimony about the effect of what had become a nonexistent encroachment.  Their experts testified about the cost to move a pool and fence, neither of which had to be moved.  Spencer was not even permitted to refute the Burlages’ expert who opined that the encroachment reduced the value of the property $100,000.  Spencer could not show that the title company solved the encroachment issue through a payment of approximately one-tenth that amount.

Without this crucial evidence, the arbitration assumed the nature of a default hearing in which the Burlages were awarded $1.5 million in compensatory and punitive damages they may not have suffered. An arbitrator must consider this evidence to make an informed decision.

178 Cal. App. 4th. at 530. 

But Section 10(a)(3) is not supposed to be a license for courts to second guess evidentiary and merits rulings by arbitrators.  For example, sometimes the question whether evidence is “pertinent and material” depends on the resolution of a legal question pertaining to the merits.  Suppose the parties disputed whether the law of State X permitted consequential damages for breach of contract in light of the circumstances presented.  And suppose the arbitrator rules that, under the facts at hand, the law of State X does not permit consequential damages, and subsequently refuses to hear evidence of consequential damages.  Assuming the basis for the arbitrator’s ruling on the legal question was at least barely colorable, then the plaintiff should not have any basis for vacating the award under Section 10(a)(3). 

Some might say that the Burlage case was wrongly decided for this very reason:  The arbitrator ruled that damages were to be “fixed” as of the date of the escrow closing in the sense that mitigation-of-damages evidence could not be introduced, and the arbitrator’s exclusion of the subsequently occurring lot-line-adjustment evidence was simply a logical consequence of that ruling.  But evidence of what subsequently transpired was material to the controversy over the amount of damages.   The amount the title company actually paid the adjoining landowner for the lot-line adjustment after the closing is highly probative of the amount it would have cost as of  the closing.  If the title company was able to resolve the encroachment problem for approximately $11,000 shortly after the closing, then it is more probable than not that buyer could have done the same thing at the time of the closing, even if it did not have title insurance.  And $11,000 is a whole lot less than the more than $1.5 million in damages and fees that the arbitrator awarded.

C.  Other Misbehavior that Prejudiced one of the Parties’ Rights

Section 10(a)(3)’s catchall provision allows vacatur where the arbitrators engaged in “misbehavior” that “prejudiced” one of the parties.  Misbehavior does not necessarily connote intentional wrongdoing by the arbitrators.  It encompasses procedural misconduct as well as procedural error, other than the two types discussed in Section A., above.  It also includes ex parte contacts.  But, as with “misconduct,” the no harm no foul rule applies:  The challenger must show prejudice.

One example of a case that may warrant relief under the catchall provision can arise when arbitrators change the rules midstream without affording the parties sufficient notice to adjust their case-presentation strategy accordingly.  Suppose an arbitrator rules that a party does not have to present evidence in a particular form to support his or her position, or that the elements of a party’s claim or defense are X, Y and Z.  Suppose the party relies on these rulings, but that the arbitrator, after the close of the hearing, rules that the party had to present evidence in a different form, or that the elements of one of the claim or defense were A, B and C, rather than X, Y and Z.   If the arbitrator issues an adverse award based on such a ruling, then the aggrieved party should be able to vacate it under the catchall provision of Section 10(a)(3).  

D.  A Word to Arbitrators

Lawyers appearing in arbitration proceedings will sometimes attempt to bolster their procedural arguments by suggesting that a ruling other than in their client’s favor will lead to vacatur under Section 10(a)(3).  For the most part, such claims should be taken with a grain of salt, since, as explained above, Section 10(a)(3) reaches only serious procedural errors that prejudice a party. 

In response to such claims, however, certain arbitrators attempt to insulate themselves against putative Section 10(a)(3) claims by simply granting virtually every request for procedural relief made by the parties.  That knee-jerk approach simply multiplies time and money costs, depriving the parties of one of the key benefits of arbitration. 

The better approach is to make the tough calls, actively manage the proceedings and move things along.  To do this effectively, while minimizing the chances that they may commit the type of procedural error that might spoil an award, arbitrators should familiarize themselves with the law interpreting Section 10(a)(3).

In part V of our Nuts & Bolts vacatur series we shall discuss Section 10(a)(4), which authorizes vacatur “where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made.”

Back in January the Ninth Circuit decided United States Life Ins. Co. v. Superior National Ins. Co., ___ F.3d ___, slip op. (9^th Cir. Jan. 4, 2010), a Federal Arbitration Act Section 10(a)(3) procedural misconduct decision that affords reinsurance and other arbitrators a good deal of leeway to devise and implement nontraditional procedures for resolving complex problems.   The case centered around a rather unusual procedure the arbitrators ordered and implemented to determine whether the cedents improperly handled some 12,604 contested workers compensation claims.  It also concerned the authority of arbitrators to interpret the scope of the submission and to award a disgorgement of investment income remedy in addition to pre-award interest. 

While we shall be publishing in the not too distant future Part IV of our Nuts & Bolts vacatur series focusing on Section 10(a)(3), United States Life is worthy of its own discussion, even though we will no doubt circle back to it in Part IV.  The focus of this post will be on the Section 10(a)(3) aspects of the case.  We’ll deal with the excess of powers aspects of the decision in Part V of our Nuts & Bolts vacatur series, which will deal with Federal Arbitration Act Section 10(a)(4).   

II.        Background

U.S. Life arose out of a reinsurance dispute between U.S. Life Insurance Co. and five cedents (the “Cedents”) who later became the subject of liquidation proceedings in California.  Prior to the commencement of liquidation proceedings, and continuing thereafter, U.S. Life and the Cedents became embroiled in a long-running, two-phase arbitration proceeding.  Phase II concerned whether the Cedents engaged in improper claims handling that resulted in increased reinsurance billings to U.S. Life.  The parties each appointed an expert who testified at the Phase II hearing concerning a sample of 500 of 12,604 disputed claims.  After a thirteen-day hearing the arbitrators informed the parties that they could not reach a decision whether the claims were improperly handled, and, if so, what the effect of the allegedly improper claims handling, if any, was on U.S. Life’s obligations under the reinsurance contract. The panel said that it would retain two workers’ compensation experts to assist it in reaching its decision. 

Following extensive correspondence between the panel and the parties, the panel announced it would implement the following expert-review procedure:

1. The  reviewers would review 162 of the 500-claim sample of.  .  . [contested claims];
2. The reviewers would meet [ex parte] with the panel for three days .  .  . and no transcript would be prepared of the .  .  .   meeting;
3. The reviewers would provide their conclusions in writing to the panel and the parties;
4. The parties could submit briefs responding to the reviewers’ conclusions;
5. A two-day hearing would be held during which the parties could question the reviewers, under oath, for five hours each as to their qualifications and the reasons for their conclusions, but not as to to the ex parte meeting; and
6. The parties could submit post-hearing briefs to the panel. 

Slip op. at 90. 

The Panel used this procedure to resolve the impasse and subsequently issued a Final Arbitration Award that, among other things, required U.S. Life to pay all reinsurance bills “submitted before December 6, 2008,” and to “pay all post-December 6, 2008 bills within thirty-days of receipt.”  Slip op.  at 91.   

U.S. Life sought to vacate the award, and alleged, among other things, that the Panel committed procedural misconduct under Section 10(a)(3)  by:  (a)  refusing to hear “pertinent and material evidence” concerning whether the Cedents’ claims handling was appropriate; and (b) engaging in prejudicial misbehavior that rendered U.S. Life unable to respond to evidence presented against it ex parte by the independent experts.  The Court rejected both of these challenges. 

III.  The Court’s Holdings and Analysis

A.  Refusing to Hear Pertinent and Material Evidence

To address the arbitrators’ alleged refusal to hear pertinent and material evidence, the Court  needed to consider whether Section 10(a)(3) required U.S. Life to demonstrate prejudice.  Section 10(a)(3) provides, with parenthetical text helpfully added by the Court: 

[An arbitration award may be vacated:]

where the arbitrators were guilty [(1)] of misconduct [(a)] in refusing to postpone the hearing, upon sufficient cause shown, or [(b)] in refusing to hear evidence pertinent and material to the controversy; or [(2)] of any other misbehavior by which the rights of any party have been prejudiced[.]

Slip op.. at 95 (parenthetical material in original).

The Court noted that the text was arguably ambiguous as to whether ground (2) — “of any other misbehavior by which the rights of any party have been prejudiced” —  implied that ground (1) — a refusal “to hear evidence pertinent and material to the controversy” —  likewise required the movant to demonstrate prejudice.  But the Court ruled there were two reasons why it “need not resolve this textual ambiguity, if any.  .  .  .”  Slip op.. at 95.  First, the Court concluded that “refusing to hear evidence pertinent and material to the controversy” “necessarily implies prejudice to the rights of a party, without regard to the final catch-all phrase.  .  .  .  ” of ground (2).  Slip op.. at 95.  Second, the Court held that U.S. Life had not established that the panel had refused to hear any evidence “pertinent and material to the controvery” by precluding the parties from attending the meeting or questioning the experts about it.  Slip op.. at 95.

The procedure adopted by the panel, said the Court, “allowed the parties to present material evidence because the parties were allowed to address why the reviewers’ conclusions were incorrect:”

It was only after the panel listened to, and considered, the parties’ experts’ opinions and other evidence that the panel determined it needed additional information to resolve the Phase II dispute: U.S. Life’s obligations under the reinsurance contract. The panel advised the parties of its dilemma and determined what process to use only after receiving input from counsel through extensive and detailed correspondence. The process employed ensured due process by allowing the parties to present their respective arguments regarding the reviewers’ conclusions by 1) reviewing the written conclusions, 2) submitting briefing addressing these conclusions, 3) questioning the reviewers about their qualifications and conclusions, and 4) submitting post-hearing briefing.  Although the parties were not privy to what occurred during the ex parte meeting, the panel gave the parties ample opportunity to discover and critique the reviewers’ conclusions.

Slip op. at 95-96 (footnote omitted). 

According to the Court, “the panel appropriately exercised .  .  .  [its] wide discretion” “to require the exchange of evidence, and to admit and exclude evidence, how and when they see fit.”  Slip op. at 96 (citation and quotation omitted). The Court said “[t]he extensive correspondence reflects that the panel’s intent was to accord due process – and it did.”  Slip op. at 97.  The Court distinguished the case from ones where:  (a) “the arbitrator misled a party into believing that evidence was admitted, but then ruled against the party because it failed to present evidence on the very point to which the excluded evidence was central;”  or (b) ”the party was not given an opportunity to complete its presentation of proof prior to the arbitration decision.”  Slip op. at 97 (distinguishing Gulf  Coast Industrial Workers Union v. Exxon Co., 70 F.3d 847 (5^th Cir. 1995) and Warehousemen and Helpers, Local Union No. 506 v. E.D. Clapp Corp., 551 F. Supp. 570, 578 (N.D.N.Y. 1982)). 

B.  Prejudicial Misbehavior

U.S. Life also argued that the ex parte meeting and cross-examination limitation was prejudicial misbehavior that prevented it from responding to evidence presented during the meeting.  But the Court held that the panel’s procedures did not constitute prejudicial misbehavior. 

First, the Court rejected the Fifth Circuit’s broad dictum in Totem Marine Tug & Barge, Inc. v. North America Towing, Inc., 607 F.2d 649, 653 (5^th Cir. 1979) that “[a]rbitrators cannot conduct ex parte hearings or receive evidence except in the presence of each other and of the parties, unless otherwise stipulated.”  (quotations and citation omitted)  Noting that Totem Marine’s “prohibition was too broad” because “the FAA does not expressly prohibit ex parte contact,” the Ninth Circuit ruled that “ex parte conduct by an arbitration panel requires vacatur of an award only if the ex parte contact constitutes misbehavior that prejudices the rights of a party.”  Slip op. at 98. 

Second, the Court observed that that “the ex parte contact was not with a party, but with neutral experts,” and “both parties were aware of the ex parte contact, submitted suggestions as to the process to be used, and had the opportunity to contest the reviewers’ conclusions.” Slip op. at 98.   The Court said that “the panel presented far less risk of prejudicial misbehavior than if one arbitrator was used,” because the tripartite arbitration panel featured two party-appointed arbitrators, and there was “extensive evidence of [the panel’s].  .  . efforts to provide due process to both parties” and to “resolve the dispute in a relatively efficient manner.  .  .  .”  Slip op. at 98-99.  The Court found it “noteworth that U.S. Life’s party arbitrator agreed to this process and that he did not mention arbitral misconduct or misbehavior in his dissent.”  Slip op.. at 99.   

Third, the Court held there was no misbehavior because the parties bestowed ”broad authority” on the panel through their agreed, procedural protocols.  While the parties “did not stipulate to the ex parte meeting,” the parties expressly authorized the panel to “adopt such other processes and procedures as it deems fair and expedient to resolve issues before it to the extent that the issues are not expressly or implicitly addressed by.  .  .” the procedural protocols agreed by the parties.   Slip op.. at 99. 

The Court also determined that, in any event,  U.S. Life did not establish that the panel’s ex parte procedure prejudiced it.  The panel ruled against U.S. Life, but U.S. Life “failed to establish that it was denied an opportunity to present its case or to contest [the Cedents’s] .  .  . evidence or the reviewers’ conclusions.”  U.S. Life may not have received “a perfect hearing[,] but it did receive a fair” one, having had “notice.  .  ., the opportunity to be heard and to present relevant and material evidence” to “decisionmakers [that] were not infected with bias.”  Slip op. at 99-100 (citation and quotation omitted). 

IV.  Our Analysis

We were initially somewhat concerned about the United States Life and its potential ramifications on arbitral procedure.  The scheme the panel adopted was unusual, at least in reinsurance cases, and it is not difficult to imagine arbitration panels crafting like ex parte procedures to resolve other seemingly difficult, technical problem, some of which might not include all the checks and balances present in United States Life. 

Yet the Ninth Circuit got it right under the facts and circumstances of the case.  Its  opinion evidences careful consideration of the Section 10(a)(3) standard and attention to the facts and practical realities of the situation in which the the panel and the parties found themselves.  

But we read the decision as being fairly narrow in scope and largely driven by its peculiar facts.   To ascertain its applicability to similar and not so similar panel-adopted ex parte procedures, we think it important to remember the following points emphasized by the Court: 

1. Before adopting the procedure, the panel attempted in good faith to resolve the issues through traditional hearing procedures;
2. The parties expressly authorized the panel to “adopt such other processes and procedures as it deems fair and expedient to resolve issues before it to the extent that the issues are not expressly or implicitly addressed by” procedural protocols agreed by the parties;  
3. The parties had an opportunity to be heard concerning the nature and scope of the ex parte procedure; 
4. The panel provided extensive “due process” in an effort to mitigate the disadvantages to the parties attendant with the ex parte procedure;
5. The parties utilized tripartite arbitration with party-appointed arbitrators, which, at least in theory, provided some assurance that the parties’ interests would be looked after in the absence of their attorney representatives;
6. U.S. Life’s party-appointed arbitrator did not suggest in his dissent that the panel’s procedures prejudiced U.S. Life;
7. The ex parte contact was not with a party, but with the claims experts; and
8. The ex parte procedure did not preclude the parties from presenting pertinent and material evidence.

Not every case in which a nontraditional procedure is adopted is likely to feature all of these factual predicates, and courts in future cases should pay the same careful consideration to the facts and circumstances as did the Ninth Circuit in this one. 

The opinion following rehearing is substantially the same as the August 31, 2009 opinion, save for a few additional paragraph the majority added to respond further to Perren, J.’s dissenting opinion.  Perren, J.’s dissent was reissued without material change. 

The additional paragraphs the majority added to address the dissenting opinion are set forth for our readers’ convenience below:

We disagree with the dissent’s suggestion that the arbitrator considered the lot-line adjustment evidence in the in limine motion.  In the context of the case, we agree with the discerning comments of our colleagues in Gonzales v. Interinsurance Exchange (1978) 84 Cal.App.3d 58, 63:  ”One cannot ‘consider’ what one has refused to ‘hear.’  Legally speaking the admission of evidence is to hear it, and the weighing of it is to give it consideration.”

The situation here is different than that in Hall v. Superior Court, supra, 18 Cal.App.4th 427.  In Hall, a party wished to reopen the arbitration hearing with additional evidence.  After hearing the party’s offer of proof, the arbitrator announced that his decision would be the same even with the proffered evidence.  The appellate court concluded the arbitrator did not prevent the losing party from fairly presenting his defense.  (Id. at p. 439.)  The trial court’s ruling to vacate the arbitration award was reversed, however, because “[w]here . . . a party complains of excluded material evidence, the reviewing court should generally focus first on prejudice, not materiality.  To find substantial prejudice the court must accept, for purposes of analysis, the arbitrator’s legal theory and conclude that the arbitrator might well have made a different award had the evidence been allowed.”  (Ibid.)  Unlike Hall, the trial court here found on substantial evidence that “[t]he Arbitrator’s refusal to admit these subsequent circumstances directly affected the issue of damages, thereby substantially prejudicing  Defendant’s [Spencer's] ability to dispute the amount of damage suffered by Plaintiffs [the Burlages].”

It may be argued that to avoid the imposition of section 1286.2, arbitrators will simply admit evidence to insulate their decisions from review.  We do not subscribe to this cynical view.  It is through judicial review that the law is shaped and developed.  Arbitrators do not subvert this process because a court might vacate an award.  Arbitrators base their decisions on a careful analysis of the law and facts.  They, like the arbitrator here, are professionals who conduct themselves according to the canons of ethics and the high degree of integrity their profession demands.

Slip op. at 6-7 (opinion following rehearing).

We shall keep readers apprised of any further developments as and when they occur.

Section 10(a)(3) of the Federal Arbitration Act authorizes courts to vacate awards “where the arbitrators were guilty of misconduct.  .  . 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.”  California’s arbitration statute says courts “shall” vacate an award where a party’s rights “were substantially prejudiced . . . by the refusal of the arbitrators to hear evidence material to the controversy . . . .”  Cal. Civ. Code § 1286.2(a)(5) (here). 

On August 31, 2009 the California Court of Appeal, Second Appellate District decided Burlage v. Superior Court of Ventura Cty., ___ Cal. App. 4^th ___, slip op. (Cal. App. 2d Dist. Aug. 31, 2009), petition for rehearing granted.  (A copy of the opinion is here.)  At the time we viewed Burlage as an excellent and relatively easy to understand example of how courts should – and do – deal with those relatively rare situations where a party is prejudiced by an arbitrator refusing to hear evidence material to the controversy, whether under the Federal Arbitration Act Section 10(a)(3) or a state law equivalent like California Civil Code Section 1286.2(a)(5).  While we still believe that the court correctly affirmed the trial court decision vacating the arbitration award, the decision has proved to be more controversial than we initially suspected it would be.  

Background 

The facts are fairly straightforward.  A seller and buyer entered into a contract to purchase land.  Seller knew that the land  — including a swimming pool and a fence — encroached on an enjoining property but did not tell buyer.  A dispute arose between the parties concerning the encroachment, and buyer claimed that seller had defrauded it.  The dispute was submitted to arbitration as required by the arbitration agreement in the contract of sale. 

After the escrow closed, but before the arbitration hearing, the title insurer paid the adjoining landowner $10,950 for a lot-line adjustment that gave buyer title to the encroaching land.  But despite this buyer sought damages for alleged diminution in value of the property, and for the cost of moving the pool and fence that were situated on previously encroaching land that buyer now owned because of the lot-line adjustment. 

Seller sought to introduce evidence of the lot-line adjustment, and buyer moved to exclude it.  Buyer said that damages must be ascertained from the date of the escrow closing, a contention the seller disputed.  The arbitrator granted the motion, ruling that damages were to be fixed as of the date of the escrow closing, and excluded evidence of the effect of the lot-line adjustment had on buyer’s damages claim. 

At the hearing buyer’s experts testified that, as of the date of the closing, it would have cost approximately $100,000 to fix the problem.  The arbitrator’s prior ruling precluded the seller from rebutting that expert testimony by showing either:  (a) that there were no damages; or (b) that damages were limited to the amount of money the title company paid to fix the encroachment problem.  After the hearing the arbitrator ruled that:  (a) seller knew that the pool and fence encroached on adjoining land; (b) seller did not disclose this fact to buyer; and (c) the encroachment materially affected the property’s value.  The arbitrator awarded buyer $552,750 in compensatory damages, $250,000 in punitive damages, and $732,570 in costs and attorney fees. 

The trial court vacated the award and the Court of Appeal, Second District, affirmed 2-1.  The court held that the evidence the seller sought to introduce was material, its exclusion was prejudicial and vacatur was therefore warranted under Cal. Civ. Code § 1286.2(a)(5):  

The arbitrator excluded evidence that the title company paid the cost of the lot-line adjustment and purchase of the encroachment. The arbitrator did not state his reasons for the evidentiary ruling, but likely it stemmed from his earlier ruling that damages are fixed at the date escrow closed.

The question whether the arbitrator was right or wrong about the proper date from which to measure damages arguably is not subject to judicial review. But it is self-evident that his ruling disallowing evidence that the title company solved the problem through a modest payment to the country club was more than a mere erroneous evidentiary ruling. The ruling substantially prejudiced Spencer and undermined the fundamental principle embodied in section 1286.2, subdivision (a)(5) that an arbitrator must consider material evidence.

Evidence of an Absolute Defense – The Problem is Fixed

What could be more material than evidence that the problem was “fixed” and there are no damages?  Yet, the Burlages presented expert testimony about the effect of what had become a nonexistent encroachment.  Their experts testified about the cost to move a pool and fence, neither of which had to be moved.  Spencer was not even permitted to refute the Burlages’ expert who opined that the encroachment reduced the value of the property $100,000.  Spencer could not show that the title company solved the encroachment issue through a payment of approximately one-tenth that amount.

Without this crucial evidence, the arbitration assumed the nature of a default hearing in which the Burlages were awarded $1.5 million in compensatory and punitive damages they may not have suffered. An arbitrator must consider this evidence to make an informed decision.

Slip op. at 5-6. 

Like many things in life – and particularly, in law – Burlage is not as straightforward as it first appears.   The dissent (Perren, J.) reasoned that the exclusion of evidence of post-closing events was a natural consequence of the arbitrator’s ruling that evidence of mitigation of damages was not permitted in a land fraud case, which meant that seller was not prejudiced.  See Slip op. at 1 (dissenting opinion).  That ruling was not subject to judicial review, as the majority acknowleged, albeit equivocally.  Slip op. at 2 (dissenting opinion).  To find prejudice, said the dissent, the court must (a) accept the arbitrator’s legal theory that damages must be ascertained as of the date of the closing without evidence of mitigation; and (b) nevertheless conclude that ”the arbitrator might well have made a different award had the [lot-line-adjustment]  evidence been allowed.”  Slip op. at 3 (dissenting opinion; emphasis deleted).    Because the dissent believed  the evidence was probative only as respects mitigation of damages, and because such evidence was inadmissible under the legal theory adopted by the arbitrator, there was no basis for finding that the arbitrator would have reached a different conclusion had it considered the evidence.  See Slip op. at 3 (dissenting opinion). 

Critical Analysis

There is definitely a tension in Burlage between the limited role of a court in reviewing arbitration awards and the need to protect parties from prejudice resulting from the exclusion of evidence material to the controversy.  Veteran-blogger Victoria Pynchon of Settle-It-Now has written some nice posts about this tension.  (Posts here, here and here)  And the Court of Appeal has granted a rehearing in the case.  (See Victoria Pynchon’s post here.) 

But we think that the outcome was correct and that the trial court decision should be affirmed on rehearing.  The case is really not about the mitigation of damages, nor is it about the fact of damages.  It is really about the amount of damages. 

Let us give the arbitrator the benefit of doubt, and assume that:   (a) the fact of damages is to be established as of the escrow closing;  and (b) applicable law does not permit evidence of mitigation of damages post closing.  No doubt that the fact of damages was established:  at the time of the escrow closing, the property encroached on adjoining property.  The question boils down to amount:  what would it have cost to fix the encroachment as of the date of the closing? 

Evidence of what subsequently transpired was material to the controversy over the amount of damages.   The amount the title company actually paid the adjoining landowner for the lot-line adjustment after the closing  is highly probative of the amount it would have cost as of  the closing.  If the title company was able to resolve the encroachment problem for approximately $11,000 shortly after the closing, then it is more probable than not that buyer could have done the same thing at the time of the closing, even if it did not have title insurance.

The exclusion of the lot-line adjustment was undoubtedly prejudicial to seller.  Even when, to paraphrase the dissent,  we “accept for the purposes of analysis, the arbitrator’s legal theory,” it is easy to “conclude that the arbitrator might well have made a different award had the evidence been allowed.”   Slip op. at 3 (dissenting opinion).  Had the lot-line-adjustment evidence been allowed, the arbitrator might well have concluded that buyer’s damages as of the date of closing attributable to diminution in the value of the property were approximately $11,000, not the $100,000 the buyer’s experts testified they were, and certainly not the $552,750  the arbitrator awarded.  And given the reduction in the amount of compensatory damages, the arbitrator might not have awarded punitive damages, or might have awarded much less than $250,000. 

Because the evidence was material to, at a minimum, the amount of damages, and because prejudice is, for all practical purposes, self-evident, we believe that the Second Appellate District should affirm the trial court on rehearing.  It will be interesting to see what actually happens, and whether this case ultimately ends up before the California Supreme Court.  And if this case goes back to the arbitrator or a new arbitrator, it will be interesting to see if the arbitrator will ignore economic reality and award some amount of damages to the buyer even though any amount would be a windfall, albeit one that the law apparently sanctions.  

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

EDITOR’S NOTE:  On October 20, 2009 the California Court of Appeal issued its opinion on rehearing, which affirmed the trial court’s judgment vacating the award.  See our update, here.