When you are before the Sixth Circuit Court of Appeals asking it to vacate an arbitrator’s award, and the court’s opinion begins with “[t]he arbitrator’s decision would doubtless be reversed if it were a decision under the precedent of this court,” you probably think you have won the case. You would be wrong. Here is what happened in Schafer v. Multiband Corporation and what it means for arbitration agreements in the Sixth Circuit.

The Case

In Schafer, Bernard Schafer and Henry Block served as trustees of a company’s two employee stock ownership plans (ESOPs). At one point Schafer and Block were investigated and then sued by the Department of Labor (DOL) for breaching their fiduciary duties as trustees. According to the DOL, these trustees had violated their fiduciary duties by allowing the ESOPs to purchase company stock at an inflated price. The two settled the claims brought by the DOL for $1,450,000 each.

As part of their service as trustees, Schafer and Block executed indemnification agreements with the company whose ESOPs they oversaw. These indemnification agreements had mandatory arbitration clauses. When Schafer and Block settled the DOL lawsuit, they sought indemnification from the company. The company refused, so Schafer and Block filed an arbitration complaint.

The company defended against indemnification by arguing that a provision of the Employee Retirement Income Security Act (ERISA) invalidated the indemnification agreement. Specifically, the company relied upon 29 U.S.C. § 1110(a) which provides that “any provision in an agreement or instrument which purports to relieve a fiduciary from responsibility or liability for any responsibility, obligation, or duty under this part shall be void as against public policy.” However, 29 U.S.C. § 1110(b)(1) includes an exception for a plan that “purchase[es] insurance for its fiduciaries or for itself to cover liability or losses occurring by reason of the act or omission of a fiduciary, if such insurance permits recourse by the insurer against the fiduciary in case of a breach of a fiduciary obligation by such fiduciary.” Numerous federal courts, including the Sixth Circuit, have held that indemnification agreements like the one at issue in this case are permitted under these sections of ERISA so long as a plan’s (i.e., the ESOPs’) assets are not used to fund the indemnification. In addition, the DOL had issued an interpretive bulletin in which it took the position that indemnification agreements like the one at issue in this case are permitted under these sections of ERISA.

However, the arbitrator disagreed with the Sixth Circuit and the DOL, instead siding with the company on its argument that the indemnification agreements with Schafer and Block were void under § 1110(a). Incredibly, the arbitrator’s decision even cited the Sixth Circuit law and the DOL interpretive guidance holding the exact opposite. Yet, according to the arbitrator, the text of §§ 1110(a) and 1110(b)(1) are “clear and unambiguous” and the “[i]ndemnity agreements [at issue in the case] do not fall within this statutory scheme.” Basically, the arbitrator’s rationale was an overly-literal conclusion that only reimbursements constituting “insurance” fall under the exception in § 1110(b)(1) because that is what the statute literally says and “indemnification” is not the same word as “insurance” so the indemnification agreements do not fall under § 1110(b)(1).

Schafer and Block then filed in federal court seeking to vacate the arbitrator’s award. The district court agreed with them, finding that the arbitrator’s decision represented a “manifest disregard of the law” and the arbitrator committed more than “a mere error of interpretation or application of the law.” The district court therefore vacated the arbitrator’s award. The company then appealed to the Sixth Circuit.

The Sixth Circuit reversed the district court. There were two holdings. First, the appellate court found that none of the four reasons for vacating an arbitrator’s decision that are explicitly listed in the Federal Arbitration Act (FAA) were satisfied. Those four explicit reasons are:

  1. where the award was procured by corruption, fraud, or undue means;
  2. where there was evident partiality or corruption in the arbitrators, or either of them;
  3. where the arbitrators were guilty of misconduct in refusing to hear evidence pertinent and material to the controversy; or of any other misbehavior by which the rights of any party have been prejudiced; or
  4. where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made.

Second, the appellate court discussed whether the arbitrator’s decision could be vacated based upon an unlisted, and sometimes implied, fifth reason for vacating an arbitrator’s award; namely, where an arbitrator has demonstrated a “manifest disregard for the law.” By way of brief background, in 2008, the U.S. Supreme Court decided Hall Street Associates, L.L.C. v. Mattel, Inc. in which the Court, in dicta, cast doubt on whether “manifest disregard for the law” was a valid basis for vacating an arbitrator’s award. After Hall Street, the Supreme Court in a 2010 decision entitled Stolt-Nielsen S.A. v. AnimalFeeds International Corporation wrote “[w]e do not decide whether ‘manifest disregard’ survives our decision in Hall Street as an independent ground for review or as a judicial gloss on the enumerated grounds for vacatur set forth [in the FAA].” Ever since, there has been a dispute among the lower federal courts about whether “manifest disregard of the law” remains a valid reason for overturning an arbitrator’s decision.

The Sixth Circuit, in an unpublished opinion, has taken the side that believes “manifest disregard” is still a valid basis for vacating an arbitrator’s award. Nevertheless, the Sixth Circuit, as its second holding in Schafer, said it did not need to conclusively reach the disputed issue on whether “manifest disregard” is still a basis for vacating an award because, even assuming it is, the arbitrator’s decision did not “manifestly disregard the law.”

The rationale of the Sixth Circuit on this second holding can be startling to those not familiar with the law surrounding arbitration agreements. As the Sixth Circuit wrote, “[w]hen courts are called on to review an arbitrator’s decision, the review is very narrow; it is one of the narrowest standards of judicial review in all of American jurisprudence.” The purpose of this narrow review is to maintain one of the advantages of arbitration over court litigation, namely “avoidance of the expense of appeals.” Along those lines, legal error by an arbitrator has long been recognized as an invalid basis for vacating an arbitrator’s award because vacating an award on that basis would be no different than injecting traditional appellate review into the arbitration process.

Keeping that mind, the Sixth Circuit noted that while “legal error” looks a lot like “manifest disregard of the law,” the two cannot be the same if only one of them can provide the basis for vacating an arbitration award. Accordingly, the Sixth Circuit held that “manifest disregard” occurs when an arbitrator bases the award on disagreement with the law rather than a simple misinterpretation of it. Basically then, in the Sixth Circuit, an arbitrator’s “manifest disregard of the law” is the arbitral equivalent of jury nullification.

What It Means For Arbitration Agreements

The Sixth Circuit’s distinction between “legal error” and “manifest disregard” looks right, as does the basis for making the distinction. Disregard looks more like a subjective state of mind where the arbitrator, instead of engaging in a good-faith analysis of the law and simply getting it wrong, opts to instead ignore the law with some level of awareness that he or she is, or may be, ignoring the law. The tougher question is at what point does an error of law start to look like disregarding the law? In other words, how badly does the arbitrator have to get it wrong before it no longer looks like a good-faith error? It seems doubtful that any arbitrator is going to provide clear evidence that he or she is ignoring the law, so it would always be a circumstantial case with an eye toward the arbitrator’s state of mind.

In Schafer, despite the Sixth Circuit saying there was no evidence the arbitrator ignored the law, the arbitrator cited numerous federal cases, including cases from the Sixth Circuit, that were adverse to his interpretation of the law. That seems like circumstantial evidence the arbitrator disregarded the law. However, the Sixth Circuit still said there is “little evidence” of that. To reach that conclusion, the Sixth Circuit said the following:

The very idea that an arbitral decision is not appealable for legal error leads to the conclusion that the arbitrator is not necessarily bound by legal holdings of this court. If an arbitrator relies on a colorable meaning of the words of the statute—as the arbitrator did here—the fact that there is Sixth Circuit precedent to the contrary is not necessarily determinative. Sixth Circuit holdings are binding in courts and on agencies whose decisions are appealable to the Sixth Circuit, ultimately because of that appealability. An arbitrator cannot reject the law, but can disagree with nonbinding precedent without disregarding the law.

So basically, an arbitrator on some level has to consciously refuse to apply what the arbitrator believes to be the meaning of a statute, at least when the law at issue is from a statute. This rationale raises more questions than it answers. What about claims based upon judge-made common law where the only relevant precedents are holdings of a court? Because an arbitrator’s decision cannot be appealed to Ohio state courts, does the Sixth Circuit’s rationale mean an arbitrator has the right to ignore court holdings and completely refashion the elements of the Ohio common law tort for wrongful termination in violation of public policy claim? At the very least, this rationale in Schafer has to be confined to legal arguments based upon statutes, for the very reason that the rationale seemingly does not translate into all situations. But on that basis, how desirable or legitimate is a rationale that is not uniform, but rather is situational only?

These questions aside, the lesson of Schafer for arbitration agreements with respect to employers is do not use these agreements for potential claims where you, as an employer, care about the ability to appeal from a horribly awful adverse arbitration decision. That is why arbitration agreements in the employment context may be more appropriate for low-value claims where the money spent litigating in court and on appeals outweighs the maximum monetary exposure for you as an employer. Arbitration agreements can be so limited; they do not have to include every possible claim.

As just one example, arbitration agreements in the context of the Fair Labor Standards Act (FLSA) can be extremely useful and thread the needle by obtaining the upsides to arbitration and avoiding its downsides. Specifically, an employer may want to use an arbitration agreement that encompasses any FLSA claim whose dollar value is $5,000 or less, exclusive of attorneys’ fees and costs. Just two benefits to this type of agreement are (a) it can keep a low-dollar claim out of expensive court litigation and prevent a plaintiffs’ attorney from abusing discovery or electronic discovery to deliberately run up costs as leverage on a higher settlement or because of the FLSA’s fee-shifting provision, and (b) it can include a class-action waiver and prevent low-dollar FLSA claims from aggregating into a larger liability. On the downsides to arbitration, if the total liability exclusive of fees and costs is $5,000 or less then appellate review will cost more than it saves so lack of meaningful appellate review is a moot point anyway. Other examples may include low-dollar pay discrimination claims, or low-dollar failure-to-promote discrimination claims. Keep in mind that while arbitration itself is favored by the law, the terms of arbitration agreements are heavily scrutinized for enforceability and so should be drafted with careful attention and caution.

Bottom line, the principles in Schafer are a great reminder of how arbitration agreements can be a useful cost-savings tool for employment claims but how they definitely have their limitations. The key to using an arbitration agreement successfully is carefully crafting it so you maximize the benefits of arbitration and minimize the downsides. If you are not using an arbitration agreement right now, you may want explore your options with counsel, whether in-house or outside, and see if these agreements may work as an effective cost-savings tool.

(By the way, for an ERISA lawyer’s take on Schafer, check out our sister blog, Employee Benefits Law Report, here).