Nifty Counsel, Dunce’s Caps in-house lawyer, came up with what he thought was a brilliant way to minimize the company’s liability to its customers.  Nifty added arbitration provisions to Dunce’s customer purchase order agreements, and included language that the customer agreed the arbitrator could not award the customer damages exceeding the price of the order.  Flat Backs, a major retail hat company, filed an arbitration action against Dunce’s after Dunce’s failed to deliver 100,000 Auburn Tigers 2019 NCAA Men’s Basketball Champions hats.[1]  The demand for arbitration alleged $4 million in damages, even though the purchase order price was only $500,000.  Terry B.L. Judge, the arbitrator, ignored Dunce’s arguments that the purchase order’s arbitration clause prohibited Judge from awarding Flat Backs more than $500,000, and awarded Flat Backs the requested $4 million.  Dunce’s then asked a court to overturn the arbitration award for the same reason – Judge exceeded his jurisdictional limits.    

Are clauses limiting an arbitrator’s authority legal?

Yes, provided that the limitations do not infringe on any statutorily-authorized rights that might lead a court to find the limitation is against public policy.  Otherwise, clauses limiting the damages an arbitrator can award are routinely used. For example, in the American Arbitration Association’s (AAA) “Drafting Dispute Resolution Clauses, A Practical Guide,” the AAA provides examples of clauses that limit the remedies available in arbitration that parties may want to include in their contract.  One example is “In no event shall an award in an arbitration initiated under this clause exceed $__________.”  Thus, one would think that Dunce’s could convince a court that Judge lacked authority to award Flat Backs more than $500,000.

Recently, however, the United States 5th Court of Appeals, in a one-word “Affirmed” opinion, upheld an arbitrator’s $18.3 million damage award on a fraud claim where one of the parties claimed the arbitration agreement prohibited the arbitrator from awarding more than $250,000.  The case made headlines in the legal community after one of the 5th Circuit justices exclaimed during oral argument to the appellant, “I’d be embarrassed to take the position you’re taking in this case.”

Why didn’t the courts enforce the limitation provision?

The trial court held the arbitrator’s determination was “rational” because the arbitrator found the limitation clause applied “only to the indemnification of a third party.”  But the parties to the arbitration proceeding were not “third parties” – they were the parties to the contract.  Thus, the limitation provision did not apply.

Tilting the Scales in Your Favor

Many parties misunderstand the purpose of indemnification clauses.  They are contract provisions where one party (the indemnitor) agrees to indemnify, or insure, the other party (the indemnitee) from losses or costs incurred in defending claims brought by third parties.  Indemnification clauses do not cover losses or damages that arise from a mere breach of contract.  For example, Flat Backs’ lawsuit against Dunce’s is simply for breach of contract, and would not fall under an indemnity provision.  But, if Dunce’s hats were made from a chemical that caused people who wore the hats to lose their hair, Dunce’s would be required to indemnify Flat Backs from any losses resulting in lawsuits by those customers if the contract between Dunce’s and Flat Backs contained an indemnification provision.  It is important to keep this distinction in mind when drafting contracts, especially if there are limitation-on-liability clauses involved.  If you are not aware of the distinction, then you may inadvertently fail to limit liability as you intended.

[1] The fact that Auburn did not win the 2019 men’s basketball championship is irrelevant.  Everyone knows the refs blew the end of the game – even Virginia fans, some of whom will admit it.  Don’t worry, I’m not still bitter.