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The AAA Commercial Rules and the Pig in a Poke: Gilbert Street Developers, LLC v. La Quinta Homes, LLC

June 24th, 2009 Arbitrability, Authority of Arbitrators, California State Courts, Grounds for Vacatur 3 Comments » By Philip J. Loree Jr.

Introduction

Under the Federal Arbitration Act and federal labor law, arbitrators can decide arbitrability questions subject only to deferential review, provided the parties “clearly and unmistakably” delegate that power to them.  California’s state arbitration law follows this familiar federal rule. 

On June 11, 2009 the California Court of Appeal, Fourth District, Division 3, held that the parties to an arbitration agreement did not “clearly and unmistakably” agree to arbitrate arbitrability by incorporating the Commercial Rules of the American Arbitration Association into their contract, because at the time the parties agreed to arbitrate, the rules were silent on whether arbitrators could decide arbitrability questions.  See Gilbert Street Developers, LLC v. La Quinta Homes, LLC, ___ Cal. Rptr.3d ___, slip op (Cal. App. 4th Dist. June 11, 2009) (certified for publication) (copy available here).  The Court so held even though the parties agreed that the arbitration would be “conducted in accordance with the Rules of the American Arbitration Association existing at the date [of the arbitration].  .  .  . ,” and by the date of the arbitration the rules had been amended to provide expressly that the arbitrators had the authority to determine their own jurisdiction.  See slip op. at 2-3.  The Court also held that the operation of a “buyout” clause in the parties’ agreement did not fall within the scope of the parties’ arbitration clause because it involved discretionary matters, which were expressly excluded from arbitration.  See slip op. at 15-16. 

Background

In July 1998 Tone Yee Investments and La Quinta Homes formed a limited liability company, Gilbert Street Development, to acquire and develop certain properties.  Prince Properties, controlled by Tone Yee, became a member of Gilbert in February 1999.  Gilbert’s operating agreement contained an arbitration clause that provided, in pertinent part: 

Any controversy or dispute arising out of or relating to this agreement or the breach thereof (exclusive of matters which are expressly within the discretion of the Members) shall be settled by binding arbitration.  Such arbitration.  .  .  shall be conducted in accordance with the Rules of the American Arbitration Association existing at the date thereof.  .  .  . 

The operating agreement also contained a “buyout” clause, which will be discussed in more detail below.  Essentially, it enabled a member that invoked the clause to either buy out another member’s interest, or have another member buy out the interest of the member invoking the clause. 

In 1998, when Yee and La Quinta formed Gilbert, and in 1999, when Prince joined Gilbert, the AAA Commercial Rules were silent on whether an arbitrator had the power to decide his or her own jurisdiction.  In September 2001, however, the AAA adopted Rule 8-(a), which provided that arbitrators “shall have the power to rule on.  .  .  jurisdiction, including any objections with respect to the existence, scope or validity of the arbitration agreement.”  (Rule 8-(a) was later recodified as Rule 7 of the AAA Commercial Rules.)

In 2008 a dispute arose between Yee and Prince (the “Lee Parties”) and La Quinta over a third-party offer to purchase one of Gilbert’s properties for $13.3 million.  The Yee Parties wanted to sell, but La Quinta did not, which prompted the Lee Parties to invoke the buyout clause and demand arbitration.  La Quinta objected to the arbitration demand, contending:  (a) the buyout clause was a matter within the “discretion” of the parties and therefore was not subject to arbitration; (b) the arbitrators were not authorized to decide their own jurisdiction, that is, whether the buyout clause was a proper subject of arbitration.   

An arbitration hearing was held later in 2008, but La Quinta did not appear.  The arbitrators determined that they had the power to decide their own jurisdiction and made the following rulings: 

  1. Gilbert owed Tone Yee more than $29 million;
  2. The Yee Parties properly invoked the buyout provision;
  3. La Quinta is no longer a member of Gilbert;
  4. Gilbert could sell the property;
  5. $13.3 million was a fair price for the property;
  6. La Quinta was not entitled to any of the proceeds from the sale of the property; and
  7. La Quinta had to execute all documents necessary to relinquish its interest in Gilbert and effectuate the sale of the property.

The Yee Parties moved to confirm the award, but the trial court vacated it on the ground that the arbitrators did not have the power to determine their own jurisdiction.  The trial court said that the AAA rules were silent in 1998 on whether the arbitrators could determine their own jurisdiction and “‘the possibility of a change in the [AAA] Rules is not sufficient to show a clear and unmistakable intent by the parties that the arbitrator would decide issues of arbitrability at the time the agreement was entered.'”  See slip op. at 4.  The trial court also held that the buyout clause procedure was discretionary and thus not subject to arbitration.   The Yee Parties appealed. 

Did the Parties Clearly and Unmistakably Delegate to the Arbitrators the Power to Determine their own Jurisdiction? 

The Court held that, under the circumstances of this case, the parties’ incorporation of the AAA Rules did not provide clear and unmistakable evidence that the parties delegated to the arbitrators the power to determine their own jurisdiction.   First, the Court reviewed the the evolution of the “clear and unmistakable rule” from the Steel Workers Trilogy through AT&T Technologies, Inc. v. Communications Workers, 475 U.S. 643, 648-49 (1986) and First Options of Chicago, Inc. v. Kaplan, 514 U.S. 938, 944-45 (1995), and concluded that the purpose of the rule was to ensure that the parties had thought about and focused on the issue of who – judge or arbitrator – would decide arbitrability. 

Second, noting that “the hard part” of the clear and unmistakable rule “is applying it,” the Court briefly examined two California appellate court cases that held that incorporation of the AAA Commercial Rules satisfied the rule, but concluded that those cases “represent[ed] the outer limits of the use of incorporation by reference” to establish a clear and unmistakable intent that the arbitrators would decide arbitrability.  See  slip op. at 9.  In those cases, observed the Court, the pertinent AAA Commercial Rule was in existence at the time the parties incorporated the rules by reference, and “the parties could go look up the AAA rules to which they were agreeing before hand, and see that .  .  . they were conferring on arbitrators the power to decide if a dispute was arbitrable in the first place.”  Id.  (emphasis in original)  Declining to extend those cases to the situation before it, the Court said that “[t]o go beyond the incorporation of an existent rule and allow for the incorporation of a rule that might not even come into existence in the future.  .  . contravenes the clear and unmistakable rule.”  Id.  (emphasis in original)  Far from meeting the clear and unmistakable requirement, “[i]ncorporating the possibility of a future rule by reference simply doesn’t even meet the basic requirements for a valid incorporation by reference under simple state contract law.”   Id.  (emphasis in original): 

To allude to that old medieval con game from which we get the expression ‘pig in a poke’ – where an unsuspecting buyer would buy what he or she thought was a pig in a bag only to later discover that it was an inedible cat or rat – in [the other two California appellate court cases].   .  . there was at least some thing in the bag that the parties could look at.  Here, by contrast, the bag was empty at the time of the transaction and might or might not, be later filled with a pig.  Or a cat or rat or, for that matter, nothing. 

Slip op. at 10.  (emphasis in original)

Third, the Court found “instructive” a split in the federal courts over whether incorporation of the NASD Rules (now, the FINRA Rules) satisfied the clear and unmistakable rule.  Those cases considered NASD Rule 35, which stated:    

The arbitrators shall be empowered to interpret and determine the applicability of all provisions under this Code and to take appropriate action to obtain compliance with any ruling by the arbitrator(s).  Such interpretations and actions to obtain compliance shall be final and binding upon the parties.

The Court observed that the majority of the federal circuit courts of appeals held that incorporating the NASD Rules, including Rule 35, did not satisfy the clear and unmistakable rule, while a minority of courts held that such incorporation demonstrated the requisite clear and unmistakable intent.  See slip op. at 10; cf. Miller v. Flume, 139 F.3d 1130, 1134 (7th Cir. 1998) (majority rule) with Painewebber Inc. v. Bybyk, 81 F.3d 1193, 1199 (2d Cir. 1996) (minority rule).  The Court found the cases espousing the majority rule to be persuasive, whereas the minority rule cases did “not focus on what First Options made explicit (and AT&T had earlier implied), about the importance of the parties specially focusing on the issue.”   Slip op. at 12.  (emphasis in original)  The minority rule cases simply reasoned “that the parties agreed that all disputes would be arbitrated between them, and jurisdiction to decide jurisdiction is necessarily included in the category of all disputes.”  Slip op. at 11.   

The majority rule cases emphasized what the Court considered to be the key to the clear and unmistakable rule:  the need for the parties to have actually have considered and focused on whether they were agreeing to alter the ordinary allocation of power between courts and arbitrators.  Here, from the standpoint of ordinary contract law, the parties clearly and unmistakably took the risk that the AAA Commercial Rules might one day provide that the arbitrators have the power to determine their own jurisdiction.  But in the Court’s view that was not enough.   To satisfy the clear and unmistakable rule, the parties, at the time of contracting, had to have evidenced their intent in no uncertain terms that the arbitrators should have the power to determine their own jurisdiction.   But query what the result would have been if  there was clear and unmistakable extrinsic evidence that:  (a) the parties were aware that there was a risk that the AAA Commercial Rules might one day provide that the arbitrators would have the power to determine their own jurisdiction; and (b) after carefully considering the risk, the parties were willing to take it by agreeing to be bound by whatever version of the AAA Commercial Rules happened to be in effect at the time an arbitration was commenced?   

Was the Buyout Clause within the Scope of the Parties’ Arbitration Agreement? 

Having concluded that arbitrability was a matter for the Court to decide, the Court  considered whether the arbitrators had the authority to decide a dispute that turned on the buyout clause.  La Quinta contended, and the Court agreed, that the operation of the buyout clause involved matters within the parties’ discretion and therefore was not subject to arbitration. 

The arbitration clause exempted from arbitration “matters which are expressly within the discretion of the Members.”  Quoting the Oxford English Dictionary, the Court said that “matters” are the “stuff of which a thing is made,” and in the context most closely related to a contract, it meant “Material for expression, something to say.”  The Oxford English Dictionary defined “discretion” as “the action of separating or distinguishing, or the condition of being distinguished or disjunct; separation, disjunction, distinction.”  See slip op. at 13. 

The “matters” the Yee parties wanted to arbitrate were its claims that:  “(a) it properly exercised its rights under the buy-out clause[;] and (b).  .  . La Quinta must either (i) pay $1.3 million to the Yee parties or (ii) transfer its entire interest in the company to the Yee parties.”    See slip op. at 13.  (emphasis in original).  But the rather lengthy buyout clause – fully reproduced in the Court’s opinion – provided that “[i]n the event of a dispute among the Members which cannot be resolved, then either Member (“electing member”) may elect to either buy the other Member’s Interest or sell its own Interest to the other Member as follows: .  .  .  .”  Id. (emphasis supplied by the Court)  What followed was a detailed procedure for effectuating the buying or selling of a member’s interest, which conferred upon each party a good deal of discretion to choose how the sale or purchase would take place.  The last paragraph of the clause said:  “If the Other Member fails to elect to either buy or sell pursuant to the Offer within the prescribed time period, the Electing Member, at its option, may (i) continue the Company, or (ii) elect within thirty days to buy the interest of the Other Members pursuant to the Offer.”   Slip op. at 15.  (emphasis supplied by the Court)

The Court reasoned that “[a] simple binary choice as here (should I buy or should I sell?) qualifies under the ordinary person’s definition of  discretion.  .   .  .”   The Yee parties’ “petition identified matters which necessarily involve member choice:  whether the Yee parties properly invoked the buy-out clause in the first place, and, if they did, who has in effect elected to buy whom out, and for what.”   Slip op. at 16.   The arbitrators, however, essentially made all of those choices for La Quinta, thereby ruling on matters that were within La Quinta’s discretion and outside the scope of the arbitration clause.

         

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3 Responses to “The AAA Commercial Rules and the Pig in a Poke: Gilbert Street Developers, LLC v. La Quinta Homes, LLC”

  1. […] Loree Reinsurance and Arbitration Law Forum provides discussion and insights on reinsurance litigation and arbitration and is published by New York-based boutique commercial and industry arbitration firm Loree & Loree. This blog demonstrates quality writing on newsworthy topics that distinguish the top ADR blog; a recent example is “The AAA Commercial Rules and the Pig in a Poke: Gilbert Street Developers, LLC v. La Quinta Homes, L…“. […]

  2. […] Loree Reinsurance and Arbitration Forum provides discussion and insights on reinsurance litigation and arbitration and is published by New York-based boutique commercial and industry arbitration firm Loree & Loree. This blog demonstrates quality writing on newsworthy topics that distinguish the top ADR blog; a recent example is “The AAA Commercial Rules and the Pig in a Poke: Gilbert Street Developers, LLC v. La Quinta Homes, L…“. […]

  3. […] to decide arbitrability when the parties clearly and unmistakably so agree.  (See, e.g., here and here.)  That’s all well and good, but what happens when:  (a)  two parties sign an arbitration […]