On The Case

9th Circuit rules that arbitrators must disclose ownership stakes

(Reuters) - Our judicial system requires federal judges to adhere to an elaborate code of conduct in order to assure not only that the men and women who preside over federal litigation are people of integrity but also that they will not be prejudiced – or even appear to be prejudiced – toward one side or the other. If federal judges have a financial interest, however small, in the outcome of a case, the rules require them to step aside. Even justices of the U.S. Supreme Court, who are not bound by the code of conduct, typically recuse themselves when they have an equity interest in a company whose case is before the court.

Arbitrators, of course, aren’t subject to the federal judiciary’s rules. And parties that agree to arbitrate their disputes are expected to understand that when they opted for a private forum, they gave up the protections against partiality that are built into the federal judicial rules and Article III of the U.S. Constitution.

Want more On the Case? Listen to the On the Case podcast.

But according to a ruling Tuesday from the 9th U.S. Circuit Court of Appeals in Monster Energy v. City, arbitrators nevertheless have an obligation to disclose their financial interests in the cases before them. In a 2-1 decision, the 9th Circuit vacated a $3 million JAMS arbitration award to Monster Energy, holding the award cannot stand because a purportedly neutral JAMS arbitrator failed to disclose that he has an equity stake in the arbitration service, which, in turn, benefits from repeat business from Monster.

The majority – Judge Milan Smith and U.S. District Judge Michael Simon of Portland, Oregon, sitting by designation – pointed out that power is frequently not well-balanced between parties in arbitration, especially when companies that make frequent use of private dispute resolution services have imposed arbitration on consumers and employees. As arbitration proliferates in everyday life, the majority said, “clear disclosures by arbitrators aid parties in making informed decisions.”

It’s hard to argue with that proposition, said City lawyer Michael Vaska of Foster Pepper, who argued the case at the 9th Circuit. “It simply can’t be that in this country, you give up the right to fairness when you are forced into arbitration,” Vaska said. “JAMS is an organization of mostly retired judges. What this ruling says to JAMS is, ‘You’re not above the law.’”

JAMS said in an email statement that it disagrees with the outcome of the case. “The very premise and foundation of the JAMS business is neutrality, and we believe that neutrality was upheld in the underlying arbitration,” the statement said. “JAMS neutrals, including the neutral in this matter, have no information about other arbitrations at JAMS involving any of the parties in the matter before them, unless they were involved in the prior proceeding. In addition, JAMS exerts absolutely no influence over an arbitrator’s arbitration decision and arbitrators are not financially incentivized to rule one way or another in any matter.”

Monster counsel Tanya Schierling of Solomon Ward Seidenwurm & Smith did not respond to a request for comment.

As the majority noted (and as I’ve previously reported), this particular case involved two sophisticated parties. City Beverages, which does business as Olympic Eagle Distributing, had a 20-year contract to distribute Monster Energy drinks in the Pacific Northwest. Eight years into the deal, Monster unilaterally terminated the deal. In accordance with the contract, City brought an arbitration proceeding at JAMS, asserting that under a Washington state law protecting franchisees, Monster could not end the deal without cause. From a panel of seven prospective arbitrators, the two sides picked retired California state court judge John Kennedy to hear the case. Kennedy ended up siding with Monster on the merits. He also ordered City to pay Monster $3 million in attorneys’ fees.

Before Monster and City picked him, Kennedy - following JAMS’ disclosure procedures - had disclosed that he, like all JAMS arbitrators, has an interest in the ongoing success of the outfit. He also disclosed that he had previously presided over a Monster case in which he ruled against the company.

Only after the arbitration concluded did City learn (in part from a 2015 UCLA Entertainment Law Review article) that Kennedy is one of about 107 JAMS arbitrators who have an equity stake in the entire enterprise. The beverage distributor’s lawyers at Foster Pepper and Bryan Cave argued that as a JAMS co-owner, Kennedy had an apparent interest in maintaining JAMS’ relationship with Monster, which requires distributors to agree to JAMS arbitration of any disputes. City insisted that Kennedy’s failure to disclose his ownership stake rendered his award invalid.

Monster, represented by Solomon Ward Seidenwurm & Smith, argued that Kennedy’s disclosure of his interest in JAMS’ success as a business encompassed his ownership interest. Kennedy showed his lack of bias, Monster said, by ruling against the company in a previous Monster case. And besides, Monster argued, 9th Circuit precedent rejects the very premise of City’s argument that arbitrators are beholden to repeat players.

The majority in Tuesday’s opinion acknowledged that there is no 9th Circuit case directly addressing the disclosure obligations of arbitrators who are co-owners of their enterprises. But the appeals court looked to the U.S. Supreme Court’s 1968 decision in Commonwealth Coatings v. Continental Casualty (89 S.Ct. 337), in which the justices vacated an arbitration award because one of the arbitrators failed to disclose substantial financial ties to one of the parties.

JAMS, the majority said, has a non-trivial business relation with Monster, for which the arbitration service has administered nearly 100 cases in the last five years. And arbitrators with an equity stake in JAMS have a much greater economic interest in the enterprise’s success than those who aren’t co-owners, the court said. So under the principles of Commonwealth Coatings, Kennedy was obliged to disclose his JAMS equity.

In a dissent, Judge Michelle Friedland argued that Kennedy’s ownership stake wasn’t material information, given that he had disclosed an interest in JAMS’ success and that City should have known Monster frequently appears in JAMS cases. “By nature of the fact that arbitrators are hired and paid by the parties for whom they conduct private arbitrations, arbitrators have an economic stake in cultivating repeat customers for their services,” she wrote. “This feature of private arbitration, even if distressing, is an inevitable result of the structure of the industry.”

Friedland also said the majority’s ruling would call other JAMS arbitration awards into doubt, although Judge Smith responded that the three-month statute of limitations on challenges to arbitration awards would mitigate the impact of Tuesday’s ruling on past cases. Going forward, he said, “arbitration organizations like JAMS, which are already well-accustomed to extensive conflicts checks and disclosures, will have no difficulty fulfilling, and even exceeding, the requirements described here.”

JAMS said in its email statement that none of the approximately 100 arbitrators with an ownership stake has ever received an annual distribution of more than one-tenth of 1% of the service’s revenue. These equity holders, it said, “are not informed about how their profit distributions are impacted by any particular client, lawyer or law firm and ... do not receive credit for the creation or retention of customer relationships.” Nevertheless, JAMS said, it is in the process of reviewing its disclosure procedures to ensure compliance with the 9th Circuit opinion.

City counsel Vaska emphasized that the 9th Circuit decision simply requires arbitrators with a meaningful financial stake in the cases before them to comply with disclosure principles the Supreme Court laid out back in the 1968 Commonwealth Coatings decision. Tuesday’s ruling doesn’t mean that arbitrators who own a piece of their enterprise must be recused from cases involving repeat players, he said. It just alerts counterparties that they might be better off before a different arbitrator.

Vaska said his client intends to re-arbitrate its case before a different JAMS arbitrator.

(NOTE: This story has been updated to include comments from JAMS.)