Exceeding Powers – May an Arbitrator Amend a Contract
As Part of an Award?
By Michael S. Oberman
The author is a litigation partner and head of the Alternative Dispute Resolution Practice Group of Kramer Levin Naftalis & Frankel LLP in New York. His experience includes service as an arbitrator. He is a member of the CPR Panels of Distinguished Neutrals, the American Arbitration Association’s Large, Complex Case Panel, and the AAA’s Commercial Arbitration Panel. He is a Fellow of the College of Commercial Arbitrators and a board member of the N.Y. International Arbitration Center.
Every now and again, a case comes along that guides what arbitrators may, or may not, do in resolving a dispute. Timegate Studios Inc. v. Southpeak Interactive LLC, 2013 WL 1437710 (5th Cir. Apr. 9, 2013)(available here), is such a case.
Reversing a vacatur of an arbitration award by the federal Southern District of Texas, the Fifth U.S. Circuit Court of Appeals held that the arbitrator had not exceeded his powers by amending the parties’ agreement to grant a perpetual license to the prevailing party in the losing party’s intellectual property.
Timegate and Gamecock (owned by Southpeak Interactive LLC) had entered into a development agreement for a video game called "Section 8." Timegate was to design the game, and Gamecock was to fund the development—and then distribute—the game. The agreement gave Gamecock only a limited distribution license, and expressly reserved in Timegate the exclusive ownership of the game intellectual property.
Additionally, the agreement specifically prohibited Gamecock from preparing derivative works and from exploiting any of the game’s subject matter except as provided for in the agreement.
Section 8 was released two years after the agreement was made, but the game did not meet expectations. The parties soon filed claims against each other in arbitration. The arbitrator—after an eight-day evidentiary hearing—unequivocally found that Timegate materially breached the agreement.
The arbitrator also found that Timegate had engaged in fraud--e.g., by failing to invest the amount of money it represented it was spending in game development, by diverting part of the money funded by Gamecock, and by releasing a version of the game for another game system contrary to the terms of the agreement.
The arbitrator awarded more than $7 million in damages to Gamecock, but he concluded that the monetary award was insufficient to fully compensate Gamecock for the injuries it would suffer due to Timegate’s failure to deliver what was required for other distribution channels and for sequels of the game.
The arbitrator therefore provided in the award that the agreement "is hereby amended as a matter of law" to give Gamecock a perpetual license in Timegate’s intellectual property in the game and to authorize Gamecock to create sequels to the game without any need to account to Timegate. "The effect of the license-modifying portion of the Award was to realign major elements of the parties’ future relationship as established by their original agreement." Id. at *3.
Gamecock filed a motion in the federal district court to confirm the award, and Timegate moved to vacate the award. The district court “found that although a finding of fraud permits an arbitrator to fashion an award which conflicts with contractual provisions,” any such award must still be ‘“rationally inferable from the parties’ central purpose in drafting the agreement.’” Id.
The district court held that “the arbitrator’s creation of the perpetual license was not a remedy rationally rooted in the contract. Id. Finding that it could "'not modify the award while still preserving its intent, and acting consistently with the essence of the parties’ contract,'" the district court vacated the award on the ground that the arbitrator had exceeded his power. Id. (Citation omitted). See 9 U.S.C. § 10(a)(4).
A unanimous three-judge Fifth Circuit panel reversed. In an opinion by Circuit Judge W. Eugene Davis, it first stated the standard of review of an award: that a court "must sustain an arbitration award even if [the court] disagree[s] with the arbitrator’s interpretation of the underlying contract as long as the arbitrator’s decision ‘draws its essence’ from the contract"—or , put another way, "if it is rationally inferable from the letter or the purpose of the underlying agreement." Timegate, 2013 WL1437710, at *4 (citations omitted).
Addressing Section 10(a)(4) of the FAA, the court observed that "[w]hether an arbitrator has exceeded his powers is tied closely to the applicable standard of review. . . . [t]he question is whether the arbitrator’s award was so unfounded in reason and fact, so unconnected with the wording and purpose of the [contract] as to manifest an infidelity to the obligation of an arbitrator." Id. (Citations and internal quotation marks omitted).
Simply put, the appellate court wrote that "the substantive question of whether an arbitrator has exceeded his arbitration power is a function of our highly deferential standard of review in such cases: an arbitrator has not exceeded his powers unless he has utterly contorted the evident purpose and intent of the parties—the ‘essence’ of the contract." Id.
The court added that "the arbitrator’s selection of a particular remedy is given even more deference than his reading of the underlying contract"; "[t]he remedy lies beyond the arbitrator’s jurisdiction only if there is no rational way to explain the remedy handed down by the arbitrator as a logical means of furthering the aims of the contract." Id. (Citation and internal quotation marks omitted).
Having framed the standard as turning on the "essence" of the underlying agreement, the court proceeded to determine the essence of the particular agreement in the case. The court did so by reviewing the agreement itself, as opposed to taking findings from the award or from the district court’s decision.
The court found that "virtually every foreseeable aspect of the parties’ business relationship is contemplated and addressed by the Agreement, representing a sensitive, interdependent balance in which each party was assured of a specific set of rights and benefits in exchange for their promise to accept a specific set of duties and responsibilities." Id.
The court added that the "entire Agreement can accurately be summed up as the creation of a mutually beneficial business relationship between two parties with distinct expertise: a video game developer and a video game publisher." Id.
Against this review of the agreement, the court held that the "perpetual license furthers these general aims of the Agreement." Id. at *5.
Because it was conceded that the record proved an inability of the parties to further work with each other, the "only way to give Gamecock the opportunity to benefit from the future development variations of Section 8 was to cut Gamecock loose from Timegate and allow it to independently pursue game marketing efforts." Id.
The court observed that "the arbitrator could have reasonably found that only by severing the parties’ obligations to work with each other to develop, publish, and sell Section 8 could each party achieve the object of the Agreement: access to the financial benefits of their agreed-upon contributions." Id.
Timegate argued that vacatur was warranted because the perpetual license was contrary to express provisions of the agreement. The court rejected the argument, finding first that the agreement ran 35 pages so that any award "which attempts to compensate and restore one contractual party for multiple, irreversible breaches committed by the other party will inevitably realign some of the original contract’s provisions." Id. at *6.
The court also noted that Texas law provides a basis for voiding provisions of a contract upon a finding of fraudulent inducement.
The court next distinguished its prior cases that found an arbitrator had exceeded his powers by saying that, in those cases, the arbitrator had "intruded on an issue that was reserved for an alternative decisionmaker or was removed from anyone’s discretion under the contract." Id. (Citation omitted).
Pulling these threads together, the Fifth Circuit concluded: "Although this court has not considered a factually similar application of the essence test, our caselaw suggests that the perpetual license is within the broad scope of the arbitrator’s authority." Id.
In particular, the court quoted from a prior case that an award must be upheld "[p]rovided that [the arbitrator’s] choice is not precluded by the arbitration provision under which he is acting, is adequately grounded in the contract, and is not arbitrary or capricious." Id. at *7 (citation omitted; emphasis added by the Fifth Circuit).
The court noted that it had located only one case on point—a decision by the California Supreme Court—and the Fifth Circuit found that case (which also upheld an award) to be persuasive authority. Id. (citing Advanced Micro Devices Inc. v. Intel Corp., 885 P.2d 994 (Cal. 1994)).
The court completed its opinion by reiterating the elements that drove the decision:
Timegate committed an extraordinary breach of the Agreement, and an equally extraordinary realignment of the parties’ original rights is necessary to preserve the essence of the Agreement. Because the Agreement bestowed broad remedial powers upon the arbitrator and because it was fraudulently induced and irreversibly violated by Timegate, the perpetual license is a rational and permissible attempt to compensate Gamecock and maintain the Agreement’s essence.The court did not detail how the arbitration provision in this agreement was broad; it merely stated that "the arbitration clause is quite broad and contains no limits relevant to the instant dispute: 'any dispute . . . shall be submitted to binding arbitration.'" Id. at *4. (Emphasis is the Fifth Circuit opinion’s.)
Nor in its analysis did the court address whether a district court—if presented with the same set of facts in a lawsuit—could provide the same remedy as the perpetual license upheld by this opinion (although the Advanced Micro Devices decision, cited with approval in Timegate, recognizes that an arbitrator may award a remedy that would not be available in a court proceeding and further recognizes that parties in their arbitration provision can limit an arbitrator’s power to do so).
So, what guidance does this case provide? First, it must be noted that there were unchallenged findings of misconduct by Timegate—not a mere breach of contract, but conduct sounding in fraud.
Second, the nature of the agreement—which envisioned future joint exploitation of the video game—meant that monetary damages accrued to date would not provide a complete remedy, and probably damages for unrealized future profits could be seen as too speculative to calculate.
Third, the arbitration provision did not limit the remedies that could be awarded. In this set of circumstances, the Fifth Circuit found that the arbitrator did not exceed his powers by amending the agreement to provide Gamecock with a perpetual license.
Given the deferential standard of review under Section 10(a)(4) and the several qualifications just noted, it cannot be said that the court was in any way suggesting that amending a contract should be considered a “best practice” for arbitrators or that arbitrators are being encouraged to be creative in fashioning remedies. But the case does teach that in the right circumstances and with the right contract provisions, an award amending a contract in order to afford complete relief to the injured party can fit within the powers of an arbitrator.