The Supreme Court’s decision today in Stolt-Nielsen S.A. v. Animalfeeds International Inc., No. 08-1198, slip op., April 27, 2010, ends months of speculation about whether the Court would clarify the status of the “manifest disregard” disregard doctrine. The District Court in Stolt-Nielsen had relied upon the manifest disregard doctrine, before the Hall Street case, in deciding to vacate the arbitration panel’s decision in favor of class arbitration. The Second Circuit in Stolt-Nielsen held, after Hall Street, that the doctrine survives as a “judicial gloss” on Section 10(a)(4) of the FAA, i.e. as a description of the circumstances in which an arbitrator exceeds her powers. Today the Supreme Court, by a 5-3 vote, reversed the Second Circuit’s decision and held that the arbitrators exceeded their powers by permitting class arbitration where the parties had stipulated that their arbitration agreement was silent about class agreement and that they had made no agreement on that subject.

The Court declined to decide whether the “manifest disregard” doctrine survived Hall Street in any form. But the Court probably made an important contribution to the eventual demise of “manifest disregard” by its own description of the circumstances in which an arbitral award must be vacated because the arbitrator exceeded her powers:

“It is not enough for the petitioners to show that the panel committed an error – or even a serious error. … ‘It is only when [an] arbitrator strays from interpretation and application of the agreement and effectively dispense[s] [her] own brand of industrial justice that [her] decision may be unenforceable.’…In that situation, an arbitration decision may be vacated under §10(a)(4) of the FAA on the ground that the arbitrator ‘exceeded [her] powers,’ for the task of an arbitrator is to interpret and enforce a contract, not to make public policy.”

Slip op. at 7 (internal citations omitted).

The arbitration panel’s decision permitting class arbitration, the Court held, was based entirely on the panel’s conception of good public policy, and not upon the intention of the parties or an applicable rule of law. By “allowing class arbitration in the absence of express consent, the panel proceeded as if it had the authority of a common law court to develop what it viewed as the best rule to be applied in such a situation.” For the majority, “[t]he conclusion [was] inescapable that the panel simply imposed its own conception of sound policy.”

The majority opinion says surprisingly little about what deference was due to the decision of the arbitral panel, to whom the parties had expressly committed the contract interpretation issue under the AAA’s Supplementary Rules for Class Arbitrations. But the Court does address the so-called “gap filler” argument –i.e. that in permitting class arbitration the panel was simply providing a reasonable rule where the parties’ agreement was indefinite and some rule was needed. The Court observed that the rule – articulated in the Howsam case — that procedural questions growing out of the dispute and bearing on its final disposition are presumptively for the arbitrator to decide, is based on a general principle of contract law that when the parties have made an agreement but omitted a term essential to determining their rights and duties, the court (or an arbitrator) may supply a term that is reasonable in the circumstances. But class arbitration so dramatically changes the complexion of the proceedings and the stakes, the Court held, that it cannot be viewed as a “gap filler,” i.e. as a reasonable term that parties presumably would have adopted if they had focused on the specific issue.

Many commentators will focus on what Stolt-Nielsen portends for class arbitration. But there is a broader theme in the decision. It is that arbitral discretion is not without important boundaries once the parties have agreed to arbitrate, or even once the parties have agreed to arbitrate a particular issue. The boundary is crossed when the arbitrator incorporates a term in the contract that is not only not expressly set forth, but is not ascertainable from (i) available indicia of party intent, (ii) industry custom and usage, (iii) an applicable rule of law, or (iv) a common-sense judgment about “gap filler” rules that the parties would likely have agreed upon if they had addressed the matter.

This principle likely will have importance in future litigation over arbitral interpretation of the rules of arbitration agreed upon by the parties. Whereas those rules are incorporated terms of the contract, the principles articulated in Stolt-Nielsen are relevant. Is the arbitrator relying upon some indicia of the intent of a rule’s drafters? Or is she instead engaging in ad hoc procedural reform? It seems reasonable to think that after Stolt-Nielsen, the boundaries of arbitral discretion in matters of contract (and rule) interpretation have become more precisely drawn, and that arbitrators have been invited to engage in careful examination of the bases and motives for their procedural rulings.

The Supreme Court of the United States today held that arbitrators exceed their powers under the Federal Arbitration Act when they impose class arbitration on parties that have not expressly agreed to class arbitration. The Court reversed a decision of the U.S. Court of Appeals for the Second Circuit, which held that the parties’ agreement to class action arbitration may be Inferred when their agreement is silent on the matter. Such inference, the Court held today, is “fundamentally at war with the foundational FAA principle that arbitration is a matter of consent. The Court divided 5-3. Justice Alito wrote the majority opinion, joined by Justices Kennedy, Scalia, Thomas and Chief Justice Roberts. Justice Ginsburg wrote a dissent, joined by Justices Breyer and Stevens. Justice Sotomayor took no part. A more detailed analysis of the Court’s decision will follow in the coming days.

Former Lehman Brothers CEO Richard Fuld last week failed to convince a federal district judge in New York to enjoin a FINRA arbitration against him arising from a Lehman bond sale in 2006. In this latest of several court decisions concerning arbitrability of pending FINRA arbitrations, Lehman’s erstwhile leader moved to enjoin the arbitration after the panel had denied his motion to dismiss. As to six of the seven claims, the court denied the motion to enjoin the arbitration — but only after accepting that the question was properly one for judicial determination. (Fuld v. Booth Foundation, Inc., 2010 U.S. Dist. LEXIS 38881 (S.D.N.Y. April 20, 2010)).

Do this and other recent mid-stream judicial “interventions” to address arbitrability in FINRA cases indicate that the doctrine of “competence-competence” is in disrepair in the United States? I think not.

U.S. courts of course require, since the First Options case in 1995, “clear and unmistakable evidence” that the parties intended to arbitrate arbitrability, and absent such evidence some questions, including whether a particular individual is bound to arbitrate under a valid arbitration agreement, are for courts to decide, either in the first instance, or without deference to an arbitrator’s prior decision on the same question.

Courts have held frequently that an agreement to arbitrate under rules, such as ICDR or ICC Rules, that invest arbitrators with power to rule upon their own jurisdiction, provides the requisite clear evidence of an agreement to “arb itrate arbitrability.”

But FINRA’s arbitration rules are viewed differently in some situations. FINRA arbitration, when requested by a member firm’s customer, is imposed upon FINRA member firms and certain persons associated with such firms, as a condition of FINRA membership, even if the customer and the firm never expressly agreed with one another directly in a signed bilateral arbitration agreement. In any FINRA arbitration, FINRA Rule 12413 confers authority on FINRA arbitrators “to interpret and determine the applicability of all provisions under the Code” — including those Code provisions that specify the scope of arbitrable disputes.

But when the arbitration arises from a request to arbitrate from a member firm’s customer that the member firm must honor only by reason of its FINRA membership, rather than from a bilateral agreement, the required “clear and unmistakable evidence” has been held not to be present. (John Hancock Life Ins. Co. v. Wilson, 254 F.3d 48 (2d Cir. 2001)).

Does it make sense that the FINRA member’s mere membership, combined with FINRA’s rules imposing arbitration on members (and associated persons) is sufficient “consent” to require arbitration of the merits of a dispute when requested by a customer, but is not sufficient “consent” to require arbitral determinations of arbitrability despite FINRA Rule 12413? Probably not. The sophisticated and well-represented member firms of FINRA understand its rules and, but for the state of the case law, could not fairly say (in the words of the Supreme Court in First Options) that “they reasonably would have thought a judge, not an arbitrator, would decide” arbitrability. The Second Circuit in the John Hancock case justified its holding by saying it was echoing the First Options court’s concern that parties would too often be forced to arbitrate threshold issues they reasonably expected would be decided by a judge.

But that concern dates from another era in the evolution of arbitration theory and practice. The holding in John Hancock appears to be an anomalous rule that in due course will be overtaken by a more contemporary view of the nature of consent in the FINRA arbitration context. In the meantime, the non-arbitrability of arbitrability issues, in FINRA arbitrations, is probably better viewed as a singular exception rather than as a symptom of US judicial disregard for the “competence-competence” principle.

Ecuador’s violation of what I have called the “Effective Means” Clause of the US-Ecuador BIT (Art. II(7)) meant that Chevron-Texaco was entitled to recover the damages, if any, proximately caused by the non-adjudication of its breach of contract claims in the courts of Ecuador for an unreasonably long period of time.

The teams of American counsel squared off against one another could readily agree that the venerable Chorzow Factory case provided the classical formulation of the measure of damages for breach of an obligation imposed by international law: in a phrase, “restitutio in integrum.”

Applying the standard of putting the Claimant in the economic position it would have enjoyed but for the violation, argued Chevron, involved no particular conceptual difficulty. The Tribunal was simply required to determine the breach of contract damages recoverable in Ecuador courts under the law of Ecuador — properly and fairly applied — and award those damages to Chevron.

Not so, said Ecuador. What Claimant lost by reason of the BIT violation, they argued, was not the breach of contract damages, but the chance — the prospect, however uncertain — of the claimed damages recovery. The measure of damages should the amount recoverable if the contract claims were sustained, times the probability of success on those claims (including collection) in the Ecuador courts.

Ecuador’s argument followed the logic of economic analysis of claims. If the BIT violation is equated with a wrongful taking, and what was taken was the unliquidated claim, then the value of what was taken is the value of the unliquidated claim. That value, Ecuador said, must be found in the normal way by applying a risk-based discount rate to the best-case revenue stream.

But the Tribunal rejected this and sided with Chevron. Assuming the Tribunal could find, as it did, that Chevron would have prevailed on its contract claims in Ecuador’s courts if those courts had functioned “effectively,” then what is lost by reason of the treaty violation (or denial of justice) is not the claim, but the judgment. To bring the uncertainty of victory back into the case as a risk discount against damages, the Tribunal reasoned (at least implicitly), would take away the benefit of the Tribunal’s determination, as a proxy for a normally-functioning Ecuiador court, that Chevron would have prevailed.

In the Tribunal’s own words: “Respondent cannot simultaneously maintain both (1) that a claimant be required to prove that it would more likely than not have prevailed in the domestic courts, and (2) that a claim be discounted to reflect the probability of success. To apply both propositions would lead to an aporoach that would necessarily and systematically undercompensate claimants in cases that allege misconduct by a State’s judiciary.”

Whereas future Claimants in denial of justice cases will surely rely upon Chevron v. Ecuador as the benchmark for the measurement of damages, it would have been gratifying had the Tribunal’s analysis on this point been more elaborated. “Systematically undercompensate” looks more like a conclusion than a reason. But the reason is fully apparent: once the international tribunal has decided the state court claim as a surrogate state court, in order to measure damages for the BIT violation or denial of justice, the Claimant’s loss is not the chance to prevail on the claim in the domestic court but the value of a victory in that court.

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Readers of Arbitration Commentaries may generally rely upon its principal author to read cases from beginning to end before reporting upon them in this corner of Cyberspace.

But whereas the Arbitral Tribunal in Chevron-Texaco v. Republic of Ecuador has seen fit to deliver a Partial Award on the Merits that runs to 265 pages, it is hoped that you will gratefully receive this interim report (based upon reading up to page 134 of the Partial Award) together with a promise that there will be more to come.( Here is a link to the full text of the Partial Award: http://ita.law.uvic.ca/documents/ChevronTexacoEcuadorPartialAward.PDF)

Chevron-Texaco brought claims under the 1997 U.S.- Ecuador Bilateral Investment Treaty, seeking redress for the fact that seven breach of contract claims against Ecuador for substantial sums were intractably snarled in the Ecuador judicial system. In general, the contract disputes related to allocation of energy production between the domestic market at domestic prices, and what Chevron-Texaco and its predecessors in interest would retain to sell in the world market at much higher prices.

The broad thematic basis of the claim in arbitration was denial of justice (“DOJ”) under customary international law, consisting of DOJ resulting from alleged unreasonable delay in the adjudication of the contract cases, and DOJ resulting from alleged manifestly unjust decisions by the Ecuador courts.

As alternative and additional theories of relief, Chevron-Texaco asserted violations of several provisions of the BIT: notably those that require “fair and equitable treatment,” “full protection and security,” avoidance of “arbitrary and discriminatory measures,” and, of particular importance to the outcome, Article II (7) of the BIT which required Ecuador to provide the investor with “effective means” of asserting claims (hereinafter, the “Effective Means Clause”).

The Tribunal examined the history of the Effective Means Clause in this BIT and related US BIT practice and found that it “was created as an independent treaty standard to address a lack of clarity in customary international law regarding denial of justice.” Per the Tribunal, the Effective Means Clause “constitutes lex specialis and not a mere restatement of the law on denial of justice,” and is a “distinct and potentially less demanding test” than DOJ under customary international law.

Here the Tribunal holds that one dimension of the duties arising from the Effective Means Clause is that the State must provide the Investor “with means of enforcing legitimate rights within a reasonable amount of time.” That treaty obligation was breached by Ecuador, the Tribunal holds, by reason of unreasonable delay in the adjudication of the seven breach of contract cases in the Ecuador courts, each of which had been pending at least 13 years and in some instances as long as 15 years, at the time of the Notice of Arbitration. Noting that the length of delay is not necessarily sufficient to reach a conclusion that the delay is unreasonable, the Tribunal cited “prolonged periods of inactivity” in nearly all the cases, especially prolonged periods of inactivity lasting many years after the close of evidentiary proceedings.

The Tribunal concludes that no adjudication of the other BIT claims — DOJ, fair and equitable treatment, full protection and security, arbitrary and discriminatory measures — is necessary, because no additional damages beyond those compensable for breach of the BIT’s Effective Means Clause were claimed by Chevron-Texaco.

… A further report will follow.