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Third Circuit Court of Appeals Holds that Honorable Engagement Clause Does Not Permit Arbitrators to Fashion Relief Not Requested by the Parties or Rationally Derived from the Contract

November 11, 2010

On November 8, 2010, the Third Circuit affirmed a district court's vacatur of a reinsurance arbitration award that was silent as to the arbitrators' rationale, highlighting the limitations on an arbitration panel's otherwise broad authority. PMA Capital Ins. Co. v. Platinum Underwriters Bermuda, Ltd., No. 09-3963 (3d Cir. Nov. 8, 2010).

In that case, PMA Capital Insurance Company ("PMA") had purchased two separate three-year finite reinsurance contracts from St. Paul Re, which was in effect from 1999 to 2001 ("1999 Agreement"), and from St. Paul Re's successor-in-interest, Platinum Underwriters Bermuda ("Platinum"), which was in effect from 2003 to 2006 ("2003 Agreement"). Pursuant to each of these contracts, PMA was required to deposit funds into an interest-bearing "Experience Account," which could be used by St. Paul Re or Platinum to indemnify PMA when so required. If claims exceeded the amount deposited into the Experience Account, St. Paul Re or Platinum would be obligated to indemnify PMA out of their own pockets. Of note, the 2003 Agreement contained two clauses that purportedly allowed (1) PMA to receive a refund of any funds remaining in the Experience Account at the time of commutation or final settlement of the parties' liabilities under the agreement (the "Profit Sharing" clause), and (2) Platinum to carry forward any deficit – i.e. amounts paid in excess of the funds in the Experience Account – that St. Paul Re experienced in connection with the 1999 Agreement to reduce PMA's recovery under the 2003 Agreement (the "Deficit Carry Forward" clause).

After a dispute arose between PMA and Platinum regarding the validity and scope of the Deficit Carry Forward provision, the parties submitted the dispute to a three-member arbitration panel ("Panel") as required by the 2003 Agreement. In the arbitration, PMA asserted, inter alia, that Platinum could not offset the St. Paul Re deficit from the 1999 Agreement against amounts Platinum owed to PMA under the 2003 Agreement because Platinum was not a party to the 1999 Agreement. The parties also disagreed as to how the deficit under the 1999 Agreement should be calculated. Following briefing and several days of hearings, the Panel issued a one-page, unreasoned award requiring PMA to pay Platinum $6,000,000 within 30 days of the award. The Panel further required "any and all" references to the Deficit Carry Forward provision in the 2003 Agreement be removed, and extinguished any future rights or claims that required a deficit carry forward.

PMA petitioned to vacate the award in the United States District Court for the Eastern District of Pennsylvania on the grounds that the Panel lacked the authority to render the relief granted because the award was contrary to the relief sought by the parties and contrary to the plain language of the 2003 Agreement. On September 17, 2009, the District Court granted PMA's petition to vacate pursuant to Section 10(a)(4) of the Federal Arbitration Act. 659 F. Supp. 2d 631 (E.D. Pa. 2009). Although acknowledging that its review of the award must be "highly deferential" to the Panel, the District Court reasoned that an award can be vacated if the arbitrators exceeded their authority – i.e., if the award cannot rationally be derived from the contract or the parties' submissions and if the terms of the award are "completely irrational." Id. at 635.

Applying those standards, the District Court found that the Panel's award could not be rationally derived from the 2003 Agreement because that agreement (1) "requires the enforcement of the Deficit Carry Forward Provision, not its elimination" and (2) "imposes conditions – neither of which has been met – before Platinum may recover any of its deficit from PMA." Id. at 637. Likewise, the District Court noted that neither party had requested the Panel to reform the contract or award any immediate payment. Thus, the District Court concluded, the Panel acted irrationally and in excess of its authority by awarding relief that was "not sought by either Party, contravenes the contract the Panel was charged with interpreting, and writes out of existence a key provision of that contract." Id. at 635.

In reaching its decision, the District Court noted that the absence of any supporting explanation or reasoning in the Panel's award made it difficult to evaluate the Panel's rationale. As such, the District Court speculated that the Panel "evidently found the Deficit Carry Forward clause to be more trouble than it was worth and simply eliminated it from the agreement." Id. at 636. The District Court further concluded that the Panel apparently had "sought to balance one irrational decision (the Deficit Carry Forward Provision's elimination) with another (the award to Platinum of a large amount of money to which it was not contractually entitled)." Id. at 639.

The District Court also rejected Platinum's argument that the Panel was within its authority to fashion such remedies by virtue of an honorable engagement clause in the 2003 Agreement. While noting that arbitrators can abstain from following strict rules of law under such a clause, the court nevertheless asserted that the honorable engagement clause does not "authorize arbitrators, acting sua sponte, to eliminate material provisions of a contract that they are charged with interpreting." Id. In this case, the District Court held that the Panel's attempt to exercise "rough justice" by eliminating the Deficit Carry Forward provision did not comport with the limitations of the honorable engagement clause and, as such, was "completely irrational." Id.

Platinum appealed the District Court's ruling to the United States Court of Appeals for the Third Circuit. On November 8, 2010, the Third Circuit affirmed the District Court's vacatur of the award, noting that the Panel went beyond the scope of its authority "by ordering unrequested relief and rewriting material terms of the contract they purported to implement . . . ."
PMA Capital, No. 09-3963 at *4. The Third Circuit also reiterated the District Court's finding that an honorable engagement clause does not give arbitrators the "authority to reinvent the contract before them, or to order relief no one requested." Id. at *5.

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The Third Circuit's holding reaffirms that, although arbitration panels generally enjoy extremely broad authority, there are important limitations. Specifically, while honorable engagement clauses are often important expressions of the parties' intention regarding the manner in which disputes are to be resolved, they do not grant arbitration panels carte blanche to fashion remedies out of whole cloth. Rather, arbitration panels must limit their awards to the specific relief requested by the parties, and issue only awards that are "rationally derived" from the agreement itself (from which the arbitration panels' authority arises). To that end, this case also presents a cautionary tale for parties and panels regarding the potential consequences that may arise from the issuance of unreasoned awards. If called into question, an award that does not reflect an arbitration panel's rationale and intent opens the door for a reviewing court to formulate its own, perhaps erroneous, assumptions and conclusions as to the motives of the arbitration panel and the basis of its award.

For more information, please contact the professional(s) listed below, or your regular Crowell & Moring contact.

Harry P. Cohen
Partner – New York
Phone: +1.212.803.4044