New England Biz Law Update
Businesses are frequently drawn to arbitration because it allows them to fashion their own private dispute resolution process.
However, the U.S. Supreme Court recently left no doubt that the Federal Arbitration Act (FAA) imposes significant limits on parties’ freedom of contract.
The FAA (9 U.S.C. § 1 et seq.) contains a narrow standard of judicial review that does not permit federal courts to review the merits of an arbitrator’s decision. It instead restricts review to instances of egregious arbitral misconduct, such as fraud or corruption. The business community – concerned about the risk of arbitrary and excessive arbitral awards that are effectively immune from review – for many years had been attempting to expand judicial review under the FAA by private agreement, typically by stipulating to review for errors of law. These efforts had met with decidedly mixed results in the federal circuits.
The Supreme Court recently sided with a minority of the circuits, ruling that parties cannot expand the FAA’s standard of review (Hall Street v. Mattel, 128 S. Ct. 1396 (2008)).
But all is not lost.
While the court closed the door to contractual expansion of judicial review under the FAA itself, the court unexpectedly raised the possibility that parties may nonetheless achieve the same result in federal court outside the FAA.
In a remarkable passage, the majority stated: “The FAA is not the only way into court for parties wanting review of arbitration awards: They may contemplate enforcement under state statutory or common law, for example, where judicial review of different scope is arguable.” Hall St., 128 S. Ct. at 1406.
This groundbreaking statement appears to establish for the first time that parties to a pre-dispute arbitration agreement may choose to opt out of the FAA, and stipulate instead to the applicability of state arbitration law when seeking federal judicial enforcement of an arbitral award.
Since the FAA’s standard of review expressly applies in federal court only, and since the issue before the court was federal judicial review, it would be inappropriate to read this passage as referring exclusively, if at all, to parties’ ability to enforce arbitral awards in state courts. Moreover, the parties’ supplemental briefing in the case, requested by the court, confirms the court was focusing on potential alternative means for federal court review of arbitral decisions.
A host of practical concerns
The cryptic opt-out passage in Hall Street raises a host of practical concerns. From the outset, parties wishing to follow the court’s lead should expressly state in their arbitration clauses they are opting out of the FAA. The FAA has a wide reach and its standard of review would otherwise apply in federal court to any binding arbitral award arising from a contract affecting interstate commerce.
Next comes the key question: Which state law should the parties choose for securing more expansive judicial review than what is available under the FAA? Parties may contract for state law because the FAA does not create federal-question jurisdiction but instead requires an independent jurisdictional basis, typically diversity of citizenship. While the Supreme Court suggested reliance on state statutory or common law, every state has some form of an arbitration statute that has generally superseded common-law enforcement of arbitral decisions, and contains a provision for limited judicial review substantially similar to the FAA.
Apparently New Jersey is the only state with an arbitration statute that, by its express terms, allows parties to expand judicial review by agreement. The statute does not provide any limits to contractual expansion and there apparently has not been any litigation testing its permissible scope. Contracting for review of legal errors should not be controversial, however, because this is an established standard of appellate review.
With the sole exception of New Jersey’s statute, state arbitration statutes contain judicial review provisions that do not allow for review on the merits. Appellate courts in many of these states – such as California, Connecticut, Illinois and North Dakota – have expressly rejected contractual expansion of judicial review. While most state courts have not addressed the issue, parties who select the uncertain law of one of these states run the risk that a court of the chosen state will follow Hall Street and decide parties cannot expand judicial review under the law of that state. That decision would govern the outcome in a later federal court action reviewing an arbitral award under the parties’ agreement.
Some states allow judicial review for certain errors of law under narrow statutory standards of review, namely, that the arbitrator has exceeded his or her powers by disregarding or misapplying the parties’ chosen law.
In Louisiana, for example, courts will review arbitral decisions for misapplication of the law when the parties have stipulated in their agreement that the arbitrator cannot commit material errors of law. The viability of this approach has not been tested in many states and is uncertain, because a court could interpret this strategy as a contractual end run around a statute’s hands-off standard of judicial review.
In Michigan, courts will review for substantial errors of law even when the parties’ agreement is silent on the matter. However, it’s unclear what constitutes a substantial error of law under this standard of review.
Garden State is the safest bet
Choosing New Jersey’s arbitration statute to apply to judicial enforcement of the arbitral award appears to be the safest bet for parties wishing to expand federal judicial review. This choice of law raises at least two key questions. First, are parties free to choose the law of a state, such as New Jersey, which may have no relationship to the parties, contract, or dispute? The answer is probably “yes.”
Courts typically defer to a choice-of-law clause in a business-to-business arbitration agreement and are unlikely sua sponte to scrutinize the clause unless the chosen law offends some fundamental public policy of the forum state. (And a federal court sitting in diversity must follow the choice-of-law rules of the forum state.)
While state arbitration laws arguably embody a policy of minimizing judicial involvement in the arbitral process, which also underlies the FAA, it is doubtful courts would consider the policy so fundamental as to trump the parties’ choice of governing law.
The second key question is whether parties can limit the applicability of New Jersey law to the judicial enforcement stage of the arbitration, and choose another state’s law to govern the merits of the dispute before the arbitrator. The answer again is likely “yes.” Courts have traditionally recognized the principle of depecage, where parties are free to choose the law of different states to apply to different terms in their agreements. Nonetheless, parties wishing to apply the law of two different states should make that intention clear in the arbitration clause.
Some commentators have speculated whether parties’ reliance on state law for more expansive judicial review in federal court after Hall Street could raise preemption concerns under the FAA. This concern appears misplaced, however, because the court in Hall Street expressly invited parties to opt out of the FAA’s limits on judicial review and rely instead on state arbitration law to secure more expansive judicial review in federal court.
Moreover, the court has already held that the FAA preempts only those state laws that conflict with the FAA’s purpose, which is primarily to ensure that private arbitration agreements are enforced according to their terms. Giving full effect to the parties’ intent to expand judicial review would advance, rather than contravene, this purpose.
While the FAA also embodies a secondary purpose of fostering the expeditious resolution of disputes, the court in Hall Street subordinated this purpose to the Act’s primary goal of recognizing party autonomy in the arbitral process.
The court also left open the question whether parties may expand judicial review through the federal court’s case management powers under Fed. R. Civ. P. 16. However, the answer to this question is of little utility because the parties in Hall Street were in the atypical posture of having no pre-dispute arbitration agreement.
Also, a pre-dispute agreement to seek a Rule 16 order is fraught with uncertainty, because a court need not adopt the parties’ request to issue an order to arbitrate.
The New England Legal Foundation filed an amicus brief in Hall Street arguing that businesses “will flee from arbitration if expanded review is not open to them.” Hall St., 128 S. Ct. at 1406.
While the court did not adopt NELF’s position that the FAA itself allows parties to expand judicial review, the court nevertheless suggested an alternative approach to achieving party autonomy regarding judicial enforcement of arbitral awards.
Businesses and their counsel should consider the implications of this groundbreaking decision for their pre-dispute arbitration agreements.
Ben Robbins is senior staff attorney at the New England Legal Foundation, a non-profit foundation whose mission is to promote balanced economic growth in New England, protect the free enterprise system, and defend economic rights in part by filing amicus briefs in litigation dealing with legal issues of concern to business. Ben wishes to thank Beth Withers, a law student interning at NELF, for her exceptional assistance in the preparation of this article.
