The 3rd U.S. Circuit Court of Appeals decided a franchise related case on Aug. 2 that addressed judicial review of arbitration awards. In Paul Green School of Rock v. Smith , the court of appeals was called upon to review the confirmation of an arbitration award by the district court. The arbitration award, among other things, imposed a covenant not to compete against a California franchisee, a remedy rarely imposed under California law.

Unlike Pennsylvania law, California law considers covenants not to compete to violate public policy. California federal courts seem to allow a “trade secret exception” to the prohibition against enforcement of non-competes, however, the trend of the state courts has been to conclude that no such exception exists. California state courts will enjoin competition only when necessary to protect trade secrets under the California Trade Secrets Act.

The arbitrator’s award did award damages for misuse of trade secrets. The award was decided under the parties’ choice of Pennsylvania law, which required the application of the California Franchise Investment Law but not the prohibition on restrictive covenants, the opinion said.

Appellant Jim R. Smith appealed the district court’s confirmation of the arbitrator’s decision on the ground that the decision constitutes “manifest disregard” of the law. The 3rd Circuit addressed whether “manifest disregard of the law” remains a possible attack on the validity of an arbitration award in the wake of the U.S. Supreme Court’s 2008 decision in Hall Street Assoc. LLC v. Mattel Inc. and the 2010 decision in Stolt-Nielsen S.A. v. Animalfeeds International Corp.

Prior to the decision in Hall Street , the 3rd Circuit and other courts of appeal held that an arbitrator’s decision may be vacated on the ground that the arbitrator exhibited “manifest disregard” for the law, rather than an erroneous interpretation of the law. The Supreme Court in Hall Street held that an arbitration award may be vacated only if the movant proves that one of the four grounds expressly articulated by Congress for vacating an arbitration award has been satisfied.

The Supreme Court required a greater showing than the arbitrator arguably construed or applied the contract within the scope of authority, even if the court is convinced that the arbitrator committed a serious error. The “manifest disregard” standard was used only in unusual circumstances where the result was not rationally inferable from the contract.

After the Hall Street decision, a split exists among the circuits on whether “manifest disregard” of the law remains a valid ground for vacating an award. The 2nd and 9th circuits have held that “manifest disregard” survives Hall Street because arbitrators who exhibit “manifest disregard” of the law have “exceeded their powers,” an express ground for vacatur under Section 10 of the Federal Arbitration Act. In contrast, the 5th and 11th circuits hold that “manifest disregard” of the law is no longer a valid ground for vacatur.

The recent Stolt-Nielsen case clarified the test for vacatur only slightly. The issue is whether the arbitrator’s decision to allow class treatment of arbitration claims was in manifest disregard of the law. A majority of the Supreme Court vacated the decision of the arbitrator to provide class treatment where the contract was silent, holding that the grant of class treatment strayed from the mere interpretation and application of the agreement and was tantamount to the arbitrators’ dispensing “their own brand of industrial justice.”

The Supreme Court, however, never reached the issue of whether the judicially created test of “manifest disregard” survived the Hall Street decision. The Supreme Court acknowledged that there is uncertainty on whether the test survived, but that the standard had been satisfied by compelling class treatment where the arbitration clause was silent. The Supreme Court vacated the decision, narrowly correcting the outcome of the case without clarifying the “manifest disregard” standard of review. This was the status of the law when the 3rd Circuit considered the Smith appeal.

The 3rd Circuit refused to address whether the “manifest disregard” of the law standard remains a valid ground for vacatur, holding that it was not necessary to reach that issue. The 3rd Circuit did adopt the test in Stolt-Nielsen that a “party seeking to vacate an arbitrator’s award on the ground of manifest disregard of the law must demonstrate that the arbitrator (1) knew of the relevant legal principle, (2) appreciated that this principle controlled the outcome of the disputed issue, and (3) nonetheless willfully flouted the governing law by refusing to apply it.” In the School of Rock case, the 3rd Circuit held that existing law supported the district court’s decision. The court concluded that the “arbitrator’s decision was not a willful flouting of known, governing law” and affirmed the district court’s decision.

The School of Rock case shows that the courts will continue their historical deference to arbitration decisions, but will scrutinize arbitrator decisions where the governing law or contract interpretation compels a different outcome and no rational basis exists to support the award. •

Craig R. Tractenberg is a partner in the New York and Philadelphia offices of Nixon Peabody. He is a former editor of the ABA Franchise Law Journal. Tractenberg can be reached by e-mail at ctractenberg@nixonpeabody.com.