United States Court of Appeals For the First Circuit

No. 06-1001

JAMES W. MCCARTHY,

Plaintiff, Appellee.,

v.

CITIGROUP GLOBAL MARKETS INC.,

Defendant, Appellant.

ON APPEAL FROM A JUDGMENT OF THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF NEW HAMPSHIRE

[Hon. Joseph A. DiClerico, Jr., U.S. District Judge]

Before

Lipez and Howard, Circuit Judges, and Gorton,* U.S. District Judge.

John R. Skelton, with whom John F. Adkins, Carol E. Head, and Bingham McCutchen LLP, were on brief for appellant. Stacey P. Nakasian, with whom William A. Jacobson, Shanna L. Pitts, and the Law Offices of William A. Jacobson, Inc., were on brief for appellee.

September 19, 2006

* Of the District of Massachusetts, sitting by designation LIPEZ, Circuit Judge. In this appeal, we must review the

district court's decision to vacate an arbitration award and remand

on the ground that the award was in manifest disregard of the law.

In an unusual circumstance, this is the second time in this case

that the district court has vacated an arbitration award in favor

of the appellee and remanded on that ground.

The award of the arbitration panel was not in manifest

disregard of the law. Instead, the district court engaged in an

analysis of the merits of the arbitration panel's award and found

legal error. Such an analysis is proscribed by the standards of

review that apply in this circuit to a district court's review of

arbitration awards. Therefore, we must vacate the district court's

ruling and direct the district court to enter a judgment confirming

the arbitration award.

I.

A. Factual Background

Plaintiff James W. McCarthy ("McCarthy") was a financial

consultant at Smith Barney, predecessor of Defendant Citigroup

Global Markets Inc. ("CGMI"), from 1985 until his resignation in

May 2003. As of 1993, he worked in the Manchester, New Hampshire

office of CGMI. CGMI is an investment bank and brokerage firm with

its principal place of business in New York City. It is a

subsidiary of Citigroup Inc., one of the world's largest financial

services companies.

-2- While an employee, McCarthy participated in the Capital

Accumulation Plan ("CAP Plan"), which was sponsored by CGMI's

parent company, Traveler's Group, Inc. The CAP Plan is a program

designed to retain employees by giving them the opportunity to

purchase restricted shares of Citigroup, either in the form of

Citigroup restricted stock at discounted prices on a tax-deferred

basis, or as grants of non-qualified stock options for Citigroup

common stock. An eligible employee must sign, at least annually,

a form electing to participate in the CAP Plan, wherein the

employee designates the amount of earnings he wants deducted from

his paychecks and used in the CAP Plan.

Under the CAP Plan restricted stock program, the

restricted stock is acquired at a twenty-five percent (25%)

discount from market value and is purchased with wage deductions

from payroll checks. However, the stock purchases are subject to

a vesting period of two years. When the restricted shares vest,

the participant pays ordinary income taxes and payroll taxes based

on the market value of the shares on the vesting date, unless the

participant has elected to pay taxes at the time of the payroll

deduction. McCarthy had paid income and payroll taxes on many of

the shares at issue here. If a participant in the CAP Plan

resigns, as McCarthy did, the participant forfeits both the

unvested restricted shares and the wages deducted from the

paychecks. The unvested restricted shares are cancelled, the

-3- underlying restricted Citigroup stock reverts to Citigroup, and

CGMI does not return the wages to the participant. Under the CAP

Plan stock option program, a participant can choose to receive up

to one-third of the restricted shares in the form of non-qualified

stock options on Citigroup common stock. If employment terminates

voluntarily, unvested options may not be exercised. As with the

restricted stock program, when an option is exercised, income and

payroll taxes are withheld.

McCarthy resigned on May 9, 2003. From 1993 until his

resignation, McCarthy voluntarily elected in writing to direct the

equivalent of 20-25% of his compensation to be invested through the

CAP Plan. He participated mostly in the restricted stock plan, but

at times also purchased stock options under the CAP Plan. McCarthy

sought to recover his contributions to the CAP Plan that had

resulted in the purchase of unvested shares, as well as funds that

had not been used to purchase shares. Pursuant to the terms of the

CAP Plan, these contributions had been forfeited.

B. Procedural Background

Pursuant to the parties' arbitration agreement and the

regulatory framework of the securities industry, McCarthy commenced

arbitration proceedings against CGMI with the National Association

of Securities Dealers ("NASD") on December 29, 2003.1 McCarthy

1 The NASD is the primary self-regulatory organization responsible for the regulation of persons and companies involved in the securities industry in the United States, with delegated

-4- asserted statutory claims under the New Hampshire wage laws (the

"Wage Law") and equitable claims.

A hearing was held on November 18, 2004 (the "First

Hearing"). The arbitrators in the First Hearing (the "First

Panel") ruled in favor of CGMI and dismissed McCarthy's claims (the

"First Award"):2

[McCarthy's] request for relief is denied. The evidence and documents presented in evidence at the hearing demonstrated that [McCarthy] knowingly and willingly participated in the [CAP Plan] by signing the election forms twice a year for several years. [McCarthy] benefitted financially from participation in the [CAP Plan] to a substantial degree over the years. While [McCarthy] invoked New Hampshire wage law to support his case, the Panel considered it irrelevant because the Panel considered the case to be a contract dispute regarding an inventive compensation plan commonly used at the firm and commonly used in the securities industry.

On December 16, 2004, McCarthy asked the district court to vacate

the First Award. CGMI cross-moved to confirm it. Focusing on the

language above, the district court remanded the matter to the NASD

for further arbitration proceedings ("First Remand Order"):

authority from the U.S. Securities and Exchange Commission. See "About NASD", http://www.nasd.com/AboutNASD/index.htm (last visited August 15, 2006). 2 In the context of arbitration, an "award" can denote both the decision an arbitration panel reaches and the authenticated document containing the decision. See 2 Martin Domke, Domke on Commercial Arbitration, Appx. B-1 § 19(a) (3d. ed. 2003)("An arbitrator shall make a record of an award. The record must be signed or otherwise authenticated by any arbitrator who concurs with the award. The arbitrator or the arbitration organization shall give notice of the award, including a copy of the award, to each party to the arbitration proceeding.").

-5- The [arbitration] panel does not appear to have intended "irrelevant" to have its usual meaning. Instead, the panel concluded that McCarthy was not protected by the wage laws because he had profited from the CAP in the past and had voluntarily agreed to its terms. As such, the panel acknowledged the applicability of the wage laws but decided not to apply them because of the circumstances attending McCarthy's claim. The panel also decided not to consider the wage laws because plans like the CAP are commonly used in the securities industry. In doing so, the panel set aside the governing law in favor of its perception of an equitable result and industry practices. The panel's decision not to consider the New Hampshire wage laws demonstrates its disregard for the governing law.

The district court concluded that "the case must be remanded to

have McCarthy's claim decided under the New Hampshire wage laws

through arbitration." Although CGMI filed an appeal from the First

Remand Order (the "First Appeal"), it never pursued that First

Appeal. Instead, CGMI voluntarily withdrew it. On March 18, 2005,

we entered a judgment dismissing the First Appeal and sending the

case back to the district court.

McCarthy re-filed his claim with the NASD, which convened

a second arbitration panel comprised of three new arbitrators (the

"Second Panel"). McCarthy withdrew all of his equitable claims,

moving forward with only his claims based on New Hampshire law.

The parties submitted briefs to the Second Panel, along with copies

of the Wage Law, case law, the district court's First Remand Order,

the CAP Plan documents, and exhibits reflecting McCarthy's

participation in the CAP Plan. The Second Panel heard argument and

testimony from several witnesses on August 2, 2005 (the "Second

-6- Hearing"). CGMI argued that the CAP Plan did not violate the Wage

Law and, in the alternative, that McCarthy was not entitled to any

damages regardless of the status of the CAP Plan under the Wage

Law.3 McCarthy asserted that the First Remand Order required the

Second Panel to apply the Wage Law to his claims, and under the

Wage Law the CAP Plan was illegal. On August 18, 2005, the Second

Panel issued its award denying McCarthy's claims with prejudice

(the "Modified Award"):

[McCarthy] requested that the panel . . . declare that the CAP Plan is illegal under New Hampshire law, to the extent the CAP Plan is implemented (i) through wage deductions, which are not actually used to purchase stock in Citigroup, or (ii) so as to cause employees to forfeit wages.

. . .

The Panel heard testimony from [McCarthy] and witnesses of both parties and considered the documentary evidence from each side as well. The Arbitrators fully considered all claims and defenses, including the applicability of the New Hampshire Wage Laws, which were heavily argued on both sides . . . . After full consideration of the matter, the panel decided to deny all claims with prejudice.

On September 8, 2005, McCarthy filed with the district

court a motion to vacate the Modified Award, asserting again that

the arbitrators had manifestly disregarded controlling law.

McCarthy also claimed that the award should be vacated because CGMI

3 CGMI asserted that "McCarthy is not entitled to any damages because, if he held all his vested shares, McCarthy netted over one million dollars from voluntarily participating in the CAP Plan, and CGMI is entitled to recover those shares or their market value in excess of McCarthy's cost of any unvested stock."

-7- improperly encouraged the arbitrators to ignore the district

court's legal findings as they were set forth in the First Remand

Order, and because the arbitrators refused to be polled as to

whether they would follow the law. CGMI again filed a cross-motion

for confirmation of the award.

In a Second Remand Order dated December 15, 2005, the

district court vacated the Modified Award because it was in

manifest disregard of the law, denied CGMI's cross-motion for

confirmation of the award, and remanded the case for a third

arbitration proceeding, if necessary (the court urged the parties

to settle).4

II.

A. Standard of review

We review a district court's decision to vacate or

confirm an arbitration award de novo. See Bull HN Info. Sys., Inc.

v. Hutson,

(1st Cir. 2000). The touchstone for

review of arbitration awards is

"Section 10

4 In the Second Remand Order, the district court rejected McCarthy's "polling" argument, stating that McCarthy had "cited no case or any other legal authority supporting his request for a poll." McCarthy did not renew this argument on appeal and we do not address it. 5 In relevant part,

states:

(a) In any of the following cases the United States court in and for the district wherein the award was made may make an order vacating the award upon the application of any party to the arbitration --

-8- authorizes vacatur of an award in cases of specified misconduct or

misbehavior on the arbitrators' part, actions in excess of arbitral

powers, or failures to consummate the award." Advest, Inc., v.

McCarthy,

(1st Cir. 1990); see also Nat'l Cas. Co. v.

First State Ins. Group,

, 497 n.4 (1st Cir. 2005).

"Courts do, however, retain a very limited power to review

arbitration awards outside of section 10." Advest,

.

As we have put it:

In the main, a successful challenge to an arbitration award, apart from section 10, depends upon the challenger's ability to show that the award is (1) unfounded in reason and fact; (2) based on reasoning so palpably faulty that no judge, or group of judges, ever could conceivably have made such a ruling; or (3) mistakenly based on a crucial assumption that is concededly a non-fact.

at 8-9 (quoting Local 1445, United Food & Commercial Workers v.

Stop & Shop Cos.,

(1st Cir. 1985)(internal

quotation marks omitted). In some of our cases, we have referred

to this non-statutory standard of review as "manifest disregard of

(1) where the award was procured by corruption, fraud, or undue means; (2) where there was evident partiality or corruption in the arbitrators, or either of them; (3) where the arbitrators were guilty of misconduct in refusing to postpone the hearing, upon sufficient cause shown, or in refusing to hear evidence pertinent and material to the controversy; or of any other misbehavior by which the rights of any party have been prejudiced; or (4) where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made.

-9- the law." Wonderland Greyhound Park, Inc. v. Autotote Sys., Inc.,

(1st Cir. 2001).6 We have elaborated that we mean

by "manifest disregard of the law" a situation "where it is clear

from the record that the arbitrator recognized the applicable law

-- and then ignored it." Advest,

. To succeed under

this standard "there must be some showing in the record, other than

the result obtained, that the arbitrators knew the law and

expressly disregarded it." Advest,

(quoting O.R.

Securities, Inc. v. Prof'l Planning Assoc., Inc.,

(11th Cir. 1988). "'[D]isregard' implies that the arbitrators

appreciated the existence of a governing legal rule but wilfully

decided not to apply it."

(emphasis added).7

6 In P.R. Tel. Co., Inc. v. U.S. Phone Mfg. Corp.,

(1st Cir. 2005), we stated that "[u]nder the FAA, an award may be vacated for legal error only when in 'manifest disregard of the law.'"

. Insofar as this statement means that the FAA does not foreclose extra-statutory judicial review of arbitration awards on a limited basis, e.g. the "manifest disregard of the law" standard, this statement is correct. However, insofar as this statement means that the "manifest disregard of the law standard" is a part of the FAA itself, it would be mistaken. Nowhere in

does the phrase "manifest disregard of the law" appear. See Advest,

n.5 ("The lane of review that has opened out of this language is a judicially created one, not to be found in

."). 7 See also Domke, § 38:9 ("Although subject to slight variations in wording, courts generally apply the following two part test in determining if the award should be vacated for manifest disregard of the law: (1) Did the arbitrator know of the governing legal principal yet refused to apply it or ignored it all together? and (2) Was the law ignored by the arbitrators well defined, explicit and clearly applicable to the case? Only if the court determines that both prongs of this test are satisfied will it overturn an award for manifest disregard of the law.").

-10- B. The district court's reasoning

On appeal, CGMI maintains that the Second Panel's

Modified Award was improperly vacated under the manifest disregard

of the law standard. McCarthy, inter alia, asserts that the

district court's Second Remand Order was correct.

1. The First Remand Order

Although not the subject of this appeal, the court's

First Remand Order provides a useful insight into its reasoning in

this case. As noted above, the First Panel explained the First

Award against McCarthy in these terms:

While [McCarthy] invoked New Hampshire wage law to support his case, the Panel considered it irrelevant because the Panel considered the case to be a contract dispute regarding an inventive compensation plan commonly used at the firm and commonly used in the securities industry.

(Emphasis added.) Focusing on the Panel's use of the word

"irrelevant", the district court concluded that "the panel set

aside the governing law in favor of its perception of an equitable

result and industry practices. The panel's decision not to

consider the New Hampshire wage laws demonstrates its disregard for

the governing law." The court saw the First Panel's reasoning as

an instance "where it is clear from the record that the

arbitrator[s] recognized the applicable law -- and then ignored

it." Advest,

. Lest there be any doubt about this

point, the court explained again in the Second Remand Order the

problem with the First Award: "In the first award, the panel stated

-11- that the New Hampshire wage laws were irrelevant. As such, the

panel explicitly disregarded the governing law." The court's First

Remand Order, given the court's interpretation of the First Award,

was a conventional application of the manifest disregard of the law

standard.

2. The Second Remand Order

The district court's application of the manifest

disregard of the law standard to the Modified Award presents a

different story. We again quote the reasoning of the Second Panel

in the Modified Award:

The Panel heard testimony from [McCarthy] and witnesses of both parties and considered documentary evidence from each side as well. The Arbitrators fully considered all claims and defenses, including the applicability of the New Hampshire Wage Laws, which were heavily argued by both sides. After full consideration of the matter, the Panel decided to deny all claims with prejudice.

The district court focused on the Second Panel's statement that it

had "fully considered all claims and defenses, including the

applicability of the New Hampshire Wage Laws," and found in that

statement a troubling ambiguity. As the court explained in its

Second Remand Order:

[t]he [Second] panel did not say whether it concluded that the wage laws were applicable or not applicable or whether it had applied that law in making its decision. Therefore, while the second panel's statement did not clearly demonstrate a manifest disregard of the governing law, as the first panel did, the second panel left open the possibility that, contrary to the court's direction in the [First] remand order, the panel concluded that the New Hampshire wage laws do not apply.

-12- The district court acknowledged that the mere

"possibility that . . . the panel concluded that the New Hampshire

wage laws do not apply" is not itself a manifest disregard of the

law.8 As the district court put it: "[T]he second panel's

statement did not clearly demonstrate a manifest disregard of the

governing law, as the first panel did." In the absence of such an

expression of manifest disregard of the law in the Modified Award

itself, the district court decided to pursue a further inquiry:

In the first award, the panel stated that the New Hampshire wage laws were irrelevant. As such, the panel explicitly disregarded the governing law so that it was not necessary to look behind that decision to determine its basis.

(Emphasis added.)

There is authority in our precedents for a court to go

behind the award of an arbitration panel to the record itself in

8 We disagree with the district court that the Modified Award of the Second Panel can be read as a possible statement that the New Hampshire wage law is irrelevant, particularly in light of the explicit statement by the Second Panel that it "fully considered all claims and defenses, including the applicability of the New Hampshire Wage Laws, which were heavily argued by both sides." If the court had vacated the award of the Second Panel on this basis alone, we would have simply vacated its judgment on this misreading of the Modified Award. However, as we explain below, the district court also identified a second possibility in the Modified Award – namely, that the Second Panel had applied the New Hampshire wage law and still found the CAP lawful. In looking behind the award of the Second Panel to determine its basis, the court explained in its decision why this second possibility would also be a manifest disregard of the law. Focusing on that explanation in the balance of our opinion, we explain its incompatibility with the narrow scope of review that a court must observe in reviewing the decision of an arbitration panel.

-13- conducting a manifest disregard of the law inquiry. For example,

we have said that "there must be some showing in the record, other

than the result obtained, that the arbitrators knew the law and

expressly disregarded it." Advest,

(emphasis

added). But resorting to the record in search of manifest

disregard of the law is constrained by the narrow scope of the

manifest disregard of the law standard itself. To repeat, manifest

disregard of the law means, at its core, that "arbitrators knew the

law and explicitly disregarded it." P.R. Tel. Co.,

(internal quotation marks omitted). "Put differently, disregard

implies that the arbitrators appreciated the existence of a

governing legal rule but wilfully decided not to apply it."

(internal citation and quotation marks omitted).

The manifest disregard of the law inquiry must not run

afoul of the well-established principle that courts "do not sit to

hear claims of factual or legal error by an arbitrator as an

appellate court does in reviewing decisions of lower courts."

United Paperworkers Int'l Union v. Misco, Inc.,

(1987); see also Poland Spring Corp. v. United Food & Commercial

Int'l Union,

(1st Cir. 2002) (a court does not

conduct appellate review "to hear claims of factual or legal error

by an arbitrator or to consider the merits of an award"). "Even

where such error is painfully clear, courts are not authorized to

-14- reconsider the merits of arbitration awards." Advest,

(internal quotation marks and citation omitted).

The district court did not observe this limitation on its

authority to review an arbitration award. Instead of finding

manifest disregard of the law by the Second Panel, it found an

application of the Wage Law with which it disagreed. To

demonstrate this point, we quote several excerpts from the court's

Second Remand Order:

CGMI's arguments to the arbitration panel, that the CAP was lawful because McCarthy's compensation, paid in cash and restricted stock, conferred a benefit to him, because McCarthy had agreed to participate in the CAP and was a sophisticated and intelligent financial consultant, and because McCarthy had benefitted in the past from the CAP, are not pertinent to the principles of New Hampshire law. Instead, CGMI's argument is based on the reasoning of the Court of Appeals of New York . . . . CGMI represented to the arbitration panel that the New Hampshire wage laws allowed deductions as long as they accrued 'to the benefit of the employee,' . . . that the New Hampshire laws, like the New York law, allowed [such] a deduction . . . .

[But] under New Hampshire law, unlike New York law, a deduction is not lawful simply because it accrues to the benefit of an employee . . . .

CGMI also argued that the CAP was a lawful deduction as a payment into a savings fund held by someone other than the employer and that it was empowered by the federal tax treatment of similar plans to offer the CAP . . . . Neither argument is persuasive.

Nevertheless, it is perhaps arguable that the panel was sufficiently confused or misled by CGMI's arguments to conclude that the CAP deductions comported with New Hampshire law. Even assuming that the CAP deductions were lawful, however, CGMI did not offer the arbitration panel any justification under New Hampshire law for its failure to pay McCarthy the compensation that he had

-15- earned before he resigned. CGMI's oft-repeated theory . . . does not comport with New Hampshire law.

After this extensive merits review, the district court

concluded:

In the absence of any explanation, there appears to be no arguable or plausible basis for the [Second] panel to have ruled either that the New Hampshire wage laws did not apply to McCarthy's claims or that CGMI's failure to pay McCarthy earned compensation, based on the forfeiture provision in the CAP, was lawful. In either case, the panel's decision necessarily was made in manifest disregard of the law.

To make its meaning unmistakable, the district court added in a

footnote to its decision that "[b]ecause neither alternative basis

for the decision is reasonable, given the governing law, a remand

for clarification would not be beneficial here." Therefore, if

there were to be a third arbitration proceeding, the district court

directed that a new panel be convened. In that circumstance, the

court said the parties were "to request that the arbitration panel

provide an explanation or reasons for its decision to allow

meaningful judicial review."

Although the district court's legal analysis of the

relationship between the Wage Law and the CAP Plan was thoughtful

(indeed, the court was thoughtful about this case throughout the

lengthy proceedings), there are several errors in the district

court's Second Remand Order. First, with its insistence that the

next arbitration panel, if one were constituted, provide an

explanation or reasons for its decision to allow meaningful

-16- judicial review, the court ignored the basic principle that

"arbitrators need not explain their award" at all. P.R. Tel. Co.,

(internal citation omitted). Second, although it

theoretically left open the possibility that a third arbitration

panel could explain why McCarthy's claim failed under New Hampshire

law, the court's elaborate rejection of that possibility in its

Second Remand Order delivered an unmistakable message to a third

panel -- such a decision would be difficult to justify. Courts

should avoid such messages when remanding cases to arbitration

panels. See Domke, § 30:6 ("[C]areful consideration should also be

given that remanding the case does not make the court itself decide

the issue in controversy or instruct the arbitration in such

direction.").

Third, in looking behind the Modified Award, the court

did not examine the record of proceedings before the panel for

manifest disregard of the law -- that is, "some showing in the

record, other than the result obtained, that the arbitrators knew

the law and expressly disregarded it." Advest,

(internal citation omitted). Instead, the court conducted its own

analysis of the compatibility of the CAP Plan with the Wage Law and

concluded that the Modified Award in favor of CGMI, absent some

further explanation, was wrong. Moreover, in conducting that legal

analysis, the court did not find that "rare" instance of manifest

disregard we described in Advest, where "the governing law may have

-17- such widespread familiarity, pristine clarity, and irrefutable

applicability that a court could assume the arbitrators knew the

rule and, notwithstanding, swept it under the rug."

. Instead, the court's analysis reveals a legal landscape devoid

of statutory language or a decision of the New Hampshire Supreme

Court that irrefutably proscribes the CAP Plan under the Wage Law.

At most, after a merits analysis of the Modified Award, the

district court arguably found a legal error in its result.

However, our precedents forbid a district court from conducting

such a review of an arbitration award. See Poland Spring Corp.,

(a court does not conduct appellate review "to hear

claims of factual or legal error by an arbitrator or to consider

the merits of an award"). We must therefore vacate the district

court's Second Remand Order and direct the court to enter a

judgment confirming the Second Panel's Modified Award.9 Each party

is to bear its own costs.

So ordered.

9 Relying on Montes v. Shearson Lehman Bros., Inc.,

(11th Cir. 1997), where the court found an award in manifest disregard of the law, McCarthy also asserts that CGMI "undermined the integrity of the Second Hearing" by "repeatedly urg[ing] the Second Panel during oral argument to disregard the law," and that this conduct constitutes an independent basis for vacating the Modified Award. The district court rejected that argument: "the circumstances in this case are not sufficiently similar to those in Montes to permit application here of that narrowly limited decision." We see no reason to disturb this ruling.

-18-