A recent decision by the United States Court of Appeals for the Sixth Circuit demonstrates binding arbitration may not be the best way to limit rising litigation costs. It also serves as a warning – if you needed one — that “binding” arbitration awards are not subject to appeal for legal error.

Here are the facts, in a brief form: Two individuals (Schafer and Block) founded a company. As part of a series of corporate transactions, two employee stock ownership plans (“ESOPs”) were formed. Schafer and Block were appointed as trustees of the ESOPs, and entered into indemnification agreements with mandatory arbitration clauses. While the Department of Labor (“DOL”) was investigating its suspicion that the ESOPs had purchased stock at inflated prices, and with knowledge of this investigation, Multiband entered into a purchase agreement to buy the holding company. As part of the transaction, Multiband entered into indemnification agreements that contained essentially the same provisions as the prior indemnification agreements. Subsequently, the DOL informed Schafer and Block that it believed they had breached their fiduciary duties by allowing the ESOPs to purchase stock at inflated prices and offered to settle. Schafer and Block asked Multiband to indemnify them in accordance with the agreements, but Multiband refused. Schafer and Block did in fact settle with the DOL and made a claim for indemnification against Multiband, but Multiband again refused to indemnify them.

Schafer and Block filed a complaint for binding arbitration. The arbitrator concluded that under ERISA Section 410(a), an indemnification agreement is categorically void as against public policy. The arbitrator rejected a DOL interpretive bulletin permitting indemnification agreements, finding the bulletin “entitled to no deference.”

The district court vacated the arbitrator’s decision on the basis that “manifest disregard for the law” survives as a basis for vacating an arbitrator’s decision even though the proceeding is “binding.” The Sixth Circuit agreed that the arbitrator’s decision was legally unsupportable under Sixth Circuit precedents, such that the Court would reverse the decision if made by a district court. But the Court held that clear legal error by itself is not sufficient grounds for vacating an arbitrator’s decision. In reversing the district court’s decision, the Court held that if the arbitrator relies on a colorable meaning of the words, the fact that Sixth Circuit precedent is contrary is not determinative. Here is the Court’s reasoning:

The very idea that an arbitral decision is not appealable for legal error leads to the conclusion that the arbitrator is not necessarily bound by legal holdings of this court. If an arbitrator relies on a colorable meaning of the words of the statute—as the arbitrator did here—the fact that there is Sixth Circuit precedent to the contrary is not necessarily determinative. Sixth Circuit holdings are binding in courts and on agencies whose decisions are appealable to the Sixth Circuit, ultimately because of that appealability. An arbitrator cannot reject the law, but can disagree with nonbinding precedent without disregarding the law.

Binding arbitration has its place, and may sound appealing to those who are trying to minimize an exposure to potential legal costs.

Consider what happened in this case however. The buyer entered into the purchase transaction well-aware of the possibility of an indemnification claim, signed indemnification agreements, and later refused to honor them. The other parties to the binding arbitration agreement, the ESOP trustees, took the matter before an arbitrator who decided that the DOL’s longstanding guidance in favor of indemnification agreements was not subject to deference and who rejected established Sixth Circuit case law. Even though the arbitrator’s decision was legally unsupportable, the binding nature of the arbitration decision on its merits meant the trustees lost without the possibility of a corrective appeal.

So, in this case, did binding arbitration control legal costs, or did it expose the parties to unexpected risks? The case is styled Schafer v. Multiband Corp, Case No. No. 13-1316 (Jan. 6, 2014).