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What Constitutes Arbitration for Federal Arbitration Act Purposes?

By Asa Lopatin – June 16, 2014

 

The Federal Arbitration Act (FAA), 9 U.S.C. §§ 1–16, codifies the federal policy of enforcing arbitration agreements. In Moses H. Cone Memorial Hospital v. Mercury Construction Corp., 460 U.S. 1 (1983), the Supreme Court noted that “Section 2 [of the Act] is a congressional declaration of a liberal federal policy favoring arbitration, notwithstanding any state substantive or procedural policies to the contrary. The effect of the section is to create a body of federal substantive law of arbitrability, applicable to any arbitration agreement within the coverage of the act.” 460 U.S. at 24.


Arbitration has a number of elements that lend to its reputation for efficiency and expediency, including traditionally faster timelines and therefore lower costs for case resolution; limited grounds for overturning awards (see generally 9 U.S.C. § 10); strong protections for arbitrators, (see Wasyl, Inc. et al. v. First. Boston Corp., 813 F.2d 1579, 1582 (9th Cir. 1987) (“While the Act does not so provide, case law dictates that arbitrators are immune from civil liability for acts within their jurisdiction arising out of their arbitral functions in contractually agreed upon arbitration hearings.”)); and the right to petition a court to issue an order immediately staying court proceedings and compelling contracted-for arbitration, 9 U.S.C. §§ 34—as well as unique rights for interlocutory appeals when such an order is denied. With respect to arbitration’s favored status, the Third Circuit noted in Ballay v. Legg Mason Wood Walker, 878 F.2d 729 (3d Cir. 1989), that amendments to the FAA “make[] clear that any order favoring litigation over arbitration is immediately appealable and any order favoring arbitration over litigation is not.”  878 F.2d at 732.


Notwithstanding arbitration’s reputation for efficiency and expediency, the Supreme Court stated in Dean Witter Reynold, Inc. v. Byrd, 470 U.S. 213 (1985):


[W]e . . . reject the suggestion that the overriding goal of the Arbitration Act was to promote the expeditious resolution of claims. The Act . . . does not mandate the arbitration of all claims, but merely the enforcement—upon the motion of one of the parties—of privately negotiated arbitration agreements. The House Report accompanying the act makes clear that its purpose was to place an arbitration agreement “upon the same footing as other contracts where it belongs,” and to overrule the judiciary’s longstanding refusal to enforce agreements to arbitrate.


470 U.S. at 219–20 (internal citations omitted). This decision, along with the earlier majority opinion in Southland Corp. et al. v. Keating et al., 465 U.S. 1 (1984), made clear that the primary purpose of the FAA was to protect the contractual expectations of those who wished to settle their disputes via arbitration.


Despite the benefits associated with resolving disputes through arbitration and the strong stance that federal courts have taken with respect to enforcing arbitration agreements, disputes continue to arise in the form of denied petitions to compel arbitration, and challenges to awards. This is largely because for all that the FAA does to “create a body of federal substantive law of arbitrability,” the law in fact fails to define “arbitration” anywhere in its text. As courts have pointed out, “arbitration is a creature of contract, a device of the parties rather than the judicial process.” Harrison v. Nissan Motor Corp., 111 F.3d 343 (3d Cir. 1997) (citing AMF Inc. v. Brunswick Corp., 621 F. Supp. 456 (E.D.N.Y. 1985)). In that sense, if the parties have clearly agreed to submit a dispute for a final and binding decision by a third party, they have agreed to arbitration. 


There are certainly options available to let parties be sufficiently explicit in their contracts so as to avail themselves to the benefits of arbitration under the FAA. For example, the standard arbitration clause provided by the American Arbitration Association (AAA) makes clear that the parties have elected to resolve their disputes through arbitration (and all of its benefits and protections). In addition, should a disagreement arise concerning the intent of the parties, the rules clearly delegate to the arbitrator the authority to resolve the issue. 


The parties can be as specific as necessary in crafting the exact procedure by which potential disputes will be resolved. As long as they are explicit in their expectations—and make it clear that they consider the procedure to be final and binding arbitration—then there should be little doubt about which protections and benefits they will enjoy. However, when the contract at issue does not explicitly mention arbitration, but instead describes some other alternative means of dispute resolution, it is left to the courts to grapple with what does and does not fall within the scope of the FAA. This lack of clarity has led to an interesting split among the federal courts of appeals that, for the time being, the Supreme Court has elected not to clarify.


State Statute as Source of Missing FAA Definition
In Wasyl, Inc. v. First Boston Corp., 813 F.2d 1579 (9th Cir. 1987), the parties to a number of option agreements included in their agreements a mechanism to determine the sales price in the event that the parties could not agree—namely, impaneling two party-appointed appraisers who would then select a third appraiser. After employing the appraisal method for determining the option sales price, Wasyl sued the third appraiser, First Boston, for breach of contract, gross negligence, and willful misconduct in the preparation of its report. The Third Circuit, noting that the FAA does not define “arbitration,” held that state law “should be preempted only to the extent necessary to protect the achievement of the aims of the federal act in question.” 813 F.2d at 1582. Observing the parties’ choice of law clause and taking note of the fact that the relevant California arbitration statute included appraisals in its definition of arbitration, the court saw no threat to the achievement of the aims of the FAA in construing the appraisal in question as an arbitration. Based on this reasoning, the court ruled that state law determines the definition of “arbitration” for FAA purposes, and that because the FAA therefore applied to the appraisal in question, the appraiser was entitled to arbitral immunity under well-established federal law.


The Fifth Circuit had the opportunity to confront a similar set of circumstances a few years later in Hartford Lloyd’s Insurance Co. v. Teachworth, 898 F.2d 1058 (5th Cir. 1990), and found the Ninth Circuit’s reasoning in Wasyl particularly persuasive. In Hartford Lloyd’s, a party to an insurance agreement challenged the appraisal award due to alleged misconduct of one of the ostensibly independent appraisers. The district court had reviewed the appraisal as an arbitration under the FAA and affirmed the award without submitting the matter to a jury. On appeal, the Fifth Circuit discussed the traditional differences under Texas law between appraisals and arbitrations, including appraisals’ lack of quasi-judicial proceedings and limited scopes, as well appraisers’ use of independent knowledge and investigations. Citing Wasyl, the court held that “[e]xcluding Texas insurance appraisals from the coverage of the FAA would not frustrate [the purpose of the FAA.]” 898 F.2d at 1063. The court therefore held that because appraisals were not within the definition of “arbitration” under Texas law, the FAA did not apply, and the validity of the appraisal award was subject to review by a jury.


Despite eventually adhering to its previous decision in Wasyl, the Ninth Circuit was faced with a challenging dilemma in Portland General Electric Co. v. U.S. Bank Trust National Ass’n, 218 F.3d 1085 (9th Cir. 2000). In this case, the parties to a lease agreement with an option to renew or purchase at the end of the first term included a mechanism whereby a qualified, independent appraiser would be appointed to determine the fair market value of the two turbine generators that were the subject of the contract. The contract included a choice of law provision, specifying Oregon law, and included specific procedures for how the appraisal should be performed. When U.S. Bank Trust challenged the appraisal, the district court treated the appraisal as an arbitration, analyzed the award under the FAA standard, and upheld it. On appeal, the Ninth Circuit, following Wasyl, held that state law was determinative of whether the term “arbitration” includes appraisals and found that Oregon law, unlike California law, did not include appraisals. Therefore, following the rule that state law defines “arbitration” for FAA purposes, the court ruled that Oregon contract law, and not the FAA, governed the review of the appraisal at issue.


In a concurring opinion for Portland General Electric, Judge Tashima stated:


It seems counterintuitive to look to state law to define a term in a federal statute on a subject as to which Congress has declared the need for national uniformity. Yet, that is exactly what Wasyl requires. This case illustrates the result of the Wasyl rule—a patchwork in which the FAA will mean one thing in one state and something else in another. In California, an “appraisal” is an “arbitration” under the FAA, but in Oregon it is not. This does not appear to me to be the way in which Congress intended that the FAA be interpreted. It is one thing to look to state law as a guide in fashioning federal common law; it is quite another to accept it as binding in interpreting the meaning of federal law.


218 F.3d at 1091 (Tashima, J., concurring).


Federal Common Law as Source of Missing FAA Definition
Four years after Portland General Electric, the Tenth Circuit pushed back at the notion that the definition of arbitration for FAA purposes should be different from state to state. In Salt Lake Tribune Publishing Co., LLC v. Management Planning, Inc., 390 F.3d 684 (10th Cir. 2004), another case involving a challenge to the final determination of an appraiser, the Tenth Circuit criticized the decisions in Wasyl and Hartford Lloyd’s, stating:


We cannot, on the basis of congressional muteness, conclude that state law should define the FAA’s pivotal word . . . . Were we to hold that state law guides our determination, we would empower states to define arbitration as they choose, thus limiting the FAA’s utility. This we decline to do. Congress passed the FAA to ensure that state law would not undermine arbitration agreements.


390 F.3d at 689. Instead, the court held, the correct standard under federal law is whether the process at issue sufficiently resembles classic arbitration, in that the disputants empowered a third party to render a final and binding decision settling their dispute. 


The Second Circuit similarly responded to Judge Tashima’s observation with its decision in Bakoss v. Certain Underwriters at Lloyds of London Issuing Certificate No. 0510135, 707 F.3d 140 (2d Cir. 2013). Bakoss centered around a dispute over a certificate of insurance that provided for evaluations by party-selected physicians, as well as a third physician if necessary, to determine if the policyholder was entitled to a benefit in the event that he became “permanently totally disabled.” During the battle over removing the case from state to federal court, the issue arose as to whether the third-physician clause should be construed as an arbitration agreement.


Recognizing the lack of clarity on the subject, the court noted that “[w]e have not directly addressed whether federal courts should look to state or federal common law for the definition of ‘arbitration’ under the FAA. We do so now and hold that federal common law provides the definition of ‘arbitration’ under the FAA.” 707 F.3d at 143. Notwithstanding the apparent absence of a single federal definition, the court went on:


Congress sometimes intends that a statutory term be given content by the application of state law, but absent a plain indication to the contrary, we presume that the application of the act is not dependent on state law. Unless uniform nationwide application clearly was not intended, we apply a federal standard without reference to state law.


707 F.3d at 143. The Supreme Court denied certiorari in October 2013.


Finding a Definition Within the Federal Common Law
Although there has yet to be a sweeping decision to settle the debate, many recent decisions have favored looking to federal common law over state statute to determine the definition of arbitration for FAA purposes. What that means, exactly, still leaves room for interpretation because there is no single federal common law definition of “arbitration.” However, several cases have provided some insight on the subject. See Evanston Insurance Co. v. Cogswell Properties, LLC, 683 F.3d 684, 693 (6th Cir. 2012) (“central to any conception of classic arbitration is that the disputants empowered a third party to render a decision settling their dispute”); Fit Tech, Inc. v. Bally Total Fitness Holding Corp., 374 F.3d 1 (1st Cir. 2004) (listing common incidents of arbitration as finality, an independent adjudicator, substantive standards, and an opportunity for each side to present its case); and Harrison v. Nissan Motor Corp., 111 F.3d 343 (3d Cir. 1997) (“although it defies easy definition, the essence of arbitration, we think, is that, when the parties agree to submit their disputes to it, they have agreed to arbitrate these disputes through to completion, i.e., to an award made by a third-party arbitrator”).


Protecting Your Right to Arbitrate
Whether state statute or federal common law provides the applicable definition of “arbitration,” and whether the coming years bring any new developments in the law, any party preparing to enter into a contractual relationship and wishing to ensure the right to arbitrate any potential disputes must be sure that the dispute resolution clause of the contract is drafted as clearly and explicitly as possible. Arbitration, after all, is a creature of contract, and it will be protected only as ardently as any other contractual right. Careful drafting at the outset can save a great deal of time and money down the road.


Keywords: ADR, litigation, issue preclusion, foreign arbitral awards, foreign judgments, collateral estoppel effect


Asa Lopatin is director of ADR Services of the American Arbitration Association in Washington, D.C.


 
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