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Res Judicata and Consolidated Arbitration: the Sixth Circuit puts the Kibosh on the “Contagion Theory of Arbitration”

September 17th, 2014 Appellate Practice, Arbitrability, Arbitration Agreements, Arbitration as a Matter of Consent, Arbitration Practice and Procedure, Authority of Arbitrators, Awards, Confirmation of Awards, Consolidation of Arbitration Proceedings, Construction Industry Arbitration, Contract Interpretation, Drafting Arbitration Agreements, Existence of Arbitration Agreement, Final Awards, Judicial Review of Arbitration Awards, Michigan State Courts, Practice and Procedure, Preclusive Effect of Awards, Res Judicata or Claim Preclusion, State Courts, United States Court of Appeals for the Sixth Circuit, United States Supreme Court Comments Off on Res Judicata and Consolidated Arbitration: the Sixth Circuit puts the Kibosh on the “Contagion Theory of Arbitration” By Philip J. Loree Jr.

Res judicata—Latin for a “matter” or “thing” “decided”—is the legal principle under which a final judgment in one action bars the same parties from relitigating in another, successive action matters that were or could have been asserted in that  first action. Also known as “claim preclusion”, it is designed to promote finality and judicial economy, and to protect persons from vexatious litigation. See, generally, Taylor v. Sturgell, 553 U.S. 880, 891 (2008).

But can an unconfirmed arbitration  award preclude a party from maintaining a court action to resolve a matter that it did not submit or agree to submit to arbitration? Suppose:

  1. A has an arbitration agreement with B (the “AB Agreement”);
  2. B has an arbitration agreement with C (the “BC Agreement”);
  3. A and C did not agree to arbitrate any disputes between them;
  4. The AB Agreement contemplates the parties arbitrating their claims against each other in a consolidated arbitration that may involve factually-related disputes that B has agreed to arbitrate with C or other third parties, provided those third parties consent to consolidated arbitration;
  5. The AB Agreement does not purport to require A or B to arbitrate any disputes between (a) A or B or both; and (b) C or any other non-party;
  6. The BC Agreement does not purport to require B or C to arbitrate any disputes between (a) B or C or both; and (b) A or any other third party;
  7. A dispute arises between A and B, and A demands arbitration against B;
  8. B, in turn, demands arbitration against C, seeking indemnity from C for any liability B may have to A;
  9. The AB and BC arbitrations are consolidated over A’s objection;
  10. A knows it has a legal and factual basis for asserting a tort claim against C arising out of the same transactions and occurrences at issue in the consolidated arbitration, but does not submit (or attempt to submit) that claim to arbitration;
  11. The arbitration proceeds, and the arbitrator issues a final award finding that B is liable to A for $X in damages and that C is not obligated to indemnify B;
  12. Nobody seeks to confirm, vacate, modify or correct the award; and
  13. A subsequently brings an action in court against C, which seeks damages from C allegedly caused by C’s negligent conduct with respect to the same transactions and occurrences that were the subject of the consolidated arbitration.

Is A’s lawsuit barred by res judicata?

On August 28, 2014, in O’Neil v. Shepley, No. 13-2320, slip op. (6th Cir. Aug. 28, 2014),  the U.S. Court of Appeals for the Sixth Circuit, in a 2-1 decision, said the answer was “no,” and that the answer would have been the same had the AB/BC award been confirmed. See slip op. at 10-11.

The two-judge majority opinion—authored by Chief Circuit Court Judge R. Guy Cole, and joined by Circuit (and former Chief) Judge Danny Julian Boggs—minced no words when it said that to bar A’s lawsuit based on res judicata would be to endorse a “contagion theory of arbitration” that “has no basis in law or the relevant contracts[:]”

Simply put: the premise of arbitration is consent and [A] did not consent to arbitrate the present claims [against C]. Our judicial doctrines do not force it to do so now.

Slip op. at 10-11.

Circuit Court Judge David William McKeague dissented, arguing that the “court does not need to infect [A] with a ‘contagion theory of arbitration’ to bar his claims with res judicata. It merely needs to hold him to the basic terms of his contract. Any infection that [A] O’Neil has acquired is its own doing.” That was so, claimed the dissent, because:

[The AB arbitration was] eventually expanded to include [C]. Moreover, in [subcontractor A’s] contract with [construction manager B], [A] agreed to arbitrate his grievances with [B] and further agreed in a standard ‘flowthrough’ provision to be ‘bound by the procedures, decision and determinations resulting from any dispute resolution process’ in the contract between [B] and [the owner].  The contract between [B] and the [owner] required all disputes, among all contractors, to be submitted to binding arbitration.

Slip op. at 13 (emphasis in original) (McKeague, J., dissenting).

All three judges appeared to agree that res judicata does not turn on whether the first proceeding would have barred the second had the first been a plenary court proceeding. The difference of opinion between the majority and dissent was that the dissent was prepared to find A’s agreement to consolidated arbitration was the functional equivalent of an agreement arbitrate its claims against any person who might consent to join such a consolidated arbitration, even if A had no contractual relationship with that person, let alone a written agreement to arbitrate.

We think the majority’s read of the relevant contractual provisions gave effect to the parties expressed intent, whereas the dissent’s view of what the parties agreed did not. But to appreciate why, you’ll need to take a closer look at the Sheply facts, which in substance are much like (but not identical to) those in our hypothetical.

Sheply Facts and Procedural History

 Shepley arose out of the construction of a hospital for a university (the “Owner”). B was the construction manager, A was a subcontractor and C represented one, two or all of three parties: the Owner, an architect and an engineer/designer.

Owner contracted with the architect, which, in turn, subcontracted with the engineer/designer, who was to provide “design services related to the mechanical, electrical, plumbing, and fireprotection systems” for the hospital. See slip op. at 2.

Owner separately contracted with B, the construction manager, who, in turn subcontracted with A, who was “to serve as the mechanical contractor to supply and install plumbing, heating, ventilation, and cooling systems.” Slip op. at 2-3. That subcontract is what in our hypothetical we referred to as the “AB contract.” A did not have a contract with the architect or the engineer/designer. Slip op. at 3.

A commenced an action against B, and the architect and engineer/designer in a Michigan state court, alleging that “design errors and other failures caused [A] to incur substantial damages during the construction.” The state court dismissed the action against B “because [B’s] contract with [A] required the two to resolve their disputes by binding arbitration.” Slip op. at 3. The state court stayed the claims against the architect and engineer/designer and subsequently dismissed them without prejudice pursuant to a stipulated order made in view of the contemplated AB arbitration.  Id.

A demanded arbitration against B, asserting claims for damages in the amount of $19 million for “breach, cardinal change, and abandonment of contract ‘arising from substantial design errors and mismanagement of the project by the owner and general contractor.’” Slip op. at 3 (apparently quoting arbitration demand). B, in turn, demanded arbitration against the Owner under its contract with the Owner, claiming indemnification for any liability B might have to A for the alleged errors of the architect and engineer/designer. These two arbitrations were consolidated, although the Court did not say whether the consolidation was ordered by the arbitrators, or by a court pursuant to a Michigan statute authorizing judicial consolidation of related arbitration proceedings. See Mich. Comp. Laws Ann. § 691.1690; slip op. at 3.

The Owner demanded arbitration against the architect, and in response, the architect sought indemnification from the engineer/designer. These claims were also made part of the consolidated arbitration proceeding.

The consolidated arbitration featured extensive discovery, a 42-day hearing conducted over a nine-month period, testimony from 50 witnesses and thee parties’ collective submission of some 1,400 hearing exhibits. A did not assert formally any claims against the architect and the engineer, but A’s claims against the construction manager (B) “implicated and were hostile” to the architect and the engineer/designer. See slip op. at 3.

The arbitrators issued an interim award against B that awarded A $2.4 million in damages attributable “‘to a change in the schedule caused by many factors, but largely due to the [hospital] plans being more difficult, time consuming, and expensive to coordinate . . . all of which constitutes a breach of [A’s] contract with [B].’” Slip op. at 3-4 (quoting interim award). The panel also ruled that B “failed to establish its indemnity claims against the [Owner], noting that ‘the bulk of the claims that [B] might have had against [the Owner] were all settled and released’ by change orders [B] had signed with the [Owner].” Slip op. at 4 (quoting interim award). The panel thus also “denied the indemnity claims flowing through the [Owner] to [the architect and engineer/designer].” Id. Ultimately, the interim award was made part of a final award concluding the arbitration, and no party sought to vacate, confirm or modify it. See slip op. at 4.

A subsequently sued the architect and engineer/designer in the United States District Court for the Eastern District of Michigan against, invoking the diversity jurisdiction. A alleged “claims for professional negligence, tortious interference, and innocent misrepresentation against both companies based on their design failures.” Slip op. at 4. The district court dismissed the action, ruling it was barred by res judicata under Michigan law. Id. A appealed and the Sixth Circuit reversed.


The Sixth Circuit’s Decision

Before addressing the merits of the res judicata question, the Court discussed a vertical choice-of-law question: whether the district court should have applied Michigan or federal res judicata rules. The Court’s discussion of that topic is interesting and worth reading, but ultimately the court did not need to resolve the question, because it concluded that Michigan and federal law on res judicata rules were materially identical. Thus, while the Court cited principally federal cases interpreting federal-law res judicata rules and principles, it noted that its analysis and conclusion would be the same under Michigan law. See slip op. at 6.

Does an Unreviewed Arbitration Award Bar the Later of Litigation of a Claim that the Parties did not—and were not Required to—Submit to Arbitration?

Having neutralized a potentially vexing vertical choice-of-law question, the court turned to whether “an unreviewed arbitration award bars the later litigation of a claim not subject to the arbitration.” Slip op. at 6. It concluded that “res judicata yields where the claims sought to be precluded were not subject to the arbitration[,]” and that, accordingly, “an unreviewed arbitration award does not bar a later claim that the parties had not agreed to arbitrate.”  Slip at 9.

The Court found that there “was good reason” not to give preclusive effect to an unreviewed award in a litigation concerning a dispute that was not subject to arbitration. Arbitral authority, said the Court, “derives solely from, and is limited by, the contract between the parties.  .  .  .” and arbitrators thus “lack[] authority to decide claim the parties have not mutually agreed to arbitrate.  .  .  .” Slip op. at 7 (citations omitted).

It “makes,” noted the Court, “little sense to allow an arbitration proceeding or award to preclude a claim the arbitrator had no authority to decide.” Slip op. at 7 (citations omitted). But even apart from that, permitting an arbitration award to bar a non-arbitrable claim in a subsequent litigation “would force a party, through the doctrine of res judicata, either to arbitrate a claim it had not agreed to arbitrate or to effectively give up the claim.” Slip op. at 7. Indeed, “[r]equiring  arbitration of a claim the plaintiff had not agreed to arbitrate would, in effect, bind the plaintiff to a contract to which it never agreed.” Id.

The Court found Moses H. Cone Memorial Hospital v. Mercury Construction Corp., 460 U.S. 1 (1983) (Brennan, J.), to be “instructive.” Slip op. at 8. Although that landmark case is most often cited as support for the FAA’s presumption of arbitrability, the Sixth Circuit found its facts, procedural history and outcome to be illustrative of the relationship between arbitrability and res judicata.

Moses Cone arose out of a multi-party construction dispute involving related arbitrable and non-arbitrable disputes. The contractor sought to recover from the owner costs attributable to project-completion delays. The owner brought a declaratory judgment action in state court against the contractor, which also sought indemnity from the architect for any liability the owner might have to the contractor. The owner had agreed to arbitrate with the contractor, but not the architect.

The contractor commenced in federal district court an action to compel the owner to arbitrate, but the district court held that abstention doctrine required it to stay the contractor’s action so that the state court action could proceed.

The U.S. Supreme Court held that the district court should not have stayed the action to compel arbitration and should have instead granted the application to compel, “in part, because ‘an arbitration agreement must be enforced notwithstanding the presence of other persons who are parties to the underlying dispute but not to the arbitration agreement.’” Slip op. at 8 (quoting Moses Cone, 460 U.S. at 20, 29). As the Sixth Circuit observed, “[t]hough the hospital’s dispute with the construction company could be arbitrated, the [Supreme] Court specifically recognized that the hospital’s dispute with the architect ‘cannot be sent to arbitration without the Architect’s consent, since there is no arbitration agreement between the Hospital and the Architect. . . . [T]he Hospital’s two disputes will be resolved separately — one in arbitration, and the other (if at all) in state court litigation.’” Slip op. at 8 (quoting 460 U.S. at 19-20).

The Sixth Circuit thought it significant that: (a) in Moses Cone “even though two disputes had closely-related facts and one dispute would be arbitrated, the Court did not require the second dispute to be arbitrated in the absence of an arbitration agreement[;]” and (b) the Supreme Court did not “indicate that decisions in the arbitration of the first dispute would preclude any claims in litigation of the second.” Slip op. at 8 (citations omitted). “Res judicata,” said the Court should operate similarly.” Slip op. at 8.

The Sixth Circuit also found support in the Restatement (Second) of Judgments, which states that “generally ‘a valid and final award by arbitration has the same effects under the rules of res judicata, subject to the same exceptions and qualifications, as a judgment of a court.’” Slip op. at 8 (quoting  Restatement (Second) of Judgments (“Restatement”) § 84(1) (1982)). The Restatement, explained the Court, applies the same res judicata rules to judgments and arbitration awards, “but ‘the terms of these rules may more often result in denying preclusive effect to determinations reached in arbitration proceedings.’” Slip op. at 8 (quoting Restatement § 84, cmt f).

According to the Restatement commentary, “‘[a]n arbitration proceeding is much like an adjudication before a court of limited jurisdiction so far as the scope of its authority is concerned.’” Slip op. at 9 (quoting Restatement § 84, cmt f). Just as a judgment of a court of limited jurisdiction does not bar a party from raising in a second proceeding a claim the party could not have asserted in the first because of a jurisdictional limitation, a prior arbitration award should not bar a later judicial proceeding concerning a claim that the parties were not contractually obligated to submit to arbitration in the first proceeding. See slip op. at 9.

Did A Agree to Submit to Arbitration its Claims against the Architect and Designer/Engineer?

The Court held that there was “no evidence” that A agreed to arbitrate its professional negligence, tortious interference and innocent misrepresentation claims against the architect and the engineer/designer, both of whom conceded that there was no contractual relationship between A and them. See slip op. at 9. The architect, however, argued that A agreed with B “to allow [B] to join [A] to any arbitration about the construction project to which [B] was a party[,]” and that A “agreed to be ‘bound by the procedures, decisions and determinations resulting from any dispute resolution process’ in the contract between [B] and [the Owner].” Slip op. at 9 (quoting A-B contract). The contract between B and the Owner required arbitration of disputes between the Owner and any construction team member, including A, the architect and the engineer/designer. The B-Owner contract also provided that “‘[a]ny person may join any other person who participated in the Project to arbitration,’ so long as ‘such person or entity has consented to arbitration.’” Slip 9-10 (quoting B-Owner contract).

But A’s contract with B did not obligate A to arbitrate its claims against the architect and the engineer/designer. It was “far from clear” that the architect or the engineer/designer could enforce the A-B contract, since they were not parties to that contract or third party beneficiaries of it.” Slip op. at 10 (citation omitted). And, “[m]ore fundamentally,” the A-B contract did not purport to require A “to raise and arbitrate claims against [the architect and the engineer/designer] or forever lose those claims.” Slip op. at 10.

The A-B contract, said the Court, “appears to require [A] to consent to be joined to the consolidated arbitration and be bound by the ‘procedures, decisions and determinations’ resulting from the arbitration[,]” but did impose upon A an obligation to assert and arbitrate claims it might have against persons who were parties to the consolidated arbitration but had not agreed to arbitrate with A. As the Court pointed out, the engineer/designer “rightly concede[d] that it would not be forced to arbitrate A’s claims[]” against it, and “[w]e agree.” Slip op. at 10.

A, the Court concluded, was not required to “arbitrate its claims against [the architect and the engineer/designer] simply because [A] had an arbitration agreement with one company [B], that company had arbitration agreements with the [architect and the engineer/designer], and the disputes among the parties arose from the same circumstances.” “Such a scenario,” said the Court, “might provide grounds to force the parties to consolidate separate arbitrations, see Mich. Comp. Laws Ann. § 691.1690, but it is not grounds to conclude that [A] agreed to arbitrate its claims against the [architect and the engineer/designer].”  Slip op. at 10-11 (citation in original).

Would the Outcome have been Different had a Michigan State Court Reviewed the Award?

The court explained that the outcome would have been the same had a Michigan court reviewed the award. In that circumstance said the Court, the district court would be required to accord the judgment confirming the award the same force and effect as would a Michigan court.

Michigan follows the general rule that a prior judgment bars in a subsequent action only matters that were or could have been resolved in the prior one. And under Michigan arbitration law, the court’s authority was limited to confirming, vacating, modifying or correcting the award. See slip op. at 11 (citations omitted).

A judgment confirming the award would not have barred A’s claims against the architect and the engineer/designer because A “could not have asserted” those claims “in a state court proceeding reviewing the arbitration [award],” and they thus “could not have been resolved in that action.” See slip op. at 11 (citations omitted).

*                  *                  *

Sheply is one of those interesting and potentially quite influential arbitration-law cases that do not necessarily seem so at first glance. Most arbitration-law cases concern the enforcement of an arbitration agreement, yet most often concern applications to: (a) compel arbitration or stay litigation (or both); (b) appoint arbitrators; or (c) confirm, vacate, modify or correct arbitration awards. Sheply concerned the enforcement of arbitration agreements, but in the context of whether a prior award in a related matter barred a subsequent litigation between persons who were parties to a consolidated arbitration involving various related claims between various persons arising out of essentially the same facts, but under circumstances where the parties to the subsequent litigation had not submitted or agreed to submit the claims between them to arbitration.

The case demonstrates that consensual nature of arbitration and the nonconsensual nature of litigation requires that they be treated a bit differently for res judicata purposes, albeit for essentially the same reasons. In litigation, whether or not a party “could have” raised a claim in a prior court proceeding depends on the jurisdiction of the court or the nature of the proceeding itself. That rule is sound because the scope of matters a court may hear as respects an underlying controversy is determined by constitutional and statutory provisions, case law and procedural codes and rules. Generally there is but one answer to the question whether a party could have—and thus should have—asserted a particular claim in the prior court proceeding.

But arbitration is very different in that the scope of matters an arbitrator or panel of arbitrators may resolve is generally limited only by contract, provided that the matter that is capable of resolution by arbitrator (as most are). No matter how narrow the scope of an arbitration agreement between two parties—and even if parties that are involved in a consolidated arbitration proceeding have not agreed to submit to arbitration claims between them arising out of the subject matter of the consolidated proceeding—a party can always request that the arbitrators decide a dispute between them, and if the other party consents by (for example) arbitrating the claim without objection, then the parties will be deemed to have submitted their dispute to arbitration even though they were not contractually obligated to do so.

In view of that reality, it may be tempting to think that parties should, to avoid claim preclusion, be required to at least offer to arbitrate all claims arising out of or related to the underlying controversy. That rule might foster judicial and arbitral economy and spare defendants from exposure to multiple proceedings arising out of the same underlying controversy. But that would turn the purposes and objectives of the FAA on their heads by transforming arbitration into a matter of coercion, not consent.

The Sixth Circuit majority wisely did not sacrifice at the proverbial altar of judicial and arbitral economy the consensual nature of arbitration envisioned by the FAA. It correctly held that the test was not whether A could have at least attempted to submit the dispute to arbitration, but whether the party was required to arbitrate its claims with the architect and engineer/designer. That put litigation and arbitration on the same footing as far as claim preclusion is concerned but at the same time accounted for the key difference between consensual and non-consensual dispute resolution.

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