Arbitration Clauses/The Punitive Damages “Minefield”

The conventional legal “gospel” with respect to agreements to arbitrate and arbitration proceedings is that such agreements/proceedings are governed by either the New York Civil Practice Law and Rules (the “CPLR”), on the one hand, or, where subject matter jurisdiction exists therefor, the Federal Arbitration Act (the “FAA”), on the other. To the contrary, however, a recent decision by the First Department is a stark reminder that both the CPLR and the FAA can be “trumped” by the rules of the arbitration forum designated by the parties.

In Matter of Flintlock Construction Services, LLC . v. Weiss, 2014 NY Slip Op 05818 (1st Dept. August 14, 2014), Supreme Court denied a petition to stay respondent’s claim for punitive damages. The petition was based upon the “legal sacrament” of Garrity v. Lyle Stuart, Inc., 40 N.Y. 2d 35, 386 N.Y.S. 2d 831 (1976).

In Garrity, the Court of Appeals held that : “The court will vacate an award enforcing an illegal agreement or one violative of public policy… Since enforcement of an award of punitive damages as a purely private remedy would violate public policy, an arbitrator’s award which imposes punitive damages, even though agreed upon by the parties, should be vacated [.]”

The First Department in Flintlock outlined the facts and prior proceedings:

This appeal arises from the motion court’s denial of a motion to stay arbitration of claims for punitive damages in a dispute among investors in a real estate development company. In 2011, respondent investor commenced an arbitration proceeding against petitioners real estate development companies and their principals, alleging fraud and breach of contract, and seeking punitive damages. The parties’ relationship was governed by a letter agreement and the operating agreements for petitioners Flintlock Construction Services, LLC (Flintlock) and Basque Construction LLC (Basque).

The Flintlock and Basque operating agreements contain identical choice of law clauses, providing that the agreements “shall be construed and enforced in accordance with the laws of the State of New York.”

The Flintlock and Basque operating agreements contain identical arbitration provisions, which provide, in relevant part, that “[a]ny controversy or claim arising out of or relating to this Agreement or the breach or alleged breach of this Agreement, shall be resolved by arbitration in accordance with the Commercial Arbitration Rules of the American Arbitration Association which are then in effect.” Although the letter agreement does not itself contain an arbitration clause, it was executed contemporaneously with the operating agreements and describes respondent’s role as a member of Flintlock and Basque. Although petitioners did not object to the punitive damages claim in the original demand for arbitration, they challenged respondent’s right to amend the demand to assert claims for fraud and intentional misrepresentation, and moved before the arbitration panel to dismiss several of the claims, including the request for punitive damages. Petitioners asserted, inter alia, that punitive damages were not available/arbitrable. The motion to dismiss the request for punitive damages was denied, on or about July 5, 2012, without prejudice to renewal at the hearing, based on a more complete record as to whether the claim affected interstate commerce, and thus, mandated application of the Federal Arbitration Act (FAA), 9 USC § 1 et seq. A hearing before the arbitration panel was scheduled to commence on November 5, 2012.

On or about September 12, 2012, petitioners commenced a special proceeding to “permanently enjoin” the arbitration on the ground that the arbitrators had exceeded their authority, and lacked power to award punitive damages. The motion court denied the petition, finding that petitioners, having “actively litigated” before the arbitration panel, had “charted their own course,” and could not now assert that the arbitrators could not hear the issue of punitive damages.

Petitioners’ argument:

Petitioners argue that the motion to stay arbitration of the claim for punitive damages was improperly denied, asserting that under New York law arbitrators “ha[ve] no power to award punitive damages, even if agreed upon by the parties” (Garrity v Lyle Stuart, Inc., 40 NY2d 354, 356 [1976]).

Affirmed Supreme Court:

…The arbitration panel denied the motion to dismiss the punitive damages claim without prejudice to renewal upon a complete record. Petitioners ask us, in effect, to render an advisory opinion concerning the availability of punitive damages, which we ought not do. It remains to be determined whether, on this record, the contracts evidence a “transaction involving commerce” such that the FAA, and not state law, applies.

To the extent petitioners argue that the New York choice-of-law provision in the contracts displaces the FAA and mandates the application of the Garrity rule, we must disagree. The rules of the American Arbitration Association (AAA) specify that an arbitrator is authorized to award “any remedy which [is] just and equitable and within the scope of the agreement.” Where parties agree that the AAA rules will govern, questions concerning the scope and validity of the arbitration agreement, including issues of arbitrability, are reserved for the arbitrators (see Life Receivables Trust v Goshawk Syndicate 102 at Lloyd’s, 66 AD3d 495, 496 [1st Dept 2009], affd 14 NY3d 850 [2010], cert denied __ US __, 131 S Ct 463 [2010]).

Under the FAA, it is for the arbitrators, and not a court, to determine the availability of punitive damages, notwithstanding the general choice-of-law provision in the contracts that they are to be construed and enforced according to New York law. The choice-of-law provision, in the absence of language expressly invoking the Garrity rule, or expressly excluding claims for punitive damages, is insufficient to remove the issue of punitive damages from the arbitrator.

Where the parties “agree to include claims for punitive damages within the issues to be arbitrated, the FAA ensures that their agreement will be enforced according to its terms even if a rule of state law would otherwise exclude such claims from arbitration” (Mastrobuono v Shearson Lehman Hutton, 514 US 52, 58 [1995]). In Mastrobuono, the United States Supreme Court held that a New York choice-of-law clause providing an agreement “shall be governed by the laws of the State of New York,” did not unequivocally demonstrate an intent to preclude an award of punitive damages. The Court reasoned that best means of “harmoniz[ing]” the choice-of-law provision with the arbitration provision was to read “the laws of the State of New York” to refer to substantive principles a New York court would apply, but not to include rules limiting the authority of arbitrators: “Thus, the choice-of-law provision covers the rights and duties of the parties, while the arbitration clause covers arbitration; neither intrudes upon the other…”

And distinguished Garrity:

Merely stating, without further elaboration, that an agreement is to be construed and enforced in accordance with the law of New York does not suffice to invoke the Garrity rule. The Supreme Court has made clear that in order to remove the issue of punitive damages from the arbitrators, the agreement must “unequivocal[ly] exclu[de]” the claim… The agreement in this case, which provided only that it was to be “construed and enforced” in accordance with the law of New York, did not unequivocally exclude claims for punitive damages from the consideration of the arbitrators…A New York choice-of-law provision does not constitute a manifestation of unequivocal intent sufficient to invoke the Garrity rule.

Life Receivables Trust, upon which the First Department relied, arose out of Supreme Court’s denial of a motion to stay or enjoin an arbitration proceeding before the American Arbitration Association, turning on the question of whether the Court or the arbitrator had jurisdiction to determine questions of arbitrability.

According to the Appellate Division:

The arbitration agreement at issue requires that “[a]ll disputes and differences arising under or in connection with this [contract] . . . be referred to arbitration under the American Arbitration Association Rules.” The AAA rules authorize the arbitration tribunal to rule on its own jurisdiction, including objections with respect to the existence, scope or validity of the arbitration agreement.

And the First Department noted that:

Although the question of arbitrability is generally an issue for judicial determination, when the parties’ agreement specifically incorporates by reference the AAA rules, which provide that “[t]he tribunal shall have the power to rule on its own jurisdiction, including any objections with respect to the existence, scope or validity of the arbitration agreement,” and employs language referring “all disputes” to arbitration, courts will “leave the question of arbitrability to the arbitrators”…Thus, the motion court was correct in finding that the scope and validity of the arbitration agreement, necessarily including issues of arbitrability, are for the arbitration tribunal to determine.

Cases are legion where our Courts have held that the rules of the arbitration forum “trump” the CPLR and the FAA:  For example:  Tong v. S.A.C. Capital Management, LLC, 16 Misc. 3d 401, 831 N.Y.S. 2d 881 ( Sup. Ct. N.Y. Co. 2007) [Fried, J.] aff’d as mod. 52 A.D.3 386, 860 N.Y.S.2d 84 (1st Dept. 2008).

Tong, who sought punitive damages, asserted that he was “subjected to sexual harassment, a hostile work environment, discrimination and retaliation by defendants.”

Tong’s employment agreement with S.A.C., “governed by the laws of the State of New York”, stated that:


Justice Fried noted that:

Since Tong does not contest that he signed the arbitration agreement at issue, the only questions before me are: first, whether the arbitration agreement signed by Tong is broad enough to cover the dispute, and, second, whether it is valid and enforceable.

Ruled that:

In the agreement, the parties agreed “that any dispute or controversy arising out of or relating to this agreement, the interpretation thereof, and/or the employment relationship [between Tong and SAC] shall be settled by arbitration.” Plaintiff has charged defendants with discrimination, harassment, and retaliation in his employment, as well as breach of contract, promissory estoppel, fraudulent inducement, defamation, and intentional torts—all arising out of the same alleged conduct. The arbitration provision is unambiguous and is plainly broad enough to cover plaintiff’s claims.

And held that Garrity did not apply:

The American Arbitration Association (AAA) Commercial Arbitration Rules say nothing about whether punitive damages may be awarded—they do not carry a presumption either way. They provide simply that “[t]he arbitrator may grant any remedy or relief that the arbitrator deems just and equitable and within the scope of the agreement of the parties.” (AAA Commercial Arbitration Rules rule R-43 [a].)

New York law does not permit arbitrators to award punitive damages. (Garrity v Lyle Stuart, Inc., 40 NY2d 354, 356 [1976].) However, the United States Supreme Court held in Mastrobuono v Shearson Lehman Hutton, Inc. (514 US 52 [1995]) that the Federal Arbitration Act (FAA) preempts the Garrity rule for an arbitration agreement governed by the FAA, even when the agreement contains a New York choice of law clause, in the absence of evidence that the parties intended to give up their right to punitive damages.

New York courts have followed Mastrobuono. (E.g. Matter of Americorp Sec. v Sager, 239 AD2d 115, 116 [1st Dept 1997] [reversing stay of arbitration of punitive damages claim, concluding that parties’ agreement that their “right and liabilities” would be governed by New York law did not invoke New York’s restrictions on arbitral awards of punitive damages, where parties agreed to submit dispute to arbitration at National Association of Securities Dealers (NASD), whose rules permit punitive damages awards]; Merrill Lynch, Pierce, Fenner & Smith v Adler, 234 AD2d 139, 139 [1st Dept 1996] [reversing stay of arbitration as to punitive damage claim, where arbitration agreement selected NASD as arbitral forum, and NASD rules contemplated “a broad range of relief”]; Matter of Prudential Sec. [Pesce], 168 Misc 2d 699 [Sup Ct, NY County 1996, Cahn, J.] [denying motion to stay arbitration as to punitive damages claim]; Matter of Cohen v S.A.C. Capital Advisors, LLC, 11 Misc 3d 1054[A], 2006 NY Slip Op 50205[U] [Sup Ct, NY County 2006] [enforcing arbitral award of punitive damages, concluding that New York choice of law provision did not displace FAA].)

Justice Fried concluded that Tong’s punitive damages claim was arbitrable under the agreement.

Lesson learned:  At the outset, carefully read the rules of the arbitration forum nominated in the dispute resolution clause of a contract.  Determine, among other things, the scope of the “gatekeeper” issues that the arbitrator is authorized to determine and the panoply of relief that the arbitrator is authorized to grant or impose.

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