This opinion by Seventh Circuit Chief Judge Frank Easterbrook skips rather lightly over some important distinctions between judicial and arbitral power. A closer look at the premises of the decision therefore seems appropriate.

A few distinctive features of the case put it in context. First, the arbitrator was a non-lawyer — a specialist in valuation of intellectual property rights, here patents on chemical formulas licensed for use in a cancer drug. Second, the license agreement provided for arbitration if the licensor believed the royalty rate was unduly low because the licensee was selling the drug in related-party deals rather than at arm’s length. Thus, the license provided for a serial arbitrations on the same issue, based on changed circumstances over time. Third, the arbitration evidently was not conducted under AAA or other rules, or under relevant state arbitration law, any of which might have addressed the ability of parties to request, or the arbitrator to grant, reconsideration.

Judge Easterbrook equates the arbitrator’s reservation of a right to reconsider based on new evidence with the right to such relief in a judicial proceeding conferred in Rule 60(b) of the Federal Rules of Civil Procedure. He suggests that the arbitrator may make such a reservation (where applicable arbitration rules, law, or the agreement of the parties don’t forbid it), without thereby rendering the decision non-final, subject to the 90-day limit FAA Section 12 for a motion in federal court under FAA Section 11 to modify or correct an award. And he cast aside the parties’ submissions regarding the “functus officio” doctrine as technical arcana of no use in deciding the case.

This approach takes some needless liberties with the FAA and arbitral common law principles. Before this case, we have understood Section 12 of the FAA to concern only a petition to a federal district court, not to an arbitrator, to modify (or correct) an award. And while it is correct to say that the passage of the 90 days without asking the arbitrator to modify the award means the award stands because a court must then confirm it without change, it is wrong to imply, as the decision does, that Section 12 directly permits a request to the arbitrator to modify or correct an award within 90 days after issuance. The FAA does not address that, and it disconcerting that a federal court of appeals would suggest that it does.

Second, the only permitted grounds for a federal judge to grant a petition to modify an award are those stated in FAA Section 11 — e.g., a material miscalculation of figures, or a material misdescription of a person, thing, or property in the award. FAA Section 11 does not provide for changing an award based on new evidence.

Third, federal appellate courts including the Seventh Circuit have recognized the “functus officio” doctrine as a federal common law principle that is read into the FAA as a limit on arbitral power. Thus, it is well-settled that an arbitrator is without power to act once she issues a final award, except to correct a mistake that clearly appears on the face of the award. A different sort of change — i.e. merits reconsideration — unless allowed by agreement, exceeds the arbitrator’s powers, and the purported amended award is be subject to vacatur under FAA Section 10(a)(5).

In this case, a non-lawyer arbitrator presumably not immersed in these nuances of arbitration law issued a decision that was contradictory — “final” and yet subject to revision based on new evidence, and with no stated time limit for presenting new evidence. The question the Court should have addressed was whether this was an award or an interlocutory order. If there was ambiguity about that, ample authority permitted remand to the arbitrator for clarification. The Seventh Circuit concluded that it was an award — or that it became an award 90 days after issuance — by superimposing on the purported arbitral reservation of power to reconsider the 90-day temporal limit of FAA Section 12. But this was an erroneous extension of FAA Section 12 beyond its judicial domain. Two possible approaches would have been more satisfactory. One would have been to remand to the arbitrator with directions to resolve the ambiguity. The other would have been to construe the arbitrator’s reservation of power simply as a recognition that under this license agreement, an award concerning the royalty rate was “final,” for the time being, but that the parties could re-open the issue, in a new arbitration whose outcome would have only prospective effect, based on changed circumstances in the future.

****

Not all readers of Arbitration Commentaries outside the United States will be aware that Chief Judge Easterbrook is widely regarded as one of the country’s most brilliant jurists. But as the opinion in this case illustrates, even the most brilling legal minds can produce troublesome applications of federal arbitration law when distinctions between judicial and arbitral power, reflected in the FAA and in evolved case law, are subordinated to reasoning that applies statutes and rules loosely and by analogy to advance what the court believes to be a sensible outcome.

The US Seventh Circuit Court of Appeals has held in a new decision that the question whether a contract containing an arbitration clause ever existed should be decided by a federal district court when it is asked to compel arbitration, and not by the arbitrator in the first instance, unless the arbitration clause indicates that the parties delegated that specific issue of contract formation to the arbitrator. (Janiga v. Questar Capital Corp., 2010 U.S. App. LEXIS 15983 (7th Cir. Aug. 2, 2010)). The Court observed that any doubt on this question appears to have been resolved recently by the Supreme Court of the United States in Granite Rock Co. v. International Brotherhood of Teamsters, 130 S.Ct. 2847 (2010), where the Supreme Court said “[i]t is similarly well settled that where the dispute at issue concerns contract formation, the dispute is generally for the courts to decide.” Whether the issue concerns contract formation, for a court to decide, or rather concerns contract validity, for the arbitrator to decide, of course depends on what grounds are asserted, by the party opposing arbitration, for saying that no contract exists. In Janiga, that party had admittedly signed the agreement, but asserted that he lacked sufficient fluency in English to have appreciated the legal significance of the document he signed. This was, in the Seventh Circuit’s view, a queston of contract formation that was properly within the province of the district court judge.

Call it the “Comma Clause” of the New York Convention. 

 Article II(1) of the Convention requires each Contracting State to recognize an “agreement in writing” for arbitration. And Article II(2) — the Comma Clause, for this discussion — states: “The term ‘agreement in writing’ shall include an arbitral clause in a contract or an arbitration agreement, signed by the parties or contained in an exchange of letters or telegrams.”

The interpretive significance of the comma in Article II (2) has divided US Circuit Courts of Appeals. The Second Circuit held in the Kahn Lucas case (186 F.3d 210 (2d Cir. 1999)) that the comma meant that the signature/letter exchange requirement applied to both an arbitration clause in a contract and independent agreement to arbitrate, as both are mentioned in the phrase preceding the comma. The Fifth Circuit in the Sphere Drake case (16 F.3d 666 (5^th Cir. 1994)) held that the signature/letter exchange requirement applies only to an independent agreement to arbitrate, not to an arbitration clause in a contract, viewing the comma as merely separating the words after the comma from the object immediately preceding it.  The Third Circuit — whose decisions bind federal district courts in New Jersey — has sided with the Second. (Std. Bent Glass Corp. v. Glassrobots Oy, 333 F.3d 440 (3d Cir. 2003)).

In a recent decision, a federal district judge in New Jersey refused to confirm an award made in China by an arbitration panel of the China International Economic and Trade Commission (“CIETAC”), ruling that an arbitration clause in a sales confirmation, which the buyer did not sign, failed to satisfy the “agreement in writing” requirement of the Convention. (Quanqing Cloth-Making Co. v. Pilgrim Worldwide Trading, Inc., 2010 U.S. Dist. LEXIS 64515 (D.N.J. June 29, 2010)).

In the Pilgrim case, the US buyer issued three purchase orders to a Korean trading company, and, after renegotiation of commercial terms, received a “Sales Confirmation” that “referred to” Quanqing, which the buyer understood to refer to a “subcontractor” from whom the Korean trader would obtain the goods. The Sales Confirmation — on its face between the Korean and Chinese parties — stated that it was signed by the Korean trader “on behalf of” and “for the account of” the US buyer. It provided for arbitration of disputes under CIETAC auspices. Upon receiving the Sales Confirmation, Buyer issued revised purchase orders in conformity with the commercial terms of the Sales Confirmation. The goods were shipped to buyer, and partial payments were made, some to the Korean trader and some directly to the manufacturer in China, Quanqing, as directed by the Korean intermediary.

A payment dispute arose; the Chinese producer Quanqing commenced CIETAC arbitration against the buyer; CIETAC sent a notice of the arbitration to the buyer which the buyer elected to ignore; and an award was made in favor of Quanqing.

The district court found that there was “no evidence” that the Korean trader was the US buyer’s agent or representative, and “thus there is no signed writing binding [buyer] to the Sales Confirmation or its arbitration clause.”

The district court rejected the Chinese award-holder’s argument that the US buyer was equitably estopped from denying an obligation to arbitrate.  While the buyer’s purchase order “reflects that it agreed to pay” for the goods, the buyer did not “consistently maintain that any provisions of the purported contract should be enforced.” Therefore, the court held, equitable estoppel furnished no basis to enforce the arbitration clause against the buyer.

Even apart from what appears to be a very stringent application of equitable estoppel principles, arguably at odds with the pro-arbitration policy of the FAA, this decision is a curious one.

The court did not discuss whether the sequence of a sales confirmation containing an arbitration clause followed by the buyer’s revised purchase order satisfied the Convention’s “exchange of letters or telegrams” condition.

In this regard, the district court made no reference to the Third Circuit decision in the Standard Bent Glass case, cited above. In that case, the Third Circuit held that an enforceable contract containing an arbitration clause was made even though the written sales agreement was never signed by both parties, because the combination of written exchanges and performance sufficiently indicated contract formation under the Uniform Commercial Code. Further, the Third Circuit held, the same exchanges satisfied the “exchange of letters of telegrams” requirement of Article II(2) of the Convention.

On the record as described in the district court opinion in Pilgrim, it would seem quite plausible to view the sales confirmation-purchase order sequence as satisfying the exchange of letters or telegrams requirement. The distinguishing factor is that the buyer’s purchase order was apparently sent only to the Korean intermediary, leaving ambiguity about whether the buyer intended to enter into a contractual relationship with the Chinese supplier of the goods.  But whereas the purchase order responded to a sales confirmation in which the Korean intermediary declared itself to be acting as agent for the US buyer in procuring goods from the Chinese supplier, common law agency principles would suggest that the Chinese party was entitled to rely on the Korean party’s apparent authority as agent for buyer after the buyer, by issuing the purchase order, appeared to ratify the agent’s dealings.  

 At the very least, these issues were not adequately explored in the district court’s opinion, and a CIETAC arbitration award was denied recognition under the Convention without the kind of painstaking analysis that one would expect in an ostensibly pro-arbitration forum.

Security for costs is scarcely the most popular partner on the arbitration dance floor.

Derains and Schwartz note in their treatise on the ICC Rules, for example, that ICC arbitrators have ordered parties to provide security for costs, although such cases are “exceptional.” They observe that the ICC Rules do not expressly provide for security for costs, but add that “parties may apply to the Arbitral Tribunal for the same under Article 23” — a phrasing that stops short of placing the writers in the camp of those who consider that a security for costs order is indeed an interim measure covered by ICC Article 23. They further quote Swiss author Marc Veit, writing in the ASA Bulletin in 2005, that “[t]he common denominator in international arbitration practice for ordering security for costs is the requirement of a fundamental change of situation since the agreement to arbitrate was entered into which results in a clear and present danger that a future costs award would not be enforceable.”  But this describes a necessary but not sufficient condition.

The LCIA Rules (Article 25.2) and Hong Kong International Arbitration Centre Rules (Article 11.1) have little company among the major rules regimes, in providing expressly that arbitrators have the power to order security for costs.

But whether the power to grant security is stated expressly or is found by implication in general interim measures rules, the question always is under what conditions such orders shall issue.

Research into the issue readily turns up the reasons why such measures might not be ordered — that an impecunious but bona fide claimant (or counterclaimant) might be unfairly deprived of access to relief on the merits; that a financial decline of the party that might be ordered to bear costs is a normal business risk taken in agreeing to arbitrate disputes. Wendy Miles and Duncan Speller of Wilmer Hale (London), writing in the European Arbitration Review in 2007, note that security for costs “serves a valuable role in complementing cost-shifting rules and acts as a deterrent against spurious or frivolous claims.” (Article is republished on Wilmer Hale website under publications).

Tests that focus on the merits of the claim will be inherently biased against the granting of security, as arbitrators will be reluctant to pre-judge the merits or to accelerate the presentation of proofs in the fashion of US court preliminary injunction hearing. 

Tests that focus only on a “fundamental change of situation” risk turning security for costs into a form of claim-owners insurance. It is rather the reasons for the fundamental change (for the worse) that should be examined. Jean Kalicki (Arnold + Porter, Washington) is on the right path, writing that “security is more likely to be awarded where the claimant’s financial incapability appears the result of deliberate actions to shield itself from potential liability, while maintaining the upside potential of a favorable merits award. A twist on this is where the claimant’s arbitration fees and expenses are being covered by a related entity or individual who stands to gain if the claimant wins, but would not be liable to meet any award of costs that might be made against the claimant if it lost” (www.arbitralwomen.org/files/publication/0207001415156.pdf)

Business failures due to competitive conditions or economic cycles are not risks that should be addressed by orders for security; these are risks a contracting party takes in the ordinary course of doing business. Contrived business failure or financial weakness, arranged specifically to frustrate enforcement of an eventual award of costs are really at the core of what security for costs orders should address.

Such conditions are prone to exist in the domain of family-owned or closely-held enterprises, or small-to-moderate sized enterprises whose financial structure may be tied to a handful of investors who can exercise de facto control over the financial affairs of the business.  In such environments, regular financial reporting and record-keeping may be non-existent, except as necessary for the filing of tax returns, and owner-employees may have essentially unilateral ability to transfer funds among a group of companies or into individual or trust accounts of family members or investors.

How shall a Tribunal identify such a situation? Relatedly, how shall the applicant for security demonstrate the existence of such circumstances to the satisfaction of the Tribunal? Manipulation, or an environment conducive to it, are probably the critical factors.

One scenario that is probably frequently encountered is the obligor of a defaulted obligation that threatens to “self-destruct” (e.g. file for bankruptcy, or liquidate) as a means to discourage a creditor who has threatened arbitration. The same debtor also threatens a counterclaim in an amount vastly disproportionate to the contract debt — one that blames the creditor for its alleged woes — to discourage the claimant from pursuing the matter.

When the counterclaim is filed, should the claimant, now faced with far higher legal expenses than were anticipated for a straightforward non-payment claim, be entitled to security for costs? And how does the Tribunal decide this without pre-judging the counterclaim to be purely tactical and lacking substantive merit?

A non-exhaustive list of considerations might be:

1. Can the debtor reliably corroborate a situation of financial distress due to business conditions?

2. Can the debtor reliably corroborate having formulated the counterclaim other than as a retaliatory measure?

3. Is the debtor’s business prone to manipulation by its owners, particularly in the ability to transfer funds to related entities or individuals?

4. Is the debtor’s claim of distress contradicted by its apparent ability to bear substantial legal expenses?

5. Does the debtor’s conduct in the arbitration indicate a strategy to promote delay and inefficiency, and to maximize the legal expenses of the claimant?

****

Despite the differences among rules and statutes, which treat security for costs less than explicitly under most regimes, the question of the power of arbitral tribunals to grant security for costs is less controversial than the question of when the power should be exercised.  Experienced arbitrators should recognize situations where the claimant or counterclaimant is using tactics to run up costs for the other side while organizing its own affairs to make an anticipated eventual final award against that entity unenforceable.  This is the realm in which security for costs can be an essential tool to prevent subterfuge and promote justice in the arbitral process.

Not so long ago, there was controversy among federal courts in the United States about whether the New York Convention ousted the courts of jurisdiction to provide injunctive relief in aid of international arbitration. Just as that issue was sorted out in favor of judicial power to grant provisional relief, controversy arose over whether institutional rules conferring power on arbitrators to grant provisional relief, when adopted by parties, left courts without power to grant such parties provisional relief, or at least when viewed in light of the Federal Arbitration Act strongly suggested that courts should wield discretion against granting provisional relief.

That issue, also, has largely been sorted out in favor of judicial power, and discretion, to grant provisional measures in aid if arbitration to preserve the efficacy of the arbitral process. (See, for example, the Commentary on the applicable law in New York, posted on this site on June 22, 2010.)

But pockets of resistance have remained, notably where federal district courts have considered themselves bound to follow older, unrevisited precedents in their Circuit Courts of Appeals. The Ninth Circuit is one such jurisdiction, and, as it embraces so many important centers of international commerce — such as Los Angeles, San Francisco, Seattle, San Diego and Phoenix — the revisitation of an older precedent by that court is a development worthy of note.

Last month the Ninth Circuit reversed a Los Angeles federal district court’s refusal to grant an injunction in aid of arbitration, where the parties had a pending arbitration under the ICC Rules, but the Tribunal was not fully formed at the time of the application for relief. The Court held that the granting of such relief was fully consistent with Article 23 of the ICC Rules, which permits a party to apply to a competent judicial authority for provisional measures before the Tribunal is formed and in “appropriate circumstances” thereafter. (Toyo Tire Holdings of Americas, Inc. v. Continental Tire North America, Inc., 2010 U.S. App. LEXIS 12475 (9th Cir. June 17, 2010)).

The district judge had considered himself bound to deny the relief under a Ninth Circuit decision dating from 1999 that also involved an arbitration under the ICC Rules, and Article 23 thereof whose text was essentially the same at that time. But here the Ninth Circuit found that 1999 precedent distinguishable, as a case in which the applicant was seeking to bypass the arbitral tribunal, maintaining that it lacked power to grant the particular provisional relief sought. In the present case, in contrast, movant’s application was made expressly for the purpose of ensuring that the status quo was maintained until the Tribunal was able to act, so that any application to the Tribunal for further provisional (or permanent injunctive) relief would not be rendered ineffectual. Specifically, the Court concluded that “a district court may issue interim injunctive relief on arbitrable claims if interim relief is necessary to preserve the status quo and the meaningfulness of the arbitration process — provided, of course, that the requirements for granting injunctive relief are otherwise satisfied.”

This decision harmonizes Ninth Circuit law with the law in other Circuits where international arbitrations in the United States often take place, notably the Second (New York), Eleventh (Miami and Atlanta) and Fifth (Houston and Dallas) Circuits. 

With so many arbitral institutions having adopted rules for fast-track procedures or appointment of an emergency arbitrator, the next wave of case law development concerning provisional relief is likely to focus upon whether an agreement to arbitrate under such rules further narrows the circumstances in which judicial relief is strictly necessary to preserve the status quo. Given the strong emphasis in US provisional remedies law on proving likely success on the merits, US judges can be expected to incline against hearing applications for provisional relief absent strong evidence that an arbitrator cannot be selected on an expedited basis.

A new decision of the US Second Circuit Court of Appeals holds when a vacancy on an arbitral tribunal occurs due to resignation of an arbitrator, and the parties’ agreement does not address that situation, a district court has broad discretion under Section 5 of the Federal Arbitration Act in deciding how the arbitration shall proceed. (Insurance Co. of North America (“INA”) v. Public Service Mut. Ins. Co., No. 09-3640-cv, 2d Cir., slip opinion, June 23, 2010. The decision may be found on the Court’s website: www.ca2.uscourts.gov).

The decision affirms a ruling if the District Court that was reported upon in Arbitration Commentaries in January 2009. (You may access that Commentary by clicking on that month in the “archive”

column along the left border of this site.)

An earlier Second Circuit case had held that where a vacancy occurs due to the death of an arbitrator, and the parties have no agreement on how to fill the vacancy, the “general rule” is that absent “special circumstances,” a new panel must be formed and the arbitration commenced anew. That decision was not overruled in INA. The Court did however take note of “eroding support” for that decision, and that the “general rule” had first been stated in a case in which the Court had in fact declined to require a new panel to be appointed when one arbitrator died after the panel had rendered a partial final award.  Thus, Second Circuit law has long recognized that the potential for waste and inefficiency might in some situations outweigh the prejudice a party might suffer from having to continue an arbitration with a replacement party-appointed arbitrator. 

In INA the Court has gone further down this path. It holds that the so-called “general rule” does not apply to resignations of any kind, even those resulting from permanent incapacity of the resigning arbitrator (and thus having the same impact on the panel as would a death). In any resignation situation, therefore, no presumption will apply that an entirely new panel must be convened and the proceedings started anew.

Equally, the Court’s holding is not stated to be limited to the resignation of a party-appointed arbitrator — although the case did involve resignation of a party-appointee, and district courts might seek to read the holding as limited to that scenario.

But if courts take the Second Circuit at its words: “in dealing with vacancies resulting from resignations, the [ “general rule” applicable on death of an arbitrator] does not apply,” then district courts are now free to decide that even in case of resignation of the sole arbitrator, or the presiding arbitrator, circumstances may dictate that the reconstituted tribunal should be allowed to move forward rather than begin anew.

Indeed, if there is a broad arbitration clause, district courts may well hold that the extent to which proceedings must be repeated is an arbitrable issue to be resolved by the reconstituted tribunal. Section 5 of the FAA addresses the filling of a vacancy, but does not expressly confer power on a court to decide to what extent proceedings should be repeated. The Second Circuit’s so-called “general rule,” requiring a fresh start in case one of three arbitrators dies, is a common-law rule, not one that purports to be based on the FAA itself. 

Institutional rules governing international arbitrations, and the UNCITRAL Rules, typically confer power on the reconstituted tribunal to decide whether and to what extent proceedings should be repeated. This reflects a broad consensus among practitioners and institutions that the tribunal is in the best position to balance considerations of efficiency and fairness, and that a case-by-case approach makes the most sense.

The Second Circuit’s decision in the INA case appears to be moving American arbitration law toward conformity with the international arbitration position.