Chasing Rainbows: the Quest for the Perfect Arbitration Clause

McCormick Barstow LLP Attorneys at Law

Chasing Rainbows: the Quest for the Perfect Arbitration Clause

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A recent Ninth Circuit opinion  again points up the need to draft arbitration clauses carefully and specifically, to capture the client’s objectives in considering a suitable alternative forum to resolve disputes over the contractual relationship.  If the parties want the arbitrator to follow legal authorities, they not only need to specify that in the clause but also need to avoid incorporating federal law.  Other issues such as the form of decision, the scope of discovery, and the scope of court review also need to be discussed with the client and not simply presumed.

State Versus Federal Law

In the 2008 Cable Connection  case, the California Supreme Court reaffirmed its 1992 Moncharsh  opinion that precludes a California state court from vacating an arbitration award if the arbitrator failed to follow the controlling law.  The court went on, however, to hold the parties can modify this rule and expand the statutory grounds for vacating an award by stipulating, in their arbitration clause, that the arbitrator is bound to follow applicable law and that the failure to do so allows a court to vacate the award.  Moreover, the Court held federal law does not preempt California law on the subject, so the exception applies in California courts regardless of whether the contract affects interstate commerce and hence is substantively governed by the Federal Arbitration Act (FAA).   Since the Cable Connection case came down, it is very common for parties, advised by counsel, to draft clauses with this broader scope of judicial review.

The federal rule is different.  In the 2008 Hall Street  case, the United States Supreme court held that the parties, by agreement, cannot expand the statutory scope of court review under the FAA. As interpreted by the federal courts for many years, the FAA permits the court to vacate an award that shows “manifest disregard of the law” or is “completely irrational.”  But these standards have been narrowed and provide hope for undoing an award only in the rarest circumstances where it is clear from the face of the award that the arbitrator recognized the controlling law, and failed to apply it.  It does not allow a court to vacate if the arbitrator simply misunderstood or misapplied the relevant law, or ignored the facts.  If the parties in their arbitration clause stipulate that the FAA governs the arbitration, the narrow federal scope of judicial review will apply even if the parties agree the arbitrator has to follow the substantive law.  The tension in these standards is what brought the Biller case to the court of appeals.

The Case of Mr. Biller, Attorney at Law

The recent case is that of Dmitrious Biller against Toyota Motor Corporation and its U.S. division Toyota Motor Sales (TMS).   Suitably enough, Mr. Biller is an attorney.  He worked as an in-house counsel for TMS, quit, and later sued for constructive discharge, citing TMS’s allegedly unethical discovery practices in litigation as the cause that drove him out the door.

TMS moved to compel arbitration under a severance agreement Biller signed when he departed.  The clause required arbitration before one of the main commercial ADR providers, Judicial Arbitration and Mediation Services (JAMS), and required the arbitrator to follow the “applicable law and case precedent of the jurisdiction where [Biller} last worked for TMS….”   The agreement separately provided that it is governed by California law but that the arbitration clause itself would be governed by the FAA unless a competent court orders otherwise.

Biller’s severance agreement further required an arbitration award “with a written discussion sufficient to permit limited judicial review to enforce or vacate the arbitration award.”   JAMS policy itself requires a “concise written statement of the reasons for the Award, stating the essential findings and conclusions on which the award is based.”

Biller and Toyota stipulated to JAMS arbitration of Biller’s federal and state claims, and of TMS’s cross-claims against Biller.  The arbitrator dismissed various claims and proceeded to hearing on what remained.  The award found against Biller on his claims and in favor of TMS on various cross-claims for damages for breach of contract, conversion, and unauthorized computer access, awarding TMS $2.5 million in liquidated damages and $100,000 in punitive damages.   The award included a permanent injunction against disclosing TMS’s confidential information.

TMS moved in the federal court action to confirm the arbitration award.  Biller opposed, arguing that the arbitrator’s award was in “manifest disregard” of the law and did not contain sufficient factual findings.  The District Court rejected Biller’s  arguments and confirmed the award.  Biller then appealed to the Ninth Circuit, which affirmed the order confirming the award.

The appeal first centered on whether the FAA governed.  If it did, it allows more limited scope of judicial review of an arbitration award than under California law, at least where the parties contract for a more expansive “merits review” of the award.  The Ninth Circuit quickly held the FAA applies, as the parties’ severance agreement expressly said it did unless, in essence, a court ruled otherwise, and no court had so ruled.  So the plain meaning of the clause required application of the FAA.

The Literal and Narrow Scope of “Manifest Disregard”

The Court then considered Biller’s arguments that the award should be vacated under the FAA.
For many years the federal courts have allowed a court to vacate an award that “manifestly disregards” the law.  Biller of course wanted to hang his hat on such an argument.  But the court emphasized the narrow range of this ground:  it does not extend to mere errors in application of law, or from a failure to understand or apply the law,  but only allows vacatur in situations where “it is clear from the record that the arbitrators recognized the applicable law then chose to ignore it.”   A more nebulous add-on allows vacating an award that is “completely irrational,” which as interpreted is limited to the narrow scenario where the award fails to honor the language and intent of the parties’ agreement.

Applying these narrow rules under a de novo standard, the panel affirmed the trial court’s order and refused to vacate the arbitration award.  The arbitrator’s failure expressly to address Biller’s unclean hands and equitable estoppel defenses did not mean he had recognized controlling law but failed to follow it.  The court found a number of ways the arbitrator could have rejected Biller’s claims, and concluded there was no basis under the FAA to vacate.  Furthermore, the court said that even if the arbitrator misstated applicable law on an attorney’s continuing duties of confidentiality, that would not suffice to vacate, making the point starkly:  “Here, perhaps the Arbitrator misunderstood the law and misapplied it, but we cannot conclude that the Arbitrator ignored the law.”   Finally, even if the District Court was correct in concluding the arbitrator had disregarded Biller’s factual evidence, this also was irrelevant under the FAA which does not allow vacatur for disregard of facts.

The Biller court failed to address the other species of “manifest disregard” —that the award was “completely irrational.”  Again, this requires a strong showing that the arbitrator disregarded the language and intent of the parties’ agreement.  Here, Biller could have argued that the arbitrator did not follow the intent of the severance agreement in the form of the award, as he did not specifically address each of Biller’s defenses.  The agreement and JAMS rules at least arguably required such a discussion.  But does a failure to follow the parties’ agreement in the form of the award render it “completely irrational”?  And in any event is the implicit rejection of defenses enough to articulate the basis of the award? The federal courts could do a service to the bar by clarifying the “completely irrational” standard, or perhaps even overruling it.  It is certainly arguable the standard is too vague to be workable in a narrow-review regime.  After all, what disappointed litigant does not consider the award “completely irrational”?

Drafting Considerations: What Does the Client Want?

Counsel drafting arbitration clauses need to know this landscape well in capturing the client’s objectives in alternative dispute resolution.  Some points to consider:

•    Biller and its predecessors, and the Cable Connection opinion under state law, illustrate the dangers, but perhaps the benefits, of  contract language mandating application of the FAA to the arbitration provision.  The FAA would support a narrow scope of court review.  If the parties want broader judicial review of the award, they should strictly avoid any express or implied reference to the FAA and instead should agree that California law governs the arbitration, procedurally and substantively, then require the arbitrator to follow an identified source of law in the dispute.  The state/federal issue is part of a broader question of client objectives.
•    It is too easy simply to conclude all clauses should call for the arbitrator to follow the controlling or applicable law.  Lawyers are taught, quite naturally, to believe anything else is anathema.  But clients often do not, or should not, want a full “merits review” of an award.  This looks far too much like an appeal, which could run counter to the finality and certainty that are key benefits of binding arbitration.  Appeal rights prolong the process and enhance the risks and uncertainties of a forum that is designed to be truly the first and last resort.  And merits review entails additional expense as the moving papers expand in direct proportion to the number of ways the award may be attacked.  The award itself becomes a lengthy and prolix document and that detail entails increased arbitrator fees.  The parties may want all of that review, but the issue should be discussed and not simply presumed.
•    The same goes for considerations of how detailed the award must be.  Requiring the equivalent of a statement of decision under California law  sounds reasonable to protect the client from an arbitrary award. But if this is required does the failure to follow procedure about the form, content, and objections to such a “statement” per se allow a court to vacate?  Ironically, litigators who routinely complain about the procedural density, vagueness, and built-in delays of the statement of decision rules for bench trials routinely insert such language into arbitration clauses. Counsel should avoid reflexive procedural “safeguards” that only build delays and costs into the arbitration process without necessarily improving the quality of justice.
•    Counsel should also give careful thought to the scope of discovery.  It may be, but is not necessarily, beneficial to allow full-blown deposition and written discovery as permitted by the California Arbitration Act (CAA) if incorporated expressly or implicitly into the arbitration provision.   Does the client want to incur the costs of unlimited depositions that are subject only to motions for a protective order? Or does the client prefer pared-down discovery that the arbitrator has up-front power to limit and allow only upon a showing of good cause?  Or to set a numerical limit on the depositions absent a stipulation, or an affirmative good-cause showing and arbitrator approval?  Documents need to be exchanged but is the cost-benefit of interrogatories and requests for admissions warranted?  Again, the more counsel breathe full litigation procedures into the arbitration, the more arbitration ceases to be truly “alternative” and is instead the proverbial “old wine in a new bottle.”  Full litigation with the added expense of the arbitrator and the chosen forum’s fees is not necessarily what the client has in mind.
•    This applies as well to whether to incorporate a given forum’s rules. JAMS and the American Arbitration Association (AAA) are two popular providers and counsel often routinely draft clauses to incorporate the rules and procedures of one or the other of these.  The other common approach is to avoid these and simply to incorporate the CAA and its discovery rules, which entail their own concerns (see above).  Yet their rules are markedly different in a number of respects on issues such as discovery, procedure, and the form and content of the award.  The fees associated with each, and with their panel arbitrators, also differ and should be investigated.  The client may have specific ideas here (and institutional clients often do), but often the client is not conversant in any of these niceties and looks to counsel for solid advice.  As ever, communication is the key to constructing a clause that meets the client’s objectives.
•    Always act in the specific context of the relationship at hand.  Employment agreements are subject to special requirements on discovery, cost-sharing, form of award, and other procedural  issues, if the clause is to avoid being thrown out as unconscionable.   Also, various industries have standard agreements and requirements as do collectively bargained relations.
•    In considering whether or not to incorporate the FAA, consider that doing so may help enforce arbitration in multiparty cases where some parties have, and some have not, signed the arbitration agreement and a court action is pending that involves the same set of transactions as that involving the contract with the arbitration clause.  Counsel sometimes are shocked to learn, too late, that California law has a provision allowing the court the discretion not only to stay but also to deny arbitration altogether, even as to signatories to the arbitration clause, in cases where non-signatories have been named in a pending suit (including the one sought to be arbitrated) and cannot be bound by the clause.   The FAA does not preempt if the parties make it clear they want California law to apply, even in a generic choice-of-law provision in the contract.   Thus the only way to avoid this effect is to make clear in the contract the parties expressly intend this provision does not apply, which may be done by expressly incorporating the FAA’s procedural rules into the agreement,  or equivalent language that arbitration is to proceed notwithstanding the presence of nonsignatory parties and nonarbitrable claims in the case.  This is a complex area where experienced counsel should be consulted in the drafting stage.
•    Decide whether to make sure the arbitrator, and not the court, will decide the scope of the arbitration clause.  By their agreement thae parties can expressly leave to the arbitrator the issue of which claims are arbitrable.  Otherwise, in the absence of an express agreement, the court will decide this.   Incorporating the rules of a forum that entrusts these rulings to the arbitrator (such as AAA’s commercial rules) is generally sufficient.


Biller again underscores the need to draft these clauses properly in the first instance in close consultation with the client.  Toyota no doubt benefited from the use of the FAA and perhaps had good reason to include it in the arbitration clause.  Mr. Biller (in hindsight) may have been advised to avoid the FAA and to insist on a broader scope of review, or perhaps he lacked the bargaining power to press it.  The law of unconscionability hovers over these agreements and needs to be consulted up front, particularly in vulnerable relationships of unequal power (employment is a key example).   But all things equal, parties should push for their own objectives in selecting an alternative forum and in making sure their language properly dictates the desired scope of court review of the award.

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