Commercial Division Blog

Posted: August 25, 2014 / Categories Commercial, Arbitation, Mediation and Other ADR

New York Choice of Law Clause Not Sufficient To Invoke New York Rule Against Punitive Damages Awards In Arbitration

On August 14, 2014, the First Department issued a decision in In re Flintlock Construction Services, LLC v. Weiss, NY Slip Op 05818, ruling (by a 3-2 vote) that a choice of law provision providing that the parties' agreement was to be "construed and enforced" in accordance with the law of New York was not sufficient to invoke New York's public policy against the imposition of punitive damages in a private arbitration, and therefore, the issue of punitive damages could be submitted to the arbitrators.

In In re Flintlock, investors in a real estate project commenced an arbitration against real estate development companies and their principals, alleging fraud and breach of contract, and seeking punitive damages. The transactions at issue were governed by two LLC operating agreements, which contained 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 defendants moved before the arbitration panel to dismiss the punitive damages claim on the ground that such a claim was not arbitrable under New York law. Specifically, the Court of Appeals held, in Garrity v. Lyle Stuart, Inc., 40 N.Y.2d 354, 356 (1976), that under New York law, arbitrators "ha[ve] no power to award punitive damages, even if agreed upon by the parties." By contrast, under the Federal Arbitration Act (which applies to any claim concerning a "transaction involving interstate commerce"), punitive damages are available if the parties' agreement so provides. See Mastrobuono v. Shearson Lehman Hutton, 514 U.S. 52, 58 (1995) (where 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"). The panel denied the motion to dismiss "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 [FAA]." The defendants then commenced a special proceeding in New York Supreme Court to permanently enjoin the arbitration, under CPLR 7503(b), on the grounds that the arbitrators had exceeded their authority, and lacked the power to award punitive damages. The motion court denied the motion, holding that the movants had "charted their own course" by "actively litigat[ing]" before the arbitration panel, and waived any argument as the arbitrability of punitive damages claims.

The First Department, in a decision by Justice Manzanet-Daniels (and joined by Justices Acosta and Saxe), affirmed. The majority rejected the argument that the New York choice of law provision in the contracts mandated application of the Garrity rule barring punitive damages claims in arbitration:

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 (id. at 60). 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.

(Citations omitted) (emphasis added).

The majority went on to hold that the defendants had waived their right to seeks a stay of the arbitration by their active participation in the arbitration:

Petitioners' motion to stay the arbitration should be denied for the further reason that they have participated in the arbitration, precluding late resort to CPLR 7503(b). CPLR 7503(b) authorizes motions to stay arbitration by parties "who ha[ve] not participated in the arbitration." Petitioners participated in the arbitration process for nearly eight months — selecting arbitrators, participating in preliminary proceedings — before registering an objection to the arbitrability of respondent's claim for punitive damages. Even then, petitioners chose not to move to stay the arbitration, but to make a motion to dismiss the claim, squarely placing the issue of the arbitrability and availability of punitive damages before the arbitrators. Having "charted their own course," in the words of the motion court, they cannot now avail themselves of the mechanisms set forth in CPLR 7503(b).

Justice Renwick wrote a dissenting opinion, which was joined by Justice Andrias. The dissenters argued that the Supreme Court's decision in Mastrobuono, on which the majority relied, was distinguishable because the choice of law provision at issue in that case provided only that the agreement would be "governed" by New York law, which the Court interpreted as requiring the application of the "substantive principles that New York courts would apply, but not . . . special rules limiting the authority of the arbitrators" (i.e., the rule precluding the award of punitive damages). The choice of law provision in In re Flintlock, calling for the agreement to be "construed and enforced" in accordance with New York law, had been construed by the New York Court of Appeals, in Matter of Diamond Waterproofing Sys., Inc. v. 55 Liberty Corp., 4 N.Y.3d 247, 252 (2005), to mandate application of New York's law requiring statute of limitations issues to be resolved by the Court, not the arbitrators. The dissent held that, under Diamond, the choice of law clause at issue in In re Flintlock required application of the Garrity rule precluding arbitrators from awarding punitive damages:

Diamond and its progeny make clear that, even if the FAA applies to an agreement, the parties may still limit the arbitrator's power by invoking New York law. To do so, however, the parties must not only make the agreement subject to New York law, but must also make its "enforcement" subject to New York law. By using such language, the parties "unequivocally" invoke the limitations on arbitration under New York State law.

The majority, however, finds it significant that the language at issue here, that "an agreement is to be construed and enforced' in accordance with New York law, has [never] been held to displace Mastrobuono." The majority finds that Diamond is not controlling here because it "involved application of the statute of limitations and does not speak to the issue sub judice." The majority's refusal to acknowledge that Diamond is controlling here appears to be based upon a fundamental difference in its approach to distinguishing between substantive and procedural law. The procedural law establishes whether the arbitrators have the power to address punitive damages claims, while the substantive law establishes whether certain circumstances are proper for granting such remedy.

For example, in an international commercial arbitration case with the situs of New York and with a general choice-of-law clause providing for New York law, New York law would be the substantive law for the dispute, and the FAA would be the procedural law governing the arbitration. New York's procedural rule would not be the proper procedural law for the aforementioned scenario, absent the critical language limiting the power of the arbitrator. Thus, the Garrity rule prohibiting arbitrators from awarding punitive damages would not be part of the procedural rule governing this international arbitration. In this hypothetical, the arbitrator would have the power to award punitive damages. As New York law is the substantive law for the case, however, New York law would be applied by the arbitrator to determine whether punitive damages are warranted.

The dissent also rejected the argument that the defendants had waived the right to seek a stay by participating in the arbitration:

[T]he majority finds that the motion to stay arbitration of punitive damages should be denied because petitioners "have participated in the arbitration, precluding late resort to CPLR 7503(b)." I disagree. The grant of a permanent stay of respondent's claim for punitive damages would not interfere with the ongoing arbitration proceeding. Moreover, a waiver is akin to an implicit agreement. Indeed, there can be no implicit agreement to submit punitive damages to an arbitrator where the parties' "unequivocal choice-of-law provision" is intended to incorporate the Garrity rule.

In re Flintlock is the second significant decision from the First Department this month on arbitrability and waiver issues in the arbitration context. We previously blogged about the Court's August 7 decision in Cusiamo v. Schnurr, which reaffirmed the broad application of the FAA even to intrastate activities that "affect" interstate commerce. Both decisions demonstrate the New York Court's implementation of the strong pro-arbitration policy of the FAA, even when that policy conflicts with New York law. The contrasting standards in the two decisions for waiver of the right to arbitrate vs. waiver of the right to move for stay of arbitration illustrate the point: In Cusiamo, the First Department held that the plaintiff had not waived the right to arbitrate, despite filing a lawsuit in New York state court, and only commencing the arbitration when the complaint was dismissed with leave to replead; in In re Flintlock, by contrast, the Court found that participation in preliminary proceedings in the arbitration effected a waiver of the right to move for a stay of the arbitration.

We can expect further litigation in In re Flintlock, since the appellants have an appeal as of right to the Court of Appeals, given the 2-justice dissent in the Appellate Division.