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

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

B.   Background

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

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

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

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

But the award said:

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

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

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

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

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

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

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

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

C.   The Seventh Circuit’s Opinion

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

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

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

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

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

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

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

Slip op. at 6 (citations omitted). 

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

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

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

D.   Analysis

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Chief Judge Easterbrook’s “agency” model of arbitral authority is instructive.  Just as agents derive their authority by the consent of the principal (subject to the rules of apparent and implied authority), arbitrators derive their authority from the parties via the arbitration agreement and the submission.  Subject to any restrictions in the arbitration agreement, the arbitrators’ powers to resolve a dispute under a broad arbitration agreement are arguably co-extensive with those of the parties that appointed them. 

But the model is not perfect.  First, unlike agents, arbitrators are not subject to the control of their principals and owe them no fiduciary duties.  Second, analogizing arbitrators as agents of the parties in the way Chief Judge Easterbrook does effectively empowers arbitrators not only to decide cases, but to negotiate settlements that the parties could have entered into.  It therefore does not require arbitrators to even arguably interpret the contract or apply the law:  As long as the arbitrators do not require the parties to violate the law, and as long as the arbitrators are at least arguably faithful to the parties’ expressed choice-of-law, if any, they can reach whatever decision they wish, whether by application of facts to legal norms or by a compromise settlement that may or may not be rooted in the parties’ agreement.    That arguably does not comport with the parties’ presumed, legitimate expectations.  For the arbitrator’s job is to decide cases; settlement is a matter for the parties, and should be subject to the parties’ control. 

University of Chicago Law School Professor Tom Ginsburg has written an excellent white paper that argues that the deferential standard of review espoused by Watts and other courts does not necessarily make arbitration an attractive substitute for litigation.  See Tom Ginsburg, John M. Olin Law & Economics Working Paper No. 502 (2d Series), The Arbitrator as Agent: Why Deferential Review Is Not Always Pro-Arbitration  (Dec. 2009) (copy available here).  He argues that a more searching standard of review would make the market for arbitrators more transparent, and thus more effective.  He advocates using Chief Judge Easterbrook’s agency model as an analytical framework for allowing parties to choose whether they prefer a very deferential standard of review, like that prescribed in Watts; something akin to de novo review, like that available in litigation; or something in between the two.  Professor Ginsburg is in the process of publishing in the University of Chicago Law Review an article based on his white paper.

As respects the tie-in between the standard of review and the effectiveness of arbitration, Professor Ginsburg explains that arbitrators are frequently experts in the subject matter of dispute, but, unlike “generalist judges,” they are not necessarily experts on the law or on the application of law to facts, and therefore are “prone to make mistakes, or at least presumptively more prone to do so than are judges.”  Since arbitration is a surrogate for adjudication, the U.S. legal system has had to decide what level of scrutiny best advances the federal policy in favor of arbitration.  Most arbitration statutes and the Convention on the Recognition and Enforcement of Foreign Arbitral Awards have eschewed mere legal error as a ground for judicial review of arbitration awards.  Only a particularly egregious error will warrant vacatur, and even then, courts differ as to what – if anything – constitutes an egregious error amounting to manifest disregard of the law (or perhaps manifest disregard of the agreement).   Courts consider this deferential approach as the one best suited to implementing a policy in favor of arbitration. 

But, as Professor Ginsburg observes, there is “a spectrum of possible alternative regimes, ranging from de novo review to complete non-reviewability,” and choosing which one best promotes arbitration involves a “tradeoff:” 

If the standard of review is too rigorous, the benefits of arbitration in terms of speed, cost, and finality may be lost because parties will frequently appeal arbitral awards to the courts.  On the other hand, if review is too limited, arbitrators might deliver very poor quality decisions that undermine the attractiveness of arbitration as a whole.

 Professor Ginsburg argues that Watts, Hall Street Assoc., L.L.C. v. Mattel , Inc., 552 U.S. ___, slip op. (March 25, 2008), and other court decisions trade off  too much in favor of speed, cost and finality by adopting a standard of review that amounts to practically no review at all.  He assumes, for the sake of argument, that there are “good arbitrators” that “always interpret the law accurately,” and “bad” ones who “do so only with a probability p < 1.”  He assumes that, in selecting arbitrators, a sufficiently large number of purchasers will seek “good” arbitrators (or “bad” arbitrators whose probability of interpreting the law correctly is close to 1.)  Parties will attempt to mitigate the risk of choosing a “bad” arbitrator through screening, but market imperfections tend to make the screening process unreliable: 

Will screening serve to adequately reduce the agency problem of arbitrators?  If the market for arbitrators is sufficiently robust, it might.  But the market for arbitrators has certain imperfections.  For example, there are no public records of arbitrator performance.  Arbitrators need not produce publicly available opinions, and parties generally have no incentive to allow them to reveal the basis for the award.  Only when an arbitrator makes an egregious error leading to a vacatur petition (such as manifestly disregarding the law outside the Seventh Circuit) will there be a public record of performance.  Hence it is difficult for the parties to a contractual dispute to evaluate potential arbitrators in terms of their ability to interpret law.  Reputational considerations are, of course, a factor, but in the absence of reasoned decisions, even past users of a particular arbitrator cannot be sure their favorable outcome resulted from skilled arbitration or a combination of lazy arbitration and luck.  There will thus be certain informational asymmetries in the market for arbitrators, allowing bad arbitrators to remain in the market.

A heightened level of judicial monitoring might compensate for some of these imperfections, says Ginsburg.  But decisions like Hall Street and Watts allow for only perfunctory review.  And while those decisions were intended to make arbitration more attractive, and to promote judicial economy as a result, Professor Ginsburg says their practical effect may be quite the opposite: 

One perverse result of the Hall Street decision might be greater pressure on courts to resolve full contract disputes.  One rationale for not allowing parties to contract into higher levels of judicial scrutiny (though not fully articulated in the Hall Street decision which relied on a textual analysis of the FAA) would be to enhance judicial economy — the public should not have to subsidize private dispute resolution. But after Hall Street, parties who want a legally proper decision cannot submit to arbitration, or at least will be less likely to do so, because there can be only minimal ex post monitoring of arbitral awards.  Like Watts, Hall Street limits the scope of review. But unlike Watts, it does not follow an agency perspective.  By preventing courts from policing arbitrator interpretations of law, Hall Street may end up reducing the number of cases sent to arbitration and, perversely, shifting contract disputes to the courts, precisely because there is no alternative way for parties to ensure that arbitrators do follow the law.  The Hall Street logic may end up sacrificing judicial economy in an attempt to preserve it, and hurt arbitration in the name of helping it.  (footnotes omitted) 

But if the parties could “designate the standard of review,” that “would improve the functioning of the market for arbitrators by allowing good arbitrators to signal their status[:]”

The point is that the standard of review will affect the mix of agents in the labor pool.  A policy of no scrutiny will draw bad types.  A policy of minimal scrutiny, such as under the FAA, will keep some bad types out: it will prevent arbitrators, for example, from applying New York law when they are instructed to apply Wisconsin law.  But it will do nothing to hinder an arbitrator who applies Wisconsin law so poorly as to produce an obvious error.  Given the existence of agency problems, the hands-off approach of the FAA after Hall Street may end up undermining the arbitration regime by drawing bad arbitrators.

So, working within the framework of the Federal Arbitration Act, and decisions other than Hall Street interpreting it, how do we justify a more heightened standard of review of arbitration awards?  Professor Ginsburg says the agency model itself provides the answer: 

An agency perspective would allow the parties more freedom in stipulating legal grounds for review.  If parties want a decision that is accurate, they could require that arbitrators not make clear errors of law.  High quality arbitrator-agents could trade on their ability to interpret law by promising not to make clear errors.  Low quality arbitrator-agents would not want to make such enforceable promises and so might be driven from the market.  The Hall Street approach limits contractual freedom; the Watts approach might expand it, and in doing so, may in fact enhance arbitration. It might thus allay concerns about a possible ‘flight from arbitration.’  (footnotes omitted) 

.  .  .  . 

Arbitration is contractual dispute resolution, and this means that arbitrators are agents. The standard of review of arbitral awards sets the level of monitoring of the agents’ interpretation of law. Some agents will prefer not to be subject to monitoring of their performance, and these are the agents who are happy with Hall Street.  Other agents have no fear of monitoring.  While specifying a universal standard of review applicable for all cases may be an inherently unstable venture, it seems clear that allowing the parties to set the standard, and to choose higher levels of monitoring by contract, will reduce agency slack and allow parties to determine what type of arbitrator they are hiring. Deferential review, in short, is not always pro-arbitration. 

We have quoted extensively from Professor Ginsburg’s work, but do not let this post be a substitute for reading and studying his white paper and the upcoming University of Chicago Law Review article.  Professor Ginsburg is a second-generation law and economics theorist, and like the first generation – whose ranks include Associate Justice Antonin G. Scalia, Circuit Judge Richard A. Posner and Chief Judge Easterbrook – he writes clearly and well, and more importantly — like those of the first generation – his theories make good sense, which is all too uncommon these days.

So far the United States Supreme Court has agreed to hear only one arbitration case governed by the Federal Arbitration Act:  Stolt-Nielsen, S.A. v. AnimalFeeds Int’l Corp., 548 F.3d 85 (2d Cir. 2009), petition for cert. granted June 15, 2009 (No. 08-1198), which has been set for oral argument at 10:00 a.m. Eastern Standard Time, December 9, 2009.   (See Russ Kunkel’s LawMemo Arbitration Blog  here.)  We have written extensively on Stolt-Nielsen, which concerns whether class arbitration may be imposed on parties whose contracts are silent on that point.  (Posts available here,  here, here, here, here, here, here, here and here.)

The Supreme Court has also agreed to hear two labor arbitration cases.  The first is Union Pacific Railroad Co. v. Brotherhood of Locomotive Engineers & Trainmen (08-604), which is governed by the the Railway Labor Act (“RLA”), 45 U.S.C. §§151 et seq.  The RLA, among other things, requires arbitration before the National Railroad Adjustment Board (“the Board”) of labor disputes involving railway workers.  Union Pacific, for all practical purposes, is therefore not a contractual arbitration case, but an administrative law one, and the outcome will likely have  little or no effect on Federal Arbitration Act jurisprudence.  The Court held oral argument on October 7, 2009.  (Oral argument Tr. here) 

The second is Granite Rock Co. v. International Brotherhood of Teamsters (08-1214), which arises under Section 301 of the Labor Management Relations Act.  The Court is expected to set argument for later this Fall.  (See Russ Kunkel’s LawMemo Employment Law Blog here.)   Though not governed by the Federal Arbitration Act, Granite Rock, unlike Union Pacific, is a contractual arbitration case.  And the outcome may be relevant to cases falling under the Federal Arbitration Act. 

We briefly summarize below the issues the Court will presumably address in these labor arbitration cases and discuss why Granite Rock may be more controversial than it appears at first blush.   

Union Pacific Railroad Co. v. Brotherhood of Locomotive Engineers & Trainmen (08-604)

Union Pacific, which arose under the RLA, concerns an administrative law question.  The RLA provides that the Board’s decisions “shall be conclusive … except … for”: (1) “failure … to comply” with the Act, (2) “failure … to conform or confine” its order “to matters within … the [Board’s] jurisdiction,” and (3) “fraud or corruption” by a Board member. 45 U.S.C. §153 First (q).  The Board denied certain employee grievance claims because the claimants had not complied with a Board rule requiring them to prove that the pre-grievance, statutory requirement of a “conference” between the parties had been met.  See 45 U.S.C. §152.  The United States Court of Appeals for the Seventh Circuit vacated the decision of the Board, holding that it violated due process by adopting a “new,” retroactive interpretation of the standards governing its proceedings.   

Before the Supreme Court are two questions: 

1. Whether the RLA includes a fourth, implied exception that authorizes courts to set aside final arbitration awards for alleged violations of due process; and
2. Whether the Seventh Circuit erroneously held that the Board adopted a new, retroactive interpretation of the standards governing its proceedings in violation of due process.

You can read the briefs here and the oral argument transcript here. 

Granite Rock Co. v. International Brotherhood of Teamsters (08-1214)

Granite Rock concerns a dispute between an employer and a union over whether the parties entered into a collective bargaining agreement containing a no-strike clause.  The disputed CBA contains an arbitration agreement, which requires arbitration of all disputes “arising under” the agreement.  The union’s position on the merits is that it never ratified the CBA.

The employer brought an action in district court to enforce the CBA, and the union argued that the dispute over whether the CBA was concluded was subject to arbitration.  In response to the union’s contention, the employer argued that the question whether the CBA was concluded was one of arbitrability for the court to decide.

The Ninth Circuit held that there was no dispute over whether the arbitration agreement – as opposed to the CBA as a whole – was entered into because:  (a) the employer sued to enforce the CBA, which contained the arbitration agreement; and (b) the union sought to enforce the arbitration agreement, albeit not the rest of the CBA.  The Ninth Circuit also held that the dispute over the formation of the CBA fell within the terms of the arbitration agreement.   

The case presents an interesting twist on the severability doctrine.  Ordinarily, where a party contends that a contract containing an arbitration agreement was never concluded, the argument applies equally to the arbitration agreement, which means the court must decide whether the parties agreed to arbitrate before it can order arbitration.  Presumably for this reason, in Buckeye Check Cashing v. Cardegna, 546 U.S. 440, 444 n.1 (2006) (citations omitted), the Supreme Court did not extend the doctrine of severability to require arbitration when there is an issue concerning whether the contract containing the arbitration agreement  — and thus the arbitration agreement itself — was ever concluded:       

The issue of the contract’s validity is different from the issue whether any agreement between the alleged obligor and obligee was ever concluded. Our opinion today addresses only the former, and does not speak to the issue decided in the cases cited by respondents (and by the Florida Supreme Court), which hold that it is for courts to decide whether the alleged obligor ever signed the contract, whether the signor lacked authority to commit the alleged principal, and whether the signor lacked the mental capacity to assent.  

But the unusual procedural posture of the case lends support to the Ninth Circuit’s holding because the parties’ respective litigation positions, taken together, and divorced from the dispute on the merits, indicate that the parties do not dispute that an arbitration agreement agreement was concluded.  And because the severability doctrine posits that an arbitration agreement is severable from the contract in which it is contained, the notion that an arbitration agreement came into existence without the parties entering into the CBA is not all that farfetched. 

On the other hand, the union appears to be taking inconsistent positions in an effort to gain what it apparently perceives to be a tactical advantage.  In response the Ninth Circuit has effectively said that the union can have its cake and eat it,  too.  It held that after the employer sued to enforce the contract, the union, through its own litigation position, could ratify the arbitration agreement while rejecting the balance of the agreement, including the no-strike provision.  It seems questionable whether the severability doctrine was designed to allow a party to argue on the one hand that a CBA containing an arbitration agreement was never concluded, and yet reap the benefits of that arbitration agreement by effectively “accepting” one aspect of the other party’s litigation position – the arbitration agreement’s existence – while rejecting the rest of it – the existence of a binding CBA containing a no-strike clause. 

It will be interesting to see how the Supreme Court decides this case.  Copies of petitioner’s briefs and amicus briefs in support of petitioner can be found here.

The Court held that, under the circumstances of the case, Party B forfeited its challenge to the replacement procedure by failing to raise it immediately under Section 5 of the Federal Arbitration Act.  In so doing it provided some clarity in an area sorely in need of it.  Its approach to the problem was straightforward and based on the text of Federal Arbitration Act Section 5.  The Court’s reasoning also raises some questions that other courts, including Courts in the Seventh Circuit, will need to address if faced with different facts.  And the decision is a helpful springboard for a discussion of the somewhat different arbitrator replacement rules adopted by the United States Court of Appeals for the Second Circuit.

So let us take a brief look at what transpired in Wellpoint and how the Court resolved the problem.  In a future post we shall analyze the decision in light of Second Circuit precedent, and give some thought to how it might influence future courts, including courts within the Seventh and Second Circuits.    

Background

WellPoint arose out of an October 1996 transaction in which WellPoint agreed to purchase various Group Business Operations of Hancock  (the “GBO Transaction”).  As in most purchase and sale transactions, several contracts were involved, including a Purchase and Sale Agreement (“PSA”), a Coinsurance Agreement (which in this context refers to a proportional life reinsurance agreement), and an Administration Agreement (collectively, the “GBO Transaction Agreements”).  Each GBO Transaction Agreement contained an arbitration clause, the arbitrator selection provisions of which provided, in pertinent part:

A panel of three (3) arbitrators will decide any dispute or difference between the parties.  All arbitrators must be (a) disinterested officers or retired officers of life insurance or life reinsurance companies other than the parties to this Agreement or their Affiliates, or (b) disinterested persons of comparable experience.  Each of the parties agrees to appoint one of the arbitrators.  In the event that either party should fail to appoint its arbitrator within twenty (20) Business Days following receipt of the notice demanding arbitration set forth in Section 15.2 hereof, the party demanding such arbitration may appoint the second arbitrator before entering upon arbitration.  The two party-appointed arbitrators shall select a third arbitrator. In the event that the two party-appointed arbitrators shall not be able to agree on the choice of the third arbitrator within twenty (20) Business Days following their appointment, the parties may agree on a third arbitrator within the next twenty (20) Business Days, and if they have not then so agreed, the Denver, Colorado office of the American Arbitration Association shall, at the request of either party, appoint as such third arbitrator a person who meets the qualifications specified in the second sentence of this Section 15.3.

A dispute arose concerning WellPoint’s obligations under three unprofitable books of life insurance business: (1) Fiduciary Administration Services Company (“FASCO Business”); (2) James E. Hackett Reinsurance Corporation (“Hackett Business”); and (3) JEH Re Underwriting Management Bermuda Ltd. (“Bermuda Business”).  The principal question was whether, as part of the GBO Transaction, WellPoint was obligated to make certain payments to Hancock.

WellPoint demanded arbitration and requested the arbitrators to (1) compel Hancock to disclose certain information about the three books of business; and (2) declare WellPoint’s rights and obligations under the GBO Transaction Agreements.  Hancock cross-demanded arbitration for $42.4 million that it claimed WellPoint owed it under the GBO Transaction Agreements.

The parties appointed their arbitrators, who were unable to agree on an umpire.  An umpire was appointed by the American Arbitration Association pursuant to the parties’ arbitration agreement.  During a two-year period leading up to the hearing, the parties conducted extensive discovery, including 29 depositions.  The Panel resolved several discovery disputes and other procedural issues. 

But in July 2005, Hancock sent WellPoint a letter stating that it was increasing its damages demand to $464.6 million.  WellPoint subsequently appointed new counsel, presumably in response to the ten-fold increase in Hancock’s damage claim.  At the same time, WellPoint requested its party-appointed arbitrator to resign.  WellPoint’s party-appointed arbitrator requested the Panel to authorize his resignation, and the Panel accepted it, advising the parties that the “the [remaining] Panel [members] will await WellPoint’s advancing of a candidate for disclosure in accord with the affirmed ‘vetting.’”  Slip op. at 4 (quoting Panel).

WellPoint proposed two replacement candidates, but Hancock objected to both.  Hancock’s party-appointed arbitrator proposed that the remaining Panel members nominate three replacement arbitrators and that WellPoint select an arbitrator from one of the three.  WellPoint initially objected to the proposal, while Hancock appeared to support it.  Hancock’s counsel stated at one point that he “believe[d] there is case law that will support this . . . .”  Slip op. at 4 (quoting Hancock’s counsel). 

WellPoint ultimately agreed, the Panel proposed three candidates, and WellPoint selected a retired Chief Justice of the Nebraska Supreme Court who also had served as an officer of a life insurance company.  During the disclosure and vetting process, Hancock renewed its objections to the resignation of WellPoint’s party-appointed arbitrator, but agreed that his replacement arbitrator met the arbitrator qualifications set forth in the arbitration agreement.  The Panel then declared itself “duly constituted.”   Slip op. at 5 (quoting umpire). 

The arbitration proceeded as scheduled and was conducted in two phases.  Phase I concerned issues relating to liability and the categories of potential damages.  The Panel determined in Phase I that WellPoint had assumed 100 percent of the Hackett Business and 100 percent of the FASCO business, but that it had not purchased the Bermuda Business.  Hancock’s party-appointed arbitrator dissented from the Bermuda Business portion of the ruling. 

Phase II was limited to the quantification of damages. The Panel issued a Phase II award directing WellPoint to pay Hancock $26 million in damages (later revised with the consent of the parties to $26.4 million), plus $2.9 million in “offsetting balances and interest assessments.”  As the outcome was effectively a victory for WellPoint, it filed a petition seeking confirmation of the award, and Hancock cross-petitioned to vacate.  Hancock contended that the panel was not selected as provided in the arbitration agreement.

The district court confirmed the award, understanding the issue to be “whether the panel has authority to render an award when an arbitrator has been duly selected by a party but subsequently withdraws, and the arbitration agreement does not expressly provide for this contingency.”  Slip op. at 6 (quoting district court).  The district court held that the arbitration award required only that arbitration proceed before a panel comprised of an arbitrator selected by each party and one neutral arbitrator and, because that is what happened, the Panel did not exceed its authority under Federal Arbitration Act Section 10(a)(4).  The district court rejected WellPoint’s alternative argument that Hancock had waived its challenge to the composition of the Panel by not seeking relief under Section 5 of the Federal Arbitration Act, which allows the Court to determine whether an arbitrator has been appointed in the manner provided for in the parties’ agreement, and to appoint replacement arbitrators under appropriate circumstances. 

The Court’s Decision

The Court held that “Section 5 of the FAA expressly gave the district court the authority to resolve any issue about the way the parties handled a vacancy on the arbitral panel.  .  .  .  [and that] Hancock’s failure to use that tool, under the circumstances of this case, resulted in its forfeiture of this challenge.  No ‘reservation of right’ to challenge the issue on appeal absolves Hancock from this requirement.”  Slip op. at 12.  

Hancock contended that the arbitration agreement does not “’permit either party to remove an arbitrator or to appoint a replacement. . . . [and] the District Court . . . misconstrued the Arbitration Agreement in a way that significantly departed from the intent of the parties . . . .’”  Slip op. at 7 (quoting Hancock’ submissions).   Relying on what it characterized as the “general rule,” Hancock argued that the arbitration must begin anew because the arbitration agreement did not expressly address the contingency of a vacancy on the panel.  It relied on the Second Circuit’s decision in Marine Products  Export Corp. v. M.T. Globe Galaxy, 977 F.2d 66, 68 (2d Cir. 1992) (here), which held that the death of a member of a tri-partite arbitration panel prior to the rendering of an award requires the arbitration to commence anew before a newly-appointed panel, unless the parties’ agreement expressly provides for the contingency of a vacancy, or there are special circumstances warranting the court’s appointment of a replacement arbitrator.   

The Court rejected this argument, finding “no such inflexible and wasteful rule in the law of arbitration.”  The Court said that Section 5 of the Federal Arbitration Act expressly provides a “rule that applies to the mid-stream loss of an arbitrator.”  Section 5, provides, in pertinent part, that:

If in the agreement provision be made for a method of naming or appointing an arbitrator or arbitrators or an umpire, such method shall be followed; but if no method be provided therein, or if a method be provided and any party thereto shall fail to avail himself of such method, or if for any other reason there shall be a lapse in the naming of an arbitrator . . . or in filling a vacancy, then upon the application of either party to the controversy the court shall designate and appoint an arbitrator . . .who shall act under the said agreement with the same force and effect as if he or they had been specifically named therein. . . .

9 U.S.C. § 5 (emphasis added). 

The Court observed that Section 5 expressly authorizes a court to appoint a replacement arbitrator in the event of a “vacancy,” and that provision of authority “would never have any room to operate.  .  .  if every time an unanticipated vacancy occurred, the clock were automatically set back to zero.”   Slip op. at 9.  The Court said it would be “inconsistent with the purpose of the FAA, which is designed to facilitate efficient resolution of commercial disputes, to permit a party like Hancock to sit silently by while a substitute arbitrator is selected according to the procedure proposed by its own representative on the panel, and then raise an objection to the process only after it has lost before the panel and it is attempting to oppose confirmation of the award.”  Slip op. at 9-10. 

The Court rejected Hancock’s argument that the FAA provided two avenues for contesting the appointment of an arbitrator:  (a) pre-award under Section 5; and (b) post-award under Section 10(a)(4), which permits a court to vacate an award “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.”  9 U.S.C. § 10(a)(4); see slip op. at 10.  The Court said: 

What Hancock fails to appreciate, however, is that this approach does not give full effect to each part of the statute.  If the statute were read to permit an objecting party to take a “wait and see” approach, no one would ever have an incentive to use § 5.  Instead, each party could hold back and await the outcome of the proceeding.  If that outcome were to its liking, then it would defend the substitution; if that outcome were not to its liking, then it could attack the method either the court or the parties used to nominate the new arbitrator.  Moreover, if there really were a general rule that substitutions are forbidden once the arbitration is underway (as long as the agreement is silent), then there would never be a case in which a court could fill a vacancy upon the application of a party. We decline to read the FAA in a way that effectively deletes this part of § 5, nor will we interpret it as creating a ‘heads I win, tails you lose” system.’

Slip op. at 10.  

The Court stopped short, however, of imposing a rule requiring resort to Section 5 in all circumstances, acknowledging that “[t]here may be some situations where a motion under § 5 cannot address the problem,” and that “there may be times when a party can show good cause to overcome a forfeiture of the § 5 process and can raise its objections at the § 10(a)(4) stage.”  Slip op. at 11.  But the Court declined to speculate as to what those situations might be, because it considered “this case.  .  . [to be] so far from any plausible scenario:”

Hancock’s equivocal behavior—starting with the fact that the substitution procedure actually used was proposed by.  .  . its own party-arbitrator, continuing with its legal argument supporting.  .  .  .  [the] suggestion, and ending with its acknowledgment that [WellPoint’s replacement arbitrator].  .  . met the qualifications required in the agreement—coupled with its decision to wait until the arbitration was concluded, was a ‘transparent attempt to preserve a threshold procedural issue in case. . . [it] eventually lost the arbitration on the merits.’  Nothing in the FAA requires us to endorse this behavior.

Slip op. at 11 (quoting  Dow Corning Corp. v. Safety National Cas. Corp., 335 F.3d 742, 748-49 (8^th Cir. 2003) (here)).  Alternatively, observed the Court, “Hancock’s own participation in the substitution process should estop it from complaining now about it, and so even if we thought that § 5 could be bypassed (which we do not), this would not be an appropriate case for relief.”  Slip op. at 12-13.  

The Court also rejected Hancock’s argument that requiring resort to Section 5 would be inefficient because it would breed interlocutory appeals.  The Court said that “while an interlocutory motion to challenge an appointment does temporarily affect the arbitration, it is far less efficient for the court to hold at the § 10 stage that the appointment was improper.  In fact, if anything risks too much judicial involvement, it is Hancock’s proposed system, under which judges would second-guess the arbitral panel’s own approach toward solving an interim procedural issue.”  Slip op. at 12.  

We shall provide in a future post our critical analysis of WellPoint, and compare it to Second Circuit law on arbitrator vacancy.  So stay tuned until then.  .  .  .