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March 26, 2018 Articles

Threat of Sanctions on Counsel Who Employed “Scorched Earth” Tactics

By P. Jean Baker

Round One: Arbitration of the Dispute
In September 2012 Hyatt and Shen Zhen New World I entered into a franchise agreement providing that Shen Zhen would renovate a hotel in Los Angeles and operate it using Hyatt's business methods and trademarks. In 2014 Hyatt declared that Shen Zhen had not kept its promises. In accordance with a provision in the franchise agreement Hyatt filed a demand for arbitration with the American Arbitration Association (AAA).

An AAA arbitrator was appointed by mutual agreement of the parties. The parties participated in 9 days of in-person evidentiary hearings. The arbitrator issued a 51-page interim award consisting of reasoned findings of fact with extensive cites to controlling statutory and case law authority. The district court found that after a "vigorous" review of the franchise agreement the AAA Arbitrator found that Hyatt was entitled to terminate the contract because Shen Zhen had breached its financial obligations by refusing multiple times to pay chain fees and marketing fees. Shen Zhen was ordered to pay $7,727,646 in damages.

Because the franchise agreement provided that the non-prevailing party must reimburse the prevailing party for all reasonable accounting, attorneys', arbitrators' and related fees, the interim award directed Hyatt to submit a request. In the final award Shen Zhen was ordered to pay an additional $1,324,546.36 in attorneys' fees and costs.

Round Two: Dueling Motions in District Court
Hyatt sought to have the award confirmed and entered as a court judgment. Shen Zhen sought to vacate the award on three grounds: 1. The arbitrator had engaged in misconduct under Federal Arbitration Act (FAA) Section 10(a)(3); 2. The arbitrator had engaged in a manifest disregard of the law under FAA Section 10(a)(4); 3. Public policy supported vacating the award.

Arbitrator Misconduct under FAA Section 10(a)(3)
Shen Zhen argued that denial of requests for discovery into the alleged incompetence of prior counsel and potential conflicts of interest amounted to a refusal to hear pertinent evidence and constituted arbitrator misconduct under FAA Section 10(a)(3). Shen Zhen had sought to subpoena the attorney who represented Shen Zhen during contract negotiations in 2012 to establish the attorney had provided incompetent representation. The arbitrator had ruled that such evidence would not be relevant as to whether the agreements themselves were ambiguous or somehow flawed at the time of contracting. Based upon the fact the attorney had been working with a sophisticated business team and in-house attorneys from Shen Zhen during the negotiations and the attorney had stopped working for Shen Zhen in 2012, the district court upheld the arbitrator's decision to deny issuance of the subpoena.

In 2015, three years after the attorney stopped representing Shen Zhen, the attorney joined the law firm that was representing Hyatt in the current dispute with Shen Zhen. The arbitrator ruled, over Shen Zhen's objections, that the franchise agreement specified application of Illinois law. In accordance with the Illinois Rules of Professional Conduct (IRPC) and relevant Illinois case law Hyatt's law firm should not be disqualified since the law firm had properly implemented a conflicts screen in compliance with the IRPC. As to whether there was misconduct when the arbitrator decided to not disqualify Hyatt's law firm, the district court noted that Shen Zhen only cited to non-precedential and factually distinguishable cases establishing misconduct by an arbitrator. The district court concluded that refusing additional discovery requests were the kinds of arbitral decisions that a court is not permitted to overturn. Thus, there was no misconduct under FAA Section 10(a)(3).

Manifest Disregard for the Law under FAA Section 10(a)(4)
Shen Zhen argued that the arbitrator manifested a disregard for law when the arbitrator failed to disqualify Hyatt's law firm; failed to consider that the franchise agreement required a notice and cure period; and failed to apply the California Franchise Investment Laws (CFIL) and the Federal Trade Commission (FTC) regulations.

The district court began its analysis by stating that the manifest disregard standard only encompasses scenarios in which an arbitrator intentionally disregarded a law to arrive at a certain result or where an arbitrator instructed the parties to violate the law. Courts lacked the authority to review for mere mistakes of law. The arbitrator applied Illinois law—the law specified in the franchise agreement—when deciding to not disqualify Hyatt's law firm so there was no intentional disregard for the law. As to whether the arbitrator's determination that a provision in the franchise agreement allowed Hyatt to terminate without providing Shen Zhen opportunity to cure, that "is precisely the kind of arbitral decision that a district court is not permitted to overturn." If the arbitrator had been incorrect about claims under the CFIL and the FTC being baseless (an assessment the district court was inclined to agree with), that would again constitute an arbitral mistake of law and not a manifest disregard for law. Finally, an arbitrator is under no obligation to apply statutes which do not provide relief for the controversies before them so there was no legal obligation to apply either the CFIL or the FTC.

Against Public Policy
Finally, Shen Zhen asked the district court to overturn the arbitrator's rulings on public policy grounds. As noted by the district court the only support offered by Shen Zhen that a court possessed the ability to vacate a commercial arbitration award on public policy grounds was a 2013 Seventh Circuit decision that involved a collective bargaining statute. See Titan Tire Corp. of Freeport v. United Steel, Paper & Forestry, Rubber Mfg., Energy, Allied Indus. & Serv. Workers Int'l Union, 734 F.3d 708 (7th Cir. 2013).

Since the FAA does not mention public policy violations as grounds for vacating an arbitration award, the District court concluded there was no clear authority to overturn a commercial arbitration award on public policy grounds.

The district court granted Hyatt's motion to confirm the award and denied Shen Zhen's motion to vacate the award. (Hyatt Franchising, L.L.C. v. Shen Zhen New World 1, LLC, 876 F.3d 900 (7th Cir. 2017).)

Round Three: Seventh Circuit Court of Appeal
Shen Zhen filed an appeal seeking reversal of the district court's decision to confirm the award.

Arbitrator's Denial of Discovery Request
The Seventh Circuit began its analysis by finding that the statutory phrase "refusing to hear evidence" concerns the conduct of the hearing, not the conduct of discovery. The court stressed that nothing in the FAA requires an arbitrator to allow any discovery. In fact, avoiding the expense of discovery is among the principal reasons why people agree to arbitrate. Thus, Respondent's argument that the AAA arbitrator should have allowed additional discovery "rings hollow," especially when one considers that Hyatt's attorneys' fees exceeded $1 million—an indication to the court that plenty of discovery had actually occurred.

Further whether the attorney had furnished good advice when negotiating the franchise agreement might be relevant in a malpractice action against the attorney but did not bear on Hyatt's allegations that Shen Zhen breached the contract. In addition, the contract had an integration clause that foreclosed use of the negotiating history as an interpretive tool. Finally, in a commercial transaction between sophisticated parties the defense of unconscionability, if available at all, was an objective one dependent upon the agreement's terms and not on what either side's attorney might say about the actual negotiations.

Arbitrator's Refusal to Disqualify Claimant's Law Firm
Next the court found that FAA Section 10(a)(3) does not provide for substantive review of an arbitrator's decisions. It provides for judicial intervention when an arbitrator misbehaves, but not when an arbitrator renders a mistaken decision, either as a matter of fact or as a matter of law. If Shen Zhen believed that the attorney or Claimant's law firm engaged in misbehavior, the appropriate forum was a complaint to the state bar.

Disregard for the Law under Section 10(a)(4)
As a "fallback argument", Shen Zhen contended that the award disregarded federal and state franchise law and therefore should be set aside under Section 10(a)(4). The court began its analysis by relying upon two prior Seventh Circuit decisions that held that Section 10(a)(4) does not make legal errors a ground on which a judge may refuse to enforce an award. See, e.g., George Watts & Sons, Inc. v. Tiffany & Co., 248 F.3d 577 (2001); Affymax, Inc. v. Ortho-McNeil-Janssen Pharmaceuticals, Inc., 660 F.3rd 281 (2011). The court concluded that just as an arbitrator is entitled to interpret the parties' contract without judicial review, an arbitrator is also entitled to interpret the law applied to that contract without judicial review.

Further Watts and Affymax concluded that an arbitrator acts as the parties' joint agent and may do anything the parties themselves may do. If the parties could have reached a compromise over some legal issue, such as compliance with a notice and cure provision in a state franchise statute, without being accused of "violating the law", then the arbitrator may do so on their behalf. Arbitrators only exceed their powers under Section 10(a)(4) if they order the parties to violate the rights of persons who have not agreed to arbitrate, such as ordering the parties to commit an illegal act. Thus, Section 10(a)(4) does not apply to contentions that Hyatt violated provisions of state or federal laws because none of Shen Zhen's arguments concerned the rights of third parties.

Violation of Public Policy
The court concluded its analysis by noting that "Shen Zhen cannot make headway by relabeling its "violation of law" arguments as "violation of public policy." The "public policy" that judges may use to annul an award is policy designed to protect the public against the parties to the arbitration. As decided by the Supreme Court when the parties are free under the law to agree on some outcome, the arbitrator's decision as their agent does not violate public policy. Eastern Associated Coal Corp. v. United Mine Workers, 531 U.S. 57 (2000).

Impact of the Fee-Shifting Provision
The court noted that when commercial parties that have agreed to final resolution by an arbitrator yet one party continues to litigate, a court may order payment of their adversaries' attorneys fee. See Continental Can Co. v. Chicago Truck Drivers Pension Fund, 921 F.2nd 126 (7th Cir. 1990). Because the franchise agreement included a fee-shifting clause, the court held that it was unnecessary to make a separate fee-shifting order under Continental Can. But if the parties were unable to agree on how much Shen Zhen owed for "pointlessly extending this dispute through the district court and the court of appeal," Hyatt could apply for an appropriate order. Hyatt Franchising, L.L.C., v. Shen Zhen New World I, LLC, No. 17-2071 (7th Cir. 2017).

Round Four: Attempt to Countermand Seventh Circuit's Final Decision
Instead of complying with the final decision of the court, Shen Zhen first declined to reimburse Hyatt for fees incurred in district court. When asked by the court to respond to a motion filed by Hyatt seeking payment, Shen Zhen indicated it was unwilling to reimburse Hyatt for any legal expenses unless Hyatt prevailed in a separate AAA arbitration dealing with legal fees. But instead of proceeding in arbitration, Shen Zhen asked AAA to dismiss the proceeding on the ground that the award of fees was exclusively a judicial matter. Shen Zhen then filed a motion in the Central District of California asking the court to relieve it of any obligation to comply with the award.

Round Five: Imposition of Additional Fees/Costs and Threat of Section 1927 Sanctions
The Court of Appeal began by stating that "it is hard to find words to describe the conduct of a party that refuses to accept not only the arbitrator's decision but also a final judicial outcome and scours the nation in search of a different opinion." The court proceeded to review the responsibility placed on counsel by 28 U.S.C. Section 1927 to not multiply proceedings in an unreasonable and vexatious way. Should counsel fail to comply, a court may order counsel to satisfy personally the excess costs, expenses, and attorneys' fees reasonably incurred because of counsel's conduct. The court concluded that the "scorched-earth tactics" employed by Shen Zhen's counsel fell "comfortably" within the description of unreasonable and vexatious. The court ordered Shen Zhen's counsel to show why counsel should not be held jointly and severally responsible for Hyatt's excess costs, expenses, and attorneys' fees.

Referencing a line of Seventh Circuit cases that, when commercial parties wage unsuccessful litigation against an arbitrator's award, grant a court the authority to order the vexatious litigant to make their adversary whole, the court ordered Shen Zhen to compensate Hyatt for all legal fees and costs incurred not only in proceedings before the court of appeal and the district court, but in any future proceedings necessary for Hyatt to defend and enforce the court's conclusion that Hyatt was entitled to fees.

In a final observation the court noted that the district court was now free to entertain any application Hyatt might make seeking an injunction against Shen Zhen's duplicative litigation in California. Hyatt Franchising, L.L.C., v. Shen Zhen New World I, LLC, No. 17-2071 (7th Cir. 2018).

Challenging arbitration awards will probably become harder, at least in the Seventh Circuit, if based on cites to non-precedential and factually distinguishable cases. Failing to cease litigation following a final judicial outcome might subject counsel's vexatious client to the imposition of substantial additional costs and fees. Allowing a client to advance inaccurate and inconsistent positions in multiple unsuccessful proceedings might result in the imposition on counsel of Section 1927 sanctions.

One final observation: when an arbitrator is confronted with an extremely contentious party it would be wise to issue an award that clearly demonstrates the thoroughness with which the arbitrator reviewed the facts and the law. For example, the AAA arbitrator devoted five pages of the 51-page interim award carefully reviewing the language of the California Franchise Investment Law and the Federal Trade Commission Regulations before concluding that Shen Zhen's claims under those regulatory regimes lacked merit.

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