In a case arising from an insurance dispute, the Seventh Circuit Court of Appeals held that the arbitrator exceeded his powers by disregarding a Wisconsin statute and thereby failing to abide by the parties' directive that he apply Wisconsin law. In reaching this holding, the Court distinguished this case from those cases in which the parties have altered the standard of review by creating contractual grounds for vacatur.

In Edstrom Industries, Inc. v. Companion Life Insurance Co., 516 F.3d 546 (7th Cir. 2008), Edstrom Industries (Edstrom) obtained a "stop loss" insurance policy from Companion Life Insurance (Companion). The policy insured Edstrom against any medical expenses exceeding $65,000 that Edstrom would be required to pay under a group health insurance plan for its employees and their dependents.

Before issuing the policy, Companion required Edstrom to identify any participant in the plan who could reasonably be expected to incur medical expenses in excess of $32,500. Edstrom identified no such participant, but Companion later discovered that one of Edstrom's employees had given birth to a child with a grave medical condition. Consequently, Edstrom raised the deductible for that child from $65,000 to $450,000 pursuant to a right of revision in the insurance policy.

Based on that revision, Companion refused to reimburse Edstrom for $890,000 in medical expenses incurred on behalf of the child. To resolve the dispute, Edstrom initiated arbitration in accordance with the policy. The arbitration agreement included a stipulation that the arbitrator "strictly apply rules of law applicable" to the policy – namely, Wisconsin law.

At arbitration, Edstrom argued that Wisconsin law precluded the policy revision because under Wis. Stat. § 631.11(1)(b), a misrepresentation cannot affect an insurer's obligations unless the insured "knew or should have known that the representation was false." Without any discussion of that statute, the arbitrator found that the insurance policy gave Companion an unfettered right to increase the deductible once it learned of the child's condition.

Edstrom filed a motion to vacate the award, arguing that the arbitrator exceeded his powers by not applying the statute and thereby failing to abide by the directive that he apply Wisconsin law. The district court denied the motion on the ground that the stop loss policy was a form of reinsurance, in which case the Wisconsin statute, by its terms, did not apply.

On appeal, the Court rejected the district court's conclusion that the stop loss policy was a form of reinsurance. More importantly, the Court held that the arbitrator exceeded his powers by disregarding the statute and thus the parties' agreement that the arbitrator strictly apply Wisconsin law. Based on this holding, the Court remanded the case with instructions to vacate the award and return the matter to the arbitrator with instructions to determine whether Edstrom made a knowing misrepresentation concerning the child's condition, in which case the increased deductible would not offend the statute.

In reaching its holding, the Court acknowledged that "errors of law committed by arbitrators are not grounds for setting aside an arbitral award." However, as the Court explained, "precisely because arbitration is a creature of contract, the arbitrator cannot disregard the lawful directions the parties have given them. If they tell him to apply Wisconsin law, he cannot apply New York law."

The Court distinguished this case from Hall Street Associates, L.L.C. v. Mattel, Inc., No. 06-989, 2008 WL 762537 (Mar. 25, 2008), in which the Supreme Court subsequently held that the grounds for vacatur under the Federal Arbitration Act (FAA) are exclusive and therefore cannot be supplemented by the parties. As the Court noted, the question in this case was not whether parties can alter the standard of review consistent with the FAA, but "whether the arbitrator can be directed to apply specific substantive norms and held to the application." The answer, according to the Court, is yes.

Under Rule 20(D) of the National Arbitration Forum (FORUM) Code of Procedure, arbitrators are directed to follow the applicable substantive law. As this case illustrates, arbitrators can be held to this directive under section 10(a)(4) of the FAA.