Introduction
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. 4th ___, 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.
Tags: California Arbitration Law, California Civil Code Section 1286.2, Damages, Exclusion of Evidence, Federal Arbitration Act, Federal Arbitration Act Section 10(a)(3), Prejudice, Procedural Misconduct, Vacatur
I think that this case raises the following question: who decides whether evidence is “material” to the case? Should it be the arbitrator? If so, then what is the role of the court in reviewing the arbitrator’s decision? What is the standard of review? I don’t know if this issue has ever been decided. Does anybody know of a case on point?
Michael,
Thanks for your insightful comment. It is flattering that a member of the California bar of your stature has taken an interest in this case and this post.
In these FAA Section 10(a)(3) and state-law equivalent cases, I think the answer is “it depends.” These statutory provisions provide a saftey valve of sorts to ensure that parties are not prejudiced by evidentiary rulings that are, for all intents and purposes, irrational. There are a number of cases interpreting these provisions, and their holdings tend to boil down to this: when parties agree to arbitration they cannot expect the same degree of procedural due process that they would receive in court, but they are entitled to a “fundamentally fair hearing.” As they always do when considering whether an award should be vacated, in determining whether evidence material to the controversy was not heard, and whether a party was prejudiced as a result, courts quite correctly accord the rulings of the arbitrators a great deal of deference.
When there is a colorable argument for the immateriality of the evidence based on a substantive law determination made by the arbitrators, then courts usually defer to the arbitrator’s decision on immateriality. I guess that’s pretty much the same thing as saying arbitrators get to decide materiality in most cases.
But where, in view of the arbitrators’ substantive law rulings, there was no colorable basis for excluding the evidence, then the court makes the materiality determination (or at least gets to second guess the arbitrators’ materiality determination). Support for the court’s role in reviewing materiality can be gleaned from the language of Section 10(a)(3) and its state law equivalents: Section 10(a)(3) authorizes vacatur where a party is prejudiced by the arbitrator’s exclusion of evidence “pertinent and material to the controversy,” and Cal. Civ. Code Section 1286.2(a)(5) says that a court “must” vacate an award where a party is prejudiced by the exclusion of “material” evidence. Because only courts decide whether awards should be vacated, it follows that courts must declare what is “material” or “pertinent” to the controversy, at least where there is no objective basis for finding that the evidence was immaterial.
As explained in more detail in the post, our view is that the evidence of post-closing events was inarguably material to the issue of the amount of damages, even if you accept all other aspects of the arbitrator’s award, and that the seller was prejudiced as a result of its exclusion.
Let me know if you are interested in reading other cases on the subject, and I’ll gather some illustrative ones and e mail them to you.
Phil
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