I have reported on three recent occasions concerning judicial decisions on arbitrability in the context of FINRA arbitrations. FINRA is the Financial Institutions Regulatory Authority, successor to the National Association of Securities Dealers, the principal self-regulatory organization of the financial services industry.

In yet another such case, a New York federal judge last week denied a motion by J.P. Morgan Securities, Inc. (“Morgan”) (on its own behalf and as successor to Bear Stearns & Co. (“Bear”)) to enjoin a FINRA arbitration pending in Louisiana. However, the Court declined to enter an order compelling arbitration, interpreting Section 4 of the Federal Arbitration Act to prohibit such an order where a choice of forum clause in the arbitration agreement provides for, or is applied to direct that, the arbitration to proceed elsewhere. (J.P. Morgan Securities, Inc. v. Louisiana Citizens Property Insurance Corp., 2010 U.S. Dist. LEXIS 42953 (S.D.N.Y. April 30, 2010).

Morgan and Bear had acted as co-underwriters on a $1 billion bond issue for the Louisiana company that commenced the arbitration. The company also entered into interest rate swaps with affiliates of Morgan and Bear to hedge its exposure on the bonds. When the market for auction rate securities (ARS) based on the bonds collapsed in 2008, interest on the bonds soared, causing losses well beyond the protection offered by the swaps. The company alleged fraud by Morgan and Bear in failing to disclosure their activities as market-makers in the ARS market.

As noted in my prior commentary, FINRA arbitrability decisions are often for the court not the arbitrators in the first instance, if a party seeks judicial intervention on that issue, becasue customer arbitration often arises not from a bilateral agreement to arbitrate with the customer, but from the FINRA member’s agreement with FINRA to submit disputes with customers to arbitration under FINRA’s Arbitration Rules at the customer’s request – provided the dispute arises out of the business activities of the firm with the customer. (As explained in this most recent decision, the customer is considered a third-party beneficiary of the FINRA-member firm agreement.) The reason for this, the Second Circuit and New York federal courts have held, is that the FINRA-member firm arbitration agreement does not provide the needed “clear and unmistakable evidence” that the member firm and its adversary in a particular case intend to submit arbitrability issues to the arbitrators.

The district court in J.P. Morgan Securities, after finding that its powers to enjoin arbitration are derived from Section 4 of the FAA even though that provision does not explicitly confer such power, declined to issue the injunction. The court held that the relationship of issuer and underwriter was indeed a member-customer relationship. It based this decision on a Third Circuit Court of Appeals case that had similarly held, and the Third Circuit’s reference to an NASD committee statement that the compulsory arbitration provision in the NASD Code was intended to cover disputes over a proposed underwriting. The court then proceeded to find that the case involved Morgan and Bear’s business activity with the member, as the alleged fraudulent nondisclosure of the role as market-maker “relate[d] directly to plaintiffs’ role as underwriters of the ARS bonds….”

The court declined, however, to compel arbitration, finding that FINRA’s designation of New Orleans as the venue of the arbitration, based on the venue-selection powers conferred in the FINRA Rules, had the effect of divesting any district court other than a district court at the arbitration venue from entering an order compelling arbitration.The key language of FAA Section 4, in the court’s view, is that “The hearings and proceedings, under such agreement, shall be within the district in which the petition for an order directing such arbitration is filed.”

While noting that some courts had interpreted Section 4 to allow a district court to compel arbitration in its own district notwithstanding the choice of another venue in the arbitration agreement, the court held that to do so would in its view ignore the statutory directive to compel arbitration “in accordance with the agreement.” The court noted that, of course, the arbitration claimant could seek an order compelling arbitration in the federal district court at the place of the arbitration.

Arbitration practitioners should take note of a trend toward renewed stringency in U.S. judicial application of historical equitable standards for the granting of preliminary and permanent injunctions. The trend is most recently reflected in an important copyright law decision from the US Second Circuit Court of Appeals, discussed today in a new posting that will appear in the Legal Developments section of my website. www.lexmarc.us. Transnational principles governing the issuance of interim measures by international arbitrators are substantially informed by standards in domestic courts of major legal systems. As the recent U.S. trend dictates a return to a more rigorous application of rules with a common law heritage dating back to the earliest days of federal equity practice, it is reasonable to expect that such decisions will be discussed in, and affect analysis of interim measures applications in, international arbitrations involving American parties, counsel, and arbitrators.

****

While at the lexmarc.us website, also read about the latest decision from the Second Circuit on securities fraud liability of attorneys who assist clients with sham transactions.

And visit the Counsel Culture Corner, with updated event and exhibition listings through mid-May.

Those of you who follow developments in U.S. securities litigation may wish to read my commentary on a recent Second Circuit decision concerning liability of professionals for fraudulent statements of their clients. www.lexmarc.us

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.