AMENDING THE FEDERAL ARBITRATION ACT*
If a pollster asked a random selection of Americans for a one-line verbal portrait of arbitration, common responses might include the following: (i) private litigation arising for construction and business disputes; (ii) a mechanism to resolve workplace tensions between management and labor; (iii) a process by which finance companies and stockbrokers shield themselves from customer complaints; (iv) a way to level the playing field in deciding commercial controversies among companies from different parts of the world; (v) the way big corporations use the North American Free Trade Agreement (NAFTA) to escape regulation. To some extent all would be correct.1
Unfortunately, these different varieties of arbitration have all been squeezed into the same antiquated arbitration statute. Enacted seventy-five years ago as a simple procedural device to enforce arbitration in federal courts, the Federal Arbitration Act (FAA) has now been pressed into service as a body of substantive law that binds state courts as well, requiring that arbitration agreements be enforced on the same footing as other contracts.2 The Act is as ill-suited to such use as an all-terrain vehicle. As drafted, the FAA ignores critical distinctions in the level of judicial supervision suitable to different types of cases. The laissez-faire court scrutiny appropriate to an international proceeding, between sophisticated business managers with access to competent counsel, may be quite misplaced in a consumer case, where an arbitration clause might require an ill-informed individual to seek uncertain remedies at an inaccessible venue.3 Moreover, basic arbitration notions are hidden in a maze of inconsistent cases that are anything but user-friendly: they disorient and confuse litigants from abroad, adding significant transaction costs to the choice of arbitration in the United States.4
The time has come to consider amending the FAA to provide greater clarity for international arbitration. One springboard for reform can be found in the UNCITRAL Model Arbitration Law,5 which has already engendered a rich case law that could serve as a prism to separate and identify many of the interrelated themes in cross-border arbitration.6 The Model Law, however, should not be imported wholesale.7 Any amendment of the FAA must take account of home-grown arbitration concerns and precedents.8 Part of the peculiar U.S. genius has been our ability to adapt (rather than adopt) inventions from abroad.9
The most critical need is for limitations on judicial review of international arbitration awards, permitting international arbitration law to evolve free from whatever paternalistic measures might be appropriate to domestically cultivated concerns.10 Such reform would facilitate efficient and neutral dispute resolution by keeping judges from second-guessing arbitrators on the merits of a dispute, while still permitting courts to support arbitration by enforcement of agreements and awards, as well as through interim measures in aid of arbitration.11 It is well known, of course, that certain arbitration service providers and industry groups oppose change.12 They justify their reform-phobia by reference to the vagaries of the U.S. legislative process.13 Once Congress goes into motion (so some fear), a Pandora’s box of special interests will open to unleash forces that would eviscerate arbitration’s effectiveness.
Such skepticism of the democratic process is misplaced. There is no reason to think that Americans today are less capable of intelligent legislation than they were in the past. Moreover, the winds of change are already blowing, and the question is no longer if but how reform will occur.14
The FAA subjects most arbitration in the United States to a single standard for judicial review,15 regardless of whether the dispute is big or small, domestic or international, and notwithstanding state attempts to create a more nuanced framework for arbitration.16 As a consequence, international arbitration unfolds haunted by the specter of anti-abuse measures intended to protect consumers and employees,17 relying on the exercise of judicial discretion in an inefficient, case-by-case fashion.18
Understanding the American framework for arbitration requires a brief look at the Second Circuit decision in Alghanim v. Toys “R” Us,19 which held that domestic judicial review standards applied to awards rendered in international arbitrations with a U.S. situs.20 The case, which involved a $46 million award rendered in New York in favor of a Kuwaiti licensee of a U.S. toystore,21 was challenged for alleged “manifest disregard of the law” by the arbitrator—a ground for vacatur under domestic law but not under the New York Arbitration Convention.22
One must remember that when adopting the 1958 New York Arbitration Convention, the United States accepted its application not only to awards rendered abroad, but also to so-called “non-domestic awards.”23 The award in Toys “R” Us fell under the latter category (“non-domestic”) and thus was subject to the Convention. Two of the three parties were non-American, and the underlying agreement involved performance in the Middle East.24
Convention awards would normally be subject to Section 207 of the FAA, which provides that a court “shall confirm the award” unless it finds one of the defenses to recognition contained in Article V of the New York Convention.25 These defenses essentially supply escape hatches related to procedural due process, public policy and vacatur at the place where an award is made.26
Drawing what seems to be a distinction between motions to confirm and motions to vacate awards, and notwithstanding the language of Section 207 of the FAA, the Court in Toys “R” Us found that a non-domestic award made in the United States would be subject to vacatur “in accordance with its domestic arbitration law and its full panoply of express and implied grounds for relief” including “manifest disregard of the law.”27
Not all jurisdictions follow the Toys “R” Us approach. The Eleventh Circuit has held that the New York Convention’s grounds for refusal to confirm foreign awards were also the exclusive bases on which to review a “non-domestic” award made in the United States.28 A federal district court in Miami came to the same result with respect to a motion to confirm an award among foreign parties made in Florida.29
Such conflation of domestic and international arbitration is a bad idea as a matter of both sound policy and national self-interest. Rather than a hospitable climate for international arbitration, the business community is left with little clear guidance to predict how courts will react to allegations of arbitrator error. Diverse cases call for different levels of judicial review, with the least interventionist role assumed in arbitration between sophisticated business entities from different countries.
The United States remains a victim of a self-inflicted competitive disadvantage imposed by its single legal framework for arbitration. The spillover of domestic precedents into international cases will inevitably chill the selection of U.S. cities for arbitration (with fewer fees to arbitrators and counsel) by foreign parties understandably hoping to avoid excessive judicial interference.
The FAA should be amended to provide a separate framework for international arbitration that would contain default rules limiting judicial review of awards to the narrowest grounds. In addition, parties might be given appropriate options to select greater judicial scrutiny. Such reform would keep courts away from arbitration except to support the process by enforcing agreements and awards and supplying interim measures in aid of arbitration.
Reform could be accomplished either through tinkering with the existing Chapters 2 and 3 of the FAA or by adding a new chapter which would cover all international proceedings in the United States, regardless of whether they fit within these two treaties. The latter approach, casting a wide net, might be the preferred avenue, since it could help limit misguided judicial inventions to fill either real or perceived gaps in the coverage of international arbitration.30
Some might observe that good arguments also exist for broader-gauge change to protect all business arbitration, domestic as well as international, from excessive judicial review on grounds such as “manifest disregard.” The proposal in this chapter is intentionally more modest, however, stemming from a concern that wider modifications of the FAA would meet more significant political impediments, thus reducing the prospect of reform in the international arena, where the special need for neutrality makes arbitration’s efficiency particularly vital. As Voltaire observed, the best is often the enemy of the good.31
The Wilko dictum
By statute, courts have been given power to vacate awards for defects in the basic procedural integrity of the arbitration,32 but not with regard to either vague notions of public policy33 or the merits of a dispute. Fifty years ago, however, this statutory scheme was amplified by dictum in a U.S. Supreme Court case prohibiting securities arbitration. In Wilko v. Swan, the Court added “manifest disregard of the law” as a basis for award vacatur.34 This power to set aside awards provides perhaps the most compelling motive for FAA reform.
Some interpretations of this concept take a restrictive view, building on notions of “excess of authority”35 to limit the principle to decisions that ignore the contract or require parties to violate the law.36 Other courts, however, have taken a more expansive view, effectively including mistakes of law37 and moving well beyond the consumer and employment context for which the doctrine had been conceived.
Yet another approach to “manifest disregard” has been suggested in Williams v. CIGNA Financial Advisors Inc.38 and Bridas S.A.P.I.C. v. Government of Turkmenistan.39 In these decisions, the Fifth Circuit followed a two-prong inquiry in which it determined first whether it was manifest that the arbitrators disregarded applicable law. Thereafter, the court considered whether the award would result in “significant injustice” under the circumstances of the case. Even if there was “manifest disregard,” an award would be upheld as long as no injustice resulted.
The problem is not necessarily in the “manifest disregard” doctrine itself, which properly applied may have a salutary effect where a special need exists for greater judiciary supervision. Rather, the difficulty lies in the doctrine’s potential for mischief and misuse in large international cases, when zealous litigators may be tempted to press “manifest disregard” into service as a proxy for attack on the substantive merits of an award.
Westerbeke v. Daihatsu
The risks of subjecting international cases to domestic grounds for vacatur are illustrated in Westerbeke v. Daihatsu Motor Co. Ltd.,40 involving breach of a distribution agreement by a Japanese manufacturer. A Japanese manufacturer had given a U.S. company an exclusive right to sell certain contractually defined categories of engines. If the manufacturer wanted to market a new line of products, the sales agreement gave the distributor a right of first refusal during a period of six months.41
Ultimately, the deal went sour over a new product line that the manufacturer began offering through another North American distributor. The parties ended up in arbitration pursuant to provisions of the 1952 Japan-U.S. Trade Arbitration Agreement referenced in their contract.42
The arbitrator awarded the distributor more than $4 million, having found the sales agreement to constitute a binding contract with a condition precedent in the form of a requirement that new lines of engines were subject to a right of first refusal. The manufacturer brought a motion to vacate the award, arguing that the parties had reached only a “preliminary agreement to agree.”43 Without a binding contract, the manufacturer argued, there could be no recovery for expectancy damages (purchase of substitution goods and lost profits), which was exactly what had been granted in the arbitration.44
To complicate matters, the arbitration had been bifurcated. A liability phase addressed whether the new product was indeed an engine within the terms of the contract. Then a subsequent stage assessed the claimant’s damages. Unfortunate language in the Interlocutory Award on liability (which arguably had res judicata effect when it came time to draft the final decision) gave rise to an argument that the arbitrator had decided the manufacturer owed no more than a duty to negotiate in good faith.45
The district court disagreed and vacated the award, holding that the arbitrator had misapplied the New York law on damages. As an additional ground for vacatur, the court held that the theory of liability expressed in the first stage of the proceedings differed from that articulated in the damages stage.46
A year later the Second Circuit reversed, upholding the award of lost profits. In deciding whether there had been “manifest disregard,” the Court of Appeals announced a two-prong test. An objective element required inquiry into whether the relevant law was “well defined, explicit and clearly applicable.” A subjective component of the test involved examination of whether the arbitrator intentionally ignored the law.47
Applying this approach, the Court of Appeals looked first at New York law on damages, which it found consistent with the arbitrator’s award on the facts of the case. The court then proceeded to examine the arbitrator’s intent, and found no evidence of knowing refusal to apply the governing law. Finally, the court addressed the alleged inconsistency between the Interlocutory and Final Awards. Giving the arbitrator the benefit of the doubt, the court interpreted ambiguous language in the Interlocutory Award in light of what the court called a “clarification” in the Final Award, which had found the sales agreement to constitute a contract with conditions precedent rather than simply an “agreement to agree.”48
Although the case itself had a happy ending for the arbitration’s prevailing party, the process involved costly appellate briefing and argument. The Court of Appeals had to examine the New York law on calculation of damages, as well as the difference between a “preliminary agreement” on one hand and a binding contract with condition precedent on the other.49 The court also had to explore the very nature of “manifest disregard” and other domestically nurtured defenses to award enforcement,50 and investigate the facts that might give an indication of the arbitrator’s state of mind when deciding the case.
The very existence of the right to have judicial review on the substantive merits of the case (particularly on a ground for challenge as vague as “manifest disregard”) hangs over international arbitration like a sword of Damocles, to be grasped by litigators and judges alike. In principle, there would be nothing wrong with having these questions decided in court. However, the parties had by contract agreed to have the merits of their dispute decided by arbitrators, not judges. The prospect of such judicial meddling in the arbitral process can only alarm foreign enterprises contemplating arbitration in the United States. The procedural and political neutrality of international dispute resolution is compromised each time a local judge intervenes in response to aggressive litigation strategies that invoke precedents from domestic contexts.
Such temptations should be placed out of reach through a new chapter in the FAA, expressly foreclosing back-door judicial interference with the merits of international cases. Giving litigants from abroad a measure of confidence that the U.S. judiciary will not unduly meddle in the substance of the case, such an amendment would promote efficient international dispute resolution and would make the United States a more user-friendly place to arbitrate.
The need for special deference to arbitration and forum selection clauses in international business was articulated thirty years ago in a decision by the U.S. Supreme Court. Addressing the problematic nature of international litigation, the Court stated:
Much uncertainty and possibly great inconvenience to both parties could arise if a suit could be maintained in any jurisdiction [where personal or in rem jurisdiction might be established]. The elimination of all such uncertainties by agreeing in advance on a forum acceptable to both parties is an indispensable element in international trade, commerce, and contracting.51
While the adjectives “all” and “indispensable” may constitute a bit of hyperbole, the basic point seems beyond cavil. In a world lacking any neutral courts of mandatory jurisdiction over transactions that cross national borders,52 arbitration usually does impose itself on international transactions faute de mieux, bringing to mind Churchill’s famous observation about democracy.53 Courts have enforced arbitration agreements in international cases involving subjects that could not have been arbitrated in a single country context, including securities,54 antitrust55 and bankruptcy.56
Not everyone sees a need to give special treatment to international arbitration.57 Some countries have retreated from divergent treatment of domestic and international arbitration, due to concern that distinctions based on nationality might conflict with international commitments.58
There should be no mystery about the justification of a special status for international arbitration. The goals that lead business managers to insert arbitration clauses in cross-border contracts have a different focus than those that drive domestic arbitration.
All forms of arbitration usually implicate perceptions about cost, efficiency and expertise. International arbitration, however, involves greater emphasis on foreclosing the gamesmanship of parallel foreign litigation in each side’s home courts.59 Arbitration clauses in cross-border contracts are usually prompted by apprehension about the real or imagined bias of foreign judicial proceedings.60 When a dispute has contacts with multiple countries, the parties may seek a playing field that is more neutral (procedurally, politically and linguistically) than national courts.61
Absent reliable arbitration, judicial proceedings might go forward in a foreign language and perhaps before a xenophobic judge in a country lacking a tradition of judicial independence.62 In an international contract, the value of a reliable dispute resolution clause may rise to a considerable percentage of the amount of the contract value.63
The special raison d’être of international arbitration means that the parties often place a premium on freedom from the type of judicial scrutiny that would impinge on procedural neutrality. For many wealth-creating transactions, the prospect of foreign court intervention will chill cross-border economic cooperation, causing productive transactions to falter or become more expensive.64 Without predictability about applicable substantive and procedural norms, business managers may hesitate to consummate transactions or may charge higher prices to cover the risk of uncertainty in the event of dispute. Although the perception of litigation bias against foreigners is sometimes more significant than the reality of prejudice, the consequences will be the same in that some transactions will not go forward without a reliable alternative to judicial litigation.65
It is often difficult for Americans to understand how disagreeable our civil justice system appears to foreigners. A recent article by a German scholar referred to U.S. litigation as a “procedural monster” that is feared because of its “appetite, sharp teeth and capriciousness.”66
Since contracts do not enforce themselves, but need flesh-and-blood adjudicators, who interprets an international agreement has often been more significant than what the applicable law says about its construction. Large portions of international arbitration procedure can be explained as an attempt to maximize the legitimacy of a process detached from the normal sources of authority.67
The specificity of international transactions has led many countries to adopt separate statutes for international arbitration. Belgium,68 France69 and Switzerland,70 as well as places that have adopted the UNCITRAL Model Arbitration Law71 such as Canada,72 Scotland73 and Hong Kong,74 all provide a more laissez-faire framework for international arbitration.
A different standard for monitoring the arbitration of domestic and international transactions requires criteria to distinguish one from the other.75 Several criteria might be considered, including the nature of the transaction as well as the parties’ residences76 and/or citizenship.77 The UNCITRAL Model Arbitration Law combines multiple tests, bringing within its scope arbitrations in which (i) parties have places of business in different countries, (ii) the place of contract performance or the place of arbitration is outside the parties’ home country, or (iii) the parties opt to treat the proceedings as international.78
A party-oriented test to define international arbitration, which looks to the residence of the litigants, has been adopted in Belgium79 and Switzerland.80 A less mechanical approach, asking whether a transaction implicates international commerce, has been adopted by the French.81 To the limited extent that the United States recognizes international arbitration’s specificity, a hybrid approach is taken.82
A residence-based test seems most sensible.83 The linguistic and procedural differences that justify a laissez-faire arbitration regime are more likely to arise when U.S. residents seek to avoid having foreigners haul them into court in Paris, Rio or Shanghai, rather than when one U.S. citizen sues another in New York over goods and/or services destined for export.
A residence-based test would also meet concerns expressed by some nations that a separate legal framework for international arbitration conflicts with treaty prohibitions on nationality-based discrimination.84