REUTERS | Eduardo Munoz

For arbitrations in New York, it matters whether federal or state law governs

A recent New York Supreme Court Commercial Division decision precluded the petitioner from seeking to vacate an arbitral award because, although he objected to the jurisdiction of the arbitrators, he participated in the arbitration proceedings. This post-award challenge to the jurisdiction of the arbitrators would have come out differently had the case been decided under the Federal Arbitration Act (FAA) rather than under article 75 of New York’s Civil Practice Law and Rules, under which the parties briefed and the court ruled on the issue.

Fava v Morgan Stanley Smith Barney Inc is a cautionary tale for parties and their counsel with an arbitration seated in New York, that the differences between the FAA and article 75 could turn out to be significant. In many practical respects, federal versus state arbitration law distinctions are unlikely to result in a materially different outcome given the pro-arbitration position of both statutes (see CPLR Article 75 or the Federal Arbitration Act: Which One Applies to Arbitration in New York and Why It Matters). The Fava case, however, marks an instance where the application of article 75, rather than the FAA, was determinative. Justice Barry Ostrager ruled that under article 75, the court could not consider Fava’s post-award challenge to the arbitrators’ jurisdiction, whereas under the FAA, the court would have been required to address that issue and to do so without giving deference to the arbitrators’ finding of jurisdiction.

New York Supreme Court Commercial Division’s decision

In Fava, Morgan Stanley initiated a FINRA arbitration against its former employee arising out of the alleged failure to repay a loan. In resolution of that arbitration, the parties entered into a settlement agreement reducing and deferring Fava’s payment obligations, dismissing the original FINRA arbitration, exchanging mutual releases, and providing that any disputes arising under the settlement agreement would be decided by “the state and federal courts of the State of New York”. Fava allegedly failed to make payment according to the terms of the settlement agreement, and Morgan Stanley commenced a second FINRA arbitration under that agreement.

When Fava moved to dismiss the arbitration as inconsistent with the dispute resolution clause in the settlement agreement, Morgan Stanley argued that because the parties were then FINRA members (Morgan Stanley as a member and Fava as an associate member of another financial firm), the litigation provision was unenforceable under FINRA rules. The FINRA panel denied the motion to dismiss, with one arbitrator dissenting. The arbitration proceeded, ultimately resulting in a final award in favour of Morgan Stanley. Fava then petitioned to vacate the award in New York state court, claiming that the FINRA panel “exceeded its authority” given the parties’ agreement to litigate disputes under the settlement agreement.

In denying Fava’s petition to vacate and confirming the award, Justice Ostrager, as did the parties, applied article 75 without any reference to the FAA. Relying on CPLR § 7511(b)(2), the court found that by “fully participating in the arbitration, while consistently maintaining his objection to the arbitration throughout the proceedings”, Fava waived judicial review of the arbitrators’ jurisdiction by having failed under CPLR § 7503 to seek a stay of the arbitration before participating in those proceedings. Having not sought a stay of the arbitration at the outset, the ground for seeking vacatur under CPLR § 7511(b)(2) when “a valid agreement to arbitrate was not made” did not apply.

How FAA rule differs from CPLR § 7511(b)(2)?

Under article 75, the grounds for vacatur to challenge an arbitral award after its issuance depend on whether the party “participated in the arbitration”. Although CPLR § 7511(b)(1) enumerates certain grounds for vacatur available to a party “who either participated in the arbitration or was served with a notice of intention to arbitration”, CPLR § 7511(b)(2) lists grounds for challenging an award that a party forfeits by failing to seek judicial relief at the outset, even if an objection is made throughout the arbitration proceeding.

In contrast, the FAA by its terms does not restrict the available grounds for vacatur depending on a party’s participation in the arbitration proceeding where it has preserved its objection during the arbitration. Courts applying the FAA (for example, the US Supreme Court in First Options of Chi Inc v Kaplan and the Southern District of New York in Goldstein v Visconti) have routinely accepted that parties who participate in the arbitration may still challenge the enforcement of an award under the four grounds for vacatur enumerated in the FAA, including specifically the argument that the party found liable under the award had never agreed to arbitrate the dispute. Moreover, following the Supreme Court’s dicta in First Options, absent evidence of a clear and unmistakable intention by the parties to delegate the issue of the arbitrators’ jurisdiction to the arbitrators, a court considering a post-award challenge to jurisdiction is to conduct that review de novo and without any deference to the determination of that issue by the arbitrators.

Accordingly, under the FAA, a respondent has the option of making its jurisdictional objection to the tribunal and seeing how the arbitration plays out. If the arbitrators either determine they lack jurisdiction or rule in favour of the respondent on the merits, the respondent will have avoided the time and expense of applying to a New York court to stay the arbitration. Alternatively, where the FAA applies, the unsuccessful respondent could challenge the arbitrators’ jurisdiction in the context of a motion to vacate, a procedural option found not to exist under article 75.

When does FAA Apply?

Generally, article 75, as New York’s arbitration law, applies by default to all arbitration-related proceedings in New York. For an entirely local, New York-based arbitration arising from a contract that that does not affect interstate commerce, article 75 is the sole source of arbitration law to govern the proceeding.

The FAA, on the other hand, applies to agreements to arbitrate in contracts concerning transactions “involving commerce”, which the Supreme Court in Citizens v Alafabco Inc, has broadly construed to encompass “a wider range of transactions than those actually “in commerce”,  so long as the type of activity has a substantial effect on interstate commerce. Courts have held that contracts between broker dealers and their customers, as well as between broker dealers and their registered representatives, are contracts that clearly affect interstate commerce. Relevant here, the US District Court for the Southern District of New York in Ameriprise Financial Services Inc v Silverman expressly found that the FAA “governs the confirmation and vacatur of an award rendered in a FINRA arbitration”. Furthermore, whenever an arbitration falls within the scope of the FAA, it applies in state court as well as in federal court (Fletcher v Kidder, Peabody & Co Inc)).

Implications of the case

Given the clearly interstate nature of the securities business, this case offers one example where the application of the FAA rather than article 75 can materially impact the outcome, in this case, whether the court would consider, post-award, if the agreement to litigate disputes was enforceable notwithstanding the FINRA rules. This decision underscores the importance to counsel of appreciating when the FAA applies, as well as the differences between the FAA and article 75.

The views expressed in this article reflect those of the authors and not necessarily those of Cleary Gottlieb Steen & Hamilton LLP or any of its clients.

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