4 of 5 Circuits Agree: Federal Common Law Controls in FAA - In House
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4 of 5 Circuits Agree: Federal Common Law Controls in FAA

If your company prefers arbitration to litigation -- and what company doesn't? -- then you're probably well-versed in the ways of the the Federal Arbitration Act. And you probably know that the FAA doesn't include a definition for "arbitration."

Congress left the courts with dirty work of figuring out what "arbitration" is, and the courts have turned to the common law for answers.

But should the courts look to federal common law or state law? In a matter of first impression, the Second Circuit Court of Appeals ruled this week federal common law should control.

This issue cropped up in an insurance contract dispute between Imad John Bakoss and Lloyds of London. Bakoss took out an insurance policy with Lloyds in the event he became "Permanently Totally Disabled." The policy stated that Bakoss could only invoke that status if "in the opinion of a Competent Medical Authority" he wouldn't recover from the effects of a sickness or injury to the extent that he would ever be able to resume the "material and substantial duties" of his occupation."

The policy provided each party with the right to have Bakoss examined by a physician of its choice for the purpose of determining whether he was "totally disabled." In the event of a disagreement between each party's physicians, the two physicians would jointly name a third doctor to make a final and binding decision.

Lloyds and Bakoss couldn't reach an agreement regarding the third physician when it came time to put the terms of the policy into practice. Bakoss sued Lloyds in New York state court. Lloyds, in turn, removed the case to federal court, claiming that the third-physician clause is an arbitration agreement, thus providing federal subject-matter jurisdiction. Applying federal common law, the district court held that (1) the third-physician clause is an agreement to arbitrate, and (2) federal jurisdiction exists under the FAA.

Bakoss appealed, arguing that the district court should have looked to New York law, rather than federal common law, to define "arbitration."

The Second Circuit disagreed, following the majority of its sister circuits in finding that federal law should define the scope of "arbitration" under the FAA, and noting that applying state law would create "a patchwork in which the FAA will mean one thing in one state and something else in another."

For now, the First, Second, Fifth, and Tenth Circuit apply federal common law in these situations. The Ninth Circuit — never shy about being an outlier— applied state common law in Wasyl, Inc., v. First Boston Corp. The Ninth Circuit's stance, however, could be second-guessed. As the Second Circuit observed, the Ninth Circuit panel in Portland General Electric Co. v. U.S. Bank Trust National Association questioned whether the appellate court had correctly decided Wasyl.

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