An Economics Approach to Hallstreet

David Kessler (Harvard student) has just posted on SSRN his Comment Why Arbitrate? The Questionable Quest for Efficiency in Hallstreet Associates.  Here's the EP version of the abstract:

    In Hallstreet Associates, the Supreme Court faced a choice between efficiency and freedom of contract, the two goals it had previously identified as motivating the Federal Arbitration Act.  On the one hand, Hallstreet Associates and Mattel had contracted for expanded judicial review; on the other hand, that expanded judicial review took more time and made the process more costly than would have an unreviewable arbitration.  When the Court had previously been faced with the choice between efficiency and freedom of contract, it opted for freedom of contract. For instance, in Dean Witter Reynolds, Inc. v. Byrd, the Court explained that “the overriding goal of the Arbitration Act was [not] to promote the expeditious resolution of claims . . . but merely the enforcement . . . of privately negotiated arbitration agreements.” In Hallstreet, however, the Court chose to preserve what it viewed as efficiency at the expense of freedom of contract, holding that parties could not contract for expanded judicial review of an arbitrator’s award.

    But the Court’s actions are unlikely to create “efficient” outcomes.  Arbitration without expanded judicial review might be efficient for the courts (at least in the short-term) and parties who would not have chosen to contract for expanded review anyway.  But there is a large group of parties for whom arbitration without expanded judicial review will not be efficient: the group of parties who would contract for expanded judicial review if it were available.  For those parties, the increased cost, in terms of time and money, of expanded judicial review would be outweighed by the benefit of having a check on the arbitrator’s decision.  By denying them expanded judicial review, the Court’s decision imposes new inefficiencies.  First, parties will have to hedge against the risk of a “bad” arbitrator in other ways, such as contracting of that risk.  Second, coping with a “bad” decision by an arbitrator—a decision that would have been corrected had expanded judicial review been available—also creates additional costs for the parties.  Third, the “bad” decision may also create costs for society: assuming that the laws are, in general, efficiency-promoting, an arbitrator’s uncorrected decision that is inconsistent with a law that is efficiency-promoting is also per se less efficient.

    How will parties who would have preferred to contract for expanded judicial review respond?  Those parties may lobby Congress to amend the FAA to allow for expanded judicial review (one might ask if the Court’s holding is intended to be legislation-forcing).  Parties may also explore other avenues for securing review of their arbitration agreements.  Inside the FAA framework, one solution would be creative “disempowerment” of arbitrators.  Since the FAA allows a court to review an arbitration decision when “the arbitrators exceeded their powers,” parties could make explicit in their agreement that arbitrators do not have power to make legal errors.

    In addition, the Court itself noted that the FAA does not preclude other avenues of expanding judicial review.  One option suggested by Judge Posner is for the parties to contract for an “appellate arbitration panel” to review the arbitration decision.  A second option might be to seek review from the trial judge under Rule 16 where, as in Hallstreet, the arbitration agreement was reached during the course of judicial proceedings.  A third option is review for “manifest disregard” of the law.  The Hallstreet Court rejected the argument that Wilko v. Swan allowed the parties to contract for expanded judicial review. But the Court’s holding may still leave open a recourse to “manifest disregard” review when the parties have not specifically contracted for it.  The most drastic result of the Hallstreet decision could be a flight from arbitration.  The Court itself acknowledged that such flight was a possibility, and both Hallstreet and its amici believed flight was likely.  Whether or not a flight takes place is essentially a question of whether the extra costs of arbitration (without expanded judicial review) outweigh the cost of moving away from arbitration altogether.

    The impact of the Hallstreet decision will not be clear for a while – but it is unlikely that the Court’s decision will create an efficient solution to the problem of contractually expanded judicial review.

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