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An Arbitrator’s Power May Be Greater Than That of a Judge

Arbitration is a creature of contract, and an arbitrator’s powers are in effect defined by the parties’ arbitration agreement. Paradoxically, although an arbitration agreement can be written (double-spaced) on one side of a cocktail napkin, in some cases it may grant greater authority to an arbitrator than a judge has.

For example, in Timegate Studios, Inc. v. Southpeak Interactive, LLC, Case No. 12-20256 (5th Cir. Apr. 9, 2013), the Fifth Circuit confirmed an arbitration award in which the arbitrator substantially reformed the parties’ commercial agreement by, among other things, awarding one a broad perpetual license to certain of the other’s intellectual property, despite the fact that the original agreement had granted only a more narrowly drawn ten-year license. The Fifth Circuit opined that the arbitral award helped fulfill the “essence” of the parties’ contract, and that the arbitrator therefore had not exceeded his authority by awarding relief that the contract itself did not contemplate.

The parties, Timegate and Southpeak, had entered into an agreement to develop a video game called Section 8. Timegate was to design the game, and Southpeak was to fund its development and distribution. Southpeak had only limited licensing rights and was expressly prohibited from exploiting the game in any way except as provided in the contract. Timegate, on the other hand, was expressly identified in the commercial agreement as the exclusive owner of the Section 8 intellectual property.

The game did not fare as well in the market as anticipated, and ultimately Timegate and Southpeak each filed suit against the other. But the parties’ contract contained a broad arbitration clause, and the disputes were referred to arbitration.

The sole arbitrator found that Timegate had not only breached the parties’ agreement, but that (i) it had fraudulently induced Southpeak to enter into the contract; (ii) it had not used Southpeak’s entire investment to develop and market the game, but rather had pocketed some of Southpeak’s funds for other uses; (iii) it had released a version of the game for another game system, and then developed a sequel without Southpeak’s involvement; and (iv) it had failed to deliver the game’s access codes to Southpeak so that it could distribute it to various distribution channels.

The arbitrator awarded Southpeak over $7 million in damages, but also decided that that monetary award alone would not sufficiently compensate Southpeak for Timegate’s violations. In order to compensate Southpeak for all of Timegate’s misconduct, the arbitrator effectively re-wrote part of the parties’ commercial contract. That is, the arbitrator “realign[ed] major elements of the parties’ future relationship as established by their original agreement. The parties’ initially-distinct roles as developer and publisher were effectively dissolved with each party being given the right to unilaterally create derivative Section 8 merchandise and property.” Thus, the arbitrator awarded Southpeak a perpetual license to Timegate’s Section 8 intellectual property, and enabled Southpeak to develop Section 8 sequels on its own without consulting Timegate.

Southpeak moved to have the award confirmed, but the District Court instead vacated it because the perpetual license “was not a remedy rationally rooted in the contract.”

The Fifth Circuit reversed. Citing a provision of the Federal Arbitration Act (the “FAA”), 9 U.S.C. § 10(a)4, the Court formulated the question before it as: “whether the arbitrator’s award was so unfounded in reason and fact, so unconnected with the wording and purpose of the [contract] as to manifest an infidelity to the obligation of an arbitrator.” The Court addressed that by opining that “an arbitrator has not exceeded his powers unless he has utterly contorted the evident purpose and intent of the parties – the ‘essence’ of the contract.”

So how does one determine the “essence” of a contract? In this instance, the Fifth Circuit reviewed the contract to determine the parties’ goals in entering into it and concluded that it was “access to the financial benefits of their agreed-upon contributions.” One provision of the contract provided that in the event of certain breaches by Timegate, Timegate would “deliver to [Southpeak] all Work Product and other materials requested […] including, but not limited to the Intellectual Property.” Thus, the Fifth Circuit concluded that the “essence” of the contract was entirely frustrated by Timegate’s conduct, and that the remedy for that frustration was already at least implied within the four corners of the agreement. Implicit in the decision was the idea that a perpetual license to Southpeak was essential to restoring the essence of the contract.

Several other factors were important to the Fifth Circuit’s decision to reverse the District Court’s vacatur of the underlying award. First, the Court reasoned that the arbitrator’s award was justified in this instance because of the finding of fraudulent inducement. Under Texas law, which governed the contract, fraudulent inducement can render a contract void. Thus, to the extent that the award of a perpetual license was inconsistent with portions of the contract granting Southpeak a limited license, the arbitrator had legal authority to void those parts of the pre-existing contract.

Second, the Court’s decision was influenced by the arbitration provision itself, which was broad and granted significant powers to the arbitrator. As importantly, the contract did not reserve any of the issues that the arbitrator had ruled on for any other decision-maker. Therefore, the arbitrator did not encroach on anyone else’s authority in fashioning this relief.

Third, the arbitrator had found that money damages alone were insufficient to compensate Southpeak for Timegate’s violations, and that injunctive relief was necessary to restore the contract’s essence.

The Court concluded that “Timegate committed an extraordinary breach of the Agreement, and an equally extraordinary realignment of the parties’ original rights is necessary to preserve the Agreement.”

The Fifth Circuit’s decision in Timegate contains lessons for the wary draftsman. Foremost, of course, is that when an arbitrator’s powers are not expressly limited by contract, those powers may be interpreted as broad, and proving that the arbitrator exceeded those powers can be difficult.

And Timegate is not an anomalous decision. State and federal courts in California and New York, among other jurisdictions, have also held that an arbitrator can provide injunctive relief that may exceed what is available to litigants in a courtroom. “In the final analysis, Arbitrators may do justice and the award may well reflect the spirit rather than the letter of the agreement [….] Those who have chosen arbitration as their forum should recognize that arbitration procedures and awards are often different from what may be expected in courts of law.” Rochester City School Dist. v. Rochester Teachers Assn., 41 N.Y.2d 578 (1977).

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Narges M. Kakalia is a Mintz commercial litigator who handles securities, insurance and risk management, corporate governance, legal ethics, and big data matters. She represents financial and professional services clients, providing administrative, trial, and appellate assistance.