Part II: Why the Fairness Act May Breed Litigation
In Part I of this multi-part post we provided some general background on the Fairness Act and said it was likely to generate litigation over the allocation of power between courts and arbitrators in commercial arbitration proceedings involving sophisticated, commercial entities. In this Part II we briefly discuss why litigation will likely occur if the Fairness Act becomes law.
The question whether an arbitrator or a court gets to decide a particular issue may raise some high stakes. The answer can be outcome determinative, or at least may increase the chances that one or the other party will prevail on the issue’s merits.
Contract invalidity claims and defenses and arbitrability issues are matters on which the parties’ decision-maker preferences are likely to differ. For any number of reasons, parties seeking to rescind or invalidate their contracts based on fraudulent inducement or other grounds may conclude that their chances of success are increased if a court decides the issue. A party that unambiguously submitted arbitrability questions to the arbitrators, but later challenges the arbitrability of a claim or issue, may likewise prefer that a court rule on arbitrability, especially if the party is principally relying on technical legal arguments.
Today these forum preferences are largely moot because under established precedent, both matters are for the arbitrators. But section 2(c) of the Fairness Act would provide at least a plausible basis for a party to argue that this precedent is no longer good law, and that a court must decide all contract validity and arbitrability questions, whether or not they arise out of commercial contracts involving commercial entities.
The result, of course, will be litigation, and we believe that a good deal of it is likely to arise out of reinsurance disputes. First, contract rescission claims probably arise more frequently in reinsurance than in other commercial contracts. Claims for rescission of reinsurance contracts are usually easier to establish than claims for rescission of ordinary contracts. What sets reinsurance contracts apart is the duty of utmost good faith (uberrimae fidei): To establish a prima facie case for rescission, a reinsurer need only show that pre-contract the cedent failed to disclose material facts concerning the original risk of loss. Even an innocent nondisclosure will suffice. See, e.g., Union Indemnity Ins. Co. v. American Centennial Ins. Co., 89 N.Y.2d 94, 106-07 (1996) (copy here). To obtain rescission of an ordinary contract based on pre-contract events, generally one must establish fraudulent misrepresentation, fraudulent concealment or mutual mistake.
Second, certain reinsurance arbitrators may be somewhat predisposed against awarding rescission. We (and, we suspect, others) believe that reinsurance arbitrators tend to be more reluctant than courts to award rescission, particularly where they consider it unfair, unwise or otherwise inappropriate based on their understanding of the customs, practices and norms of the industry. Rescission is the exception, not the rule, in reinsurance arbitration practice. Institutional predispositions of arbitrators (real or perceived) tend to make the court seem the more attractive forum for the party seeking rescission.
Third, reinsurance arbitrators may have even greater leeway than other commercial arbitrators to depart from the strict rules of law, and this leeway may increase the odds that they will deny rescission (or grant alternative relief) when faced with facts that would likely lead a court to grant rescission. Many reinsurance contracts feature “honorable engagement” clauses that provide that arbitrators: (a) are not required to abide by the strict rules of law; (b) may base their decisions on the customs and practices of the industry; and (c) should interpret the contract as an honorable engagement, rather than a strict legal obligation. If a party has a strong rescission claim on the law, commonsense and logic suggests that it is risky business to submit that claim to arbitrators who have been relieved expressly of any obligation to follow strict rules of law.
One final note. The spate of litigation that may follow the Fairness Act could occur shortly after its effective date. The Fairness Act would “take effect on the date of [its] enactment” and would “apply with respect to any dispute or claim that arises on or after that date.” Thus, in the reinsurance context the Fairness Act might apply to an arbitration agreement in a treaty entered into decades ago, so long as the claim arose subsequent to the Act’s effective date.
In Part III of this post we shall explore two alternative interpretations of the Fairness Act as applied to domestic arbitration proceedings between sophisticated parties. Part IV will tackle how courts might interpret the Fairness Act as applied to nondomestic arbitration proceedings falling under the Convention on the Recognition and Enforcement of Foreign Arbitral Awards.
Tags: Arbitrability, Arbitration, Arbitration Fairness Act, jurisdiction of arbitrators, severability
