And That's Final!

Arbitration proceedings are supposed be simple, quick and final.  But the finality of arbitration has a potential downside as the stakes get higher.  It is unlikely that a losing party can overturn an arbitrator’s decision even if it seems completely at odds with clear legal precedent.

A recent case from the Sixth Circuit highlights this problem.  Schaffer v. Multiband Corp. grew out of dispute between trustees of an employee stock ownership plan (ESOP) and the parent company over an indemnification claim.  The US Department of Labor claimed that the trustees had breached their fiduciary duties by permitting the ESOP to pay an inflated price for employer stock.  The trustees settled the claims for $1.45 million each and then demanded contractual indemnification from Multiiband.  Multiband refused and the dispute went to arbitration.  

The arbitrator found the indemnification agreements to be invalid under a provision of the Employee Retirement Income Act of 1974 (ERISA), which makes exculpatory agreements unenforceable.  That provision, however, is tempered by another provision of ERISA that permits trustees to obtain insurance for fiduciary breaches as well as DOL guidance and case law that treats indemnification agreements as insurance as long as the benefit plan has no liability for the indemnification.  The trustees should have prevailed and so they filed suit in federal district to vacate the arbititrator's decision. 

The trustees faced a high hurdle.  Under the Federal Arbitration Act (FAA) the principle of finality carries the most weight.  A court ‘must' confirm an arbitration award `unless' it is vacated, modified, or corrected `as prescribed' in §§ 10 and 11.  Section 10 lists grounds for vacating an award. These are:

(1) where the award was procured by corruption, fraud, or undue means;

(2) where there was evident partiality or corruption in the arbitrators, or either of them;

(3) 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; or

(4) 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.

Despite the very narrow grounds for vacating the arbitrator's award under the FAA, the trustees were successful.  The district court concluded that the arbitrator had acted in “manifest disregard of the law" by ignoring the "clearly established legal precedent (including that of the Sixth Circuit)” that made the indemnification obligation clearly enforceable.  Thus, the district court vacated the decision.  Multiband promptly appealed.

Notice that "manifest disregard” of the law is not listed as reason to vacate an award.  Arguably, the FAA makes no provision for vacating the arbitrator’s award even if he is plainly wrong about the meaning of a law.  Some courts accept that idea that “manifest disregard of the law” is an implied “fifth” reason to overturn the arbitrator.  The Schaffer court, however, was not convinced that the manifest disregard standard was a legitimate basis for vacating an arbitrator’s decision.  But even if there were such grounds for vacatur, it concluded that “manifest disregard” meant something more than the usual error of law.  Indeed, according to the Schaffer court, not even a “manifest error of law” is sufficient to vacate the award.  The arbitrator must have done something even worse.  The Schaffer court suggested that if the arbitrator expressed “disagreement” with the law and refused to apply it, an order vacating the award might be justified. 

The arbitrator's decision would have “doubtless" been reversed had it been issued by a court.  But because the arbitrator did not “clearly disregard” the relevant ERISA provision or the terms of the contract, his decision was final.  Finality, not legal correctness, was the guiding principle here.

The prospect of using a quick and simple process for dispute resolution is tempting.  As the Schaffer case shows,however, an arbitrator’s decision will be upheld even if it is based on an obvious misunderstanding of the law.  With a court proceeding, the losing party at least has the opportunity for an appeals court to consider whether the judge may have made a mistake of law.  

In considering whether to include an arbitration clause in one of your contracts, you should think about the trade-off between finality and simplicity.