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Do Courts Create Moral Hazard?: When Judges Nullify Employer Liability in Arbitrations

By Michael H. LeRoy. Full text here.

State courts are creating conditions for moral hazard in the arbitration of employment disputes. The problem begins when employers compel individuals to arbitrate their legal claims, denying them access to juries and other benefits of a trial. This empirical study identifies a disturbing trend: state courts vacated many arbitration wins for employees, but not for employers. The lopsided results suggest a moral hazard. When courts vacate many awards that rule for employees, the individual must either return to a lengthy and costly “do over” arbitration—or worse, be stuck with a useless award and no other recourse because Gilmer v. Interstate/Johnson Lane Corp. bars employees in this situation from suing.

The problem is that the number of award-reviewing standards is growing due to new state laws and the creeping expansion of common-law standards. This causes judges to deviate from the Federal Arbitration Act’s (FAA) extremely deferential principles. As a result, court review is becoming an insurance program that protects employers from costly awards. This poses a moral hazard, as judges reduce incentives for employers to be responsible for their actions.

This trend undermines the purpose of the FAA, which meant to end court interference with awards. Gilmer reinforced this view by stating a theory of forum substitution—the idea that by “agreeing to arbitrate a statutory claim, a party does not forgo the substantive rights afforded by [a] statute; it only submits to their resolution in an arbitral, rather than a judicial, forum.” After Gilmer, employers adopted mandatory arbitration to control litigation costs and liability. But the data raise new doubts about forum substitution. Courts interfere with arbitration more than the FAA or Gilmer envisioned.

I propose two solutions. Judicial review of awards in all courts should be limited to the four explicit FAA standards. This would free arbitration from court interference, just as Congress intended. Indeed, the gist of my legislative proposal was supported in the current term of the Supreme Court in Preston v. Ferrar: “The [FAA], which rests on Congress’ authority under the Commerce Clause, supplies not simply a procedural framework applicable in federal courts; it also calls for the application, in state as well as federal courts, of federal substantive law regarding arbitration.” Second, arbitration losers who incur liability should be required to post judgment bonds if they challenge an award. This idea borrows from civil procedure codes and is therefore consistent with the goal of forum substitution. The current practice erodes award finality by allowing employers to make cost-free appeals. Arbitration offers attractive benefits: reduced cost, simplicity, and easy accessibility to disputants. But these benefits will not be achieved until the growing vacatur problem—and its attendant quality of relieving employers of liability for unlawful behavior—is addressed.