Marc J. Goldstein Arbitrator & Mediator NYC
April 22, 2013

Arbitral Power to Rewrite the Contract: Has the Fifth Circuit Overextended Judicial Deference?

Does an arbitrator exceed her powers when, as a remedy for fraud in the inducement of a limited-duration intellectual property license, she modifies the contract “as a matter of law” to provide the licensor with a perpetual royalty-free license? The U.S. Fifth Circuit Court of Appeals, reversing a Texas district court’s vacatur order, held that the arbitrator’s award should stand. (Timegate Studios, Inc. v. Southpeak Interactive, L.L.C., 2013 WL 1437710 (5th Cir. April 9, 2013)).

Even though the question presented was whether the arbitrator could rewrite the contract as a fraud remedy, the Court held that the relevant legal test under Section 10(a)(4) of the Federal Arbitration Act (permitting vacatur where an arbitrator exceeds her powers) is whether the award “draws its essence from the contract.

So it is useful to understand where the “draws its essence” formula comes from. It source is in a very famous Supreme Court arbitration case: United Steelworkers of America v. Enterprise Wheel & Car Corp., 363 U.S. 593 (1960). That case involved a labor arbitration under a collective bargaining agreement, and the Supreme Court, referring not to the FAA but to the need for finality in the resolution of labor disputes under collective bargaining agreements, stated: “The arbitrator … does not sit to dispense his own brand of industrial justice; he may of course look for guidance from many sources, yet his award is legitimate only so long as it draws its essence from the collective bargaining agreement.” 363 U.S. at 597.

The Supreme Court has not seen fit in 53 years to incorporate the “draws its essence” phrase into the lexicon of commercial arbitration and the FAA. Not a single instance of reference to the “draws its essence” phrase is found in any FAA case in the Supreme Court.  That might be due to some key differences between collective bargaining agreements and commercial contracts, and between disputes under the two types of agreements. Perhaps most significantly, when a dispute arises under the collective bargaining agreement, that agreement is in practical terms the applicable law.  In the particular dispute, the labor arbitrator decides the respective rights and duties of employee and employer under a collective agreement which is likely to be a lengthy and self-contained charter. Certainly the steel industry agreements circa 1960 fit that mold.

But the commercial agreement with an arbitration clause typically requires the arbitrator to apply the contract law of a particular geopolitical unit, and typically does not limit the remedies of either side to those enumerated in the contract but leaves the arbitrator free to impose the contract remedies permitted by the applicable law. In that context, judicial deference to an award whose remedy “draws its essence” from the contract risks becoming formula for the arbitrator and the deferential reviewing court to disregard the applicable law in service of a generous construction of the contract’s commercial terms. This strengthens but also possibly transforms the arbitral process, inviting the process to become less of an adjudication and more of a binding form of conciliation.

Does a “binding conciliation” vision of arbitral power explain the Fifth Circuit’s decision? Nothing explicit in the decision suggests this. The Court seems to have been less attentive to the implications for arbitral power, and mainly attuned to the injury sustained by this particular licensee. The Court’s opinion does not suggest that the applicable Texas law of contracts provided that a court or arbitrator may rewrite the parties’ agreement “as a matter of law.”  Indeed the Court’s opinion does not discuss Texas contract law. The sole reference to Texas law is the statement that where there is fraud in the inducement of the contract, the remedy granted may “void contract provisions.”  But here the Court cited only to a case where punitive damages for fraud were awarded in conjunction with declaring null and void a contract, induced by fraud, that forbade punitive damages as a breach of contract remedy.

By using the “draws its essence” test to uphold the award, the Court in effect holds that even a remedy not allowed by the applicable law is not an excess of arbitral power where it plausibly advances the original contractual objectives of the prevailing party. But doesn’t that approach dislodge the applicable law as a defining and confining source of arbitral power?

Another drawback of transposing the “draws its essence” formula to commercial arbitration jurisprudence is that the commercial arbitrator routinely is invited to resolve non-contractual causes of action, and yet the “draws its essence” formula is focused on the contract. The fraud claim in the Timegate case is typical.

When the arbitrator is alleged to have exceeded her powers in providing a re-written perpetual license as a remedy for fraudulent inducement of the negotiated license , it seems the proper question to ask, about the scope of arbitral power, is not whether that remedy “draws its essence from the contract,” but whether the remedy is permitted by the law applicable to the fraud claim that the arbitrator was required to apply (or possibly by a more specific agreement of the parties about remedies). If the remedy of contract revision is allowed by (suppose) Oklahoma law, but the contract specifies that the arbitrator shall apply Texas law and the arbitrator is informed that Texas law permits rescinding the contract entirely but not rewriting it, as a remedy for fraud in the inducement, and the arbitrator invokes Oklahoma law on the basis that it strikes her as a more desirable remedial scheme, the arbitrator exceeds her powers, as she was given no power in the contract to invoke any other than Texas law.

The Supreme Court in the 2010 Stolt-Nielsen case gave renewed vitality in “exceeds powers” jurisprudence to the phrase from the 1960 Steelworkers’ case that immediately adjoins the “draws its essence” language, i.e. that an arbitrator exceeds her powers when she dispenses her “own brand of industrial justice.” In Stolt-Nielsen, this label was pinned on an arbitral award that construed an arbitration clause to allow for class arbitration, doing so (according to Justice Alioto and the majority) without reference to any body of law arguably applicable to that clause, but instead by reference to other AAA clause construction awards that had allowed class arbitration.

Whether one agrees or not that this is what the arbitrators did in Stolt-Nielsen, the “own brand of industrial justice” phrase is a sensible practical shorthand for adjudication unhinged from the applicable law that the arbitrator is bound to apply. To sustain, as the Fifth Circuit did, an arbitral revision of the parties’ contract on the basis that the revision “draws its essence” from the contract, would seem to sanction the same unhinging as a legitimate exercise of arbitral power but without adequately justifying how the contract functions as a source for that power.

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