Delaware Business Litigation Report

The Other 'Nessie': An Order Vacating an Arbitral Decision

Authored by Peter B. Ladig
This article was originally published in the Delaware Business Court Insider | July 31, 2013

In Steiner v. Meyerson, 1995 Del. Ch. LEXIS 95 (Aug. 16, 1995), former Delaware Court of Chancery Chancellor William T. Allen famously described claims of corporate waste as "rarest of all — and indeed, like Nessie, possibly non-existent." Perhaps equally rare are decisions vacating an arbitral award. Both the Federal Arbitration Act and the Delaware Uniform Arbitration Act provide for limited judicial review of arbitral decisions and awards, leaving the losing party to an arbitration very little room to argue the award should be vacated. One of the grounds often cited by disgruntled parties as a reason for vacating an award is that the arbitrator exceeded or imperfectly executed his or her powers by issuing an incorrect decision. In keeping with the public policy of limiting judicial review of arbitral awards, however, courts have construed those grounds narrowly, requiring more than a mere disagreement with the arbitrator's interpretation of the law. Instead, courts have uniformly held that to exceed or imperfectly execute his or her powers, the arbitrator must act with "manifest disregard" for the law. As such, most petitions to vacate an arbitral award relying on an arbitrator "imperfectly executing his powers" will fail, and it is the rare case in which an arbitral award is vacated because of manifest disregard for the law.

In Garda USA v. SPX, C.A. No. 7115-VCL (Del. Ch. June 4, 2013), that rare case occurred. In a bench ruling, the Court of Chancery granted the plaintiffs' motion for summary judgment and entered an order vacating the arbitrator's award on the grounds that the arbitrator "manifestly disregarded controlling contractual language and, consequently, so imperfectly executed its powers that a final and definite award on the subject matter submitted was not made." Not only was this the first time a Delaware court had vacated an award on these specific grounds, but the court applied for the first time a three-part test to analyze the request.

The underlying arbitration arose out of Garda's acquisition of Vance International from SPX Corp. As is often the case with the sale of an operating subsidiary that does not maintain separate financial records, the seller was required to provide an estimate of Vance's working capital, subject to a later adjustment after the sale. Working capital, or current assets minus current liabilities, can have a profound effect on the sale price; by underestimating a current liability, such as workers' compensation reserves, a party can make its working capital appear to be larger than it actually is, and cause the buyer to overpay.

In the transaction documents for the Vance sale, the parties specifically negotiated terms defining how current liabilities would be calculated in determining working capital. The contract excluded "incurred but not reported" liabilities (IBNR) related to risk-management programs from the calculation of current liabilities, except with respect to workers' compensation, which the contract stated "shall be included in the calculation of current liabilities."

Prior to closing, SPX informed Garda that it maintained a reserve for Vance's workers' compensation claims of approximately $1.4 million. After closing, Garda learned that SPX's actuary had estimated that the appropriate reserve for Vance's workers' compensation claims was almost twice what SPX had reserved. The actuary subsequently revised its estimate upward to approximately $1.8 million more than SPX's original estimate. After learning this information, although not the underlying reasons why the actuarial estimate differed so greatly, Garda formally disputed SPX's workers' compensation reserve calculation. After three years of efforts to resolve the dispute, Garda invoked the dispute-resolution mechanism of the sale agreement requiring a proceeding before an independent accountant.

During the proceedings before the independent accountant, Garda learned for the first time that SPX had not included IBNR in its calculation of the workers' compensation reserve for purposes of the sale agreement. Garda argued to the independent accountant that SPX violated the agreement by failing to incorporate IBNR as required by its plain language. SPX countered by arguing that other language in the agreement permitted SPX to calculate reserves as they had been calculated historically, but SPX did not deny that its calculation of Vance's workers' compensation reserve did not include IBNR.

The independent accountant subsequently rendered a decision and award that did not adjust the working capital of Vance or the workers' compensation reserve in any way. The independent accountant did not explain its conclusions or cite to any portion of the record to support his decision. Garda then filed an action in the Chancery Court seeking an order vacating the award on the grounds that, among other things, the independent accountant exceeded his powers by ignoring the plain language of the agreement and not including workers' compensation IBNR liabilities in the working capital of Vance.

Although other courts had found that the failure of an arbitrator to follow contractual language constituted manifest disregard, no Delaware court had expressly addressed the issue. The court, however, readily followed prior precedent and agreed with the concept that failure to follow the plain language of a contract justified vacating an arbitral award, citing dicta in RBC Capital Markets v. Thomas Weisel Partners, 2010 Del. Ch. LEXIS 36 (Del. Ch. Feb. 25, 2010). Having cleared that hurdle, the court applied a three-part test to Garda's request to vacate the arbitral award.

First, the court needed to determine whether the contractual language was clear and unambiguous. That was the core issue because "under Delaware's version of the Uniform Arbitration Act, an arbitration award can be vacated if the arbitrator acted in manifest disregard of the law and controlling contractual provisions." The court found that the agreement between the parties set forth a clear and unambiguous formula for calculating current liabilities that required IBNR to be included in the calculation of workers' compensation liabilities. The court rejected SPX's argument that whether to include IBNR was within the judgment of the independent accountant, and therefore entitled to deference:

"If the issue were whether IBNR had been calculated appropriately, that would be the type of accountant's judgment where the reading might be arguably more colorable. You'd give deference to the colorable reading, and the idea that the accountant could exercise its judgment and experience. ... This isn't that type of question. This is a question of, 'Do you add back in the variable Z?' That's not a judgment call. That's not an accountant call. That's a specific aspect of the formula under this agreement."

Second, after determining that the law — here, the contract — was clear and plainly applicable, the court then could only vacate if "the law, in fact, was improperly applied, leading to an erroneous outcome." The court easily found this to be true here, as the failure to include IBNR in the workers' compensation reserve resulted in a conclusion "directly opposite to the calculation required" by the agreement.

Third, the court had to determine whether the arbitrator had knowledge of the error. While ordinarily this part of the test means whether the arbitrator knew of a statute or regulation, here it meant whether the arbitrator knew of the calculations required by the agreement. The court held that there was no question that the arbitrator had the contract provision and applicable formula before him but failed to follow it.

Does the decision in Garda presage a new era of judicial review of arbitral awards? Hardly. Garda had unique facts not easily found elsewhere: plain and unambiguous language in the contract and little disagreement that the arbitrator did not follow that language. Garda is most notable for being the first instance in which a Delaware court has expressly addressed whether failure to follow a contract constitutes manifest disregard of the law. Moreover, the court made plain the three things a party seeking to vacate an arbitral award on these grounds must show to earn vacatur. Parties in arbitration should take note of these factors, including making sure the arbitrator is aware of the relevant contractual provision.

 

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