Federal Appeals Court Rules in Favor of El Salvadoran Hemp-CBD Company in Arbitration Clause Dispute

06 May Federal Appeals Court Rules in Favor of El Salvadoran Hemp-CBD Company in Arbitration Clause Dispute

We regularly write about arbitration as an alternative to litigation on this blog and on our sister blog, the China Law Blog. Topics have included the pros and cons of arbitration in the cannabis industry, international arbitration issues, and U.S. Supreme Court cases:

This post is about a recent ruling by the Eleventh Circuit Court of Appeals at the confluence of international arbitration and hemp-derived CBD. The case is Earth Science Tech, Inc. v. Impact UA, Inc., No. 19-10118. (Email me if you’d like a copy of the decision).

Background – Florida company distributes CBD manufactured by El Salvadoran company

Earth Science is a Florida-based company that distributes CBD products throughout the United States. Cromogen Biotechnology Corporation is an El Salvador-based company that supplies hemp-based biotechnology. In 2014, Cromogen entered into a Distribution Agreement with Earth Science that allowed Earth Science to exclusively market, distribute, and sell Cromogen’s CBD oil to other companies. Generally, Cromogen agreed to provide conforming quantities of CBD oil and Earth Science agreed to purchase the oil and sell it in the United States, with the two companies sharing the sales revenue.

The Distribution Agreement included an arbitration clause stating that the contract would be construed under the laws of New York and that the parties agreed to “exclusive International Arbitration through JAMS International using UNCITRAL rules in New York” and provided the U.N. Convention on International Sales of Goods would not apply. (That convention is similar to Article 2 of the Uniform Commercial Code adopted by every state in the U.S.)

The relationship quickly soured. Four months in, Cromogen served Earth Science a demand for arbitration asserting breach of contract, conversion, and tortious interference. Earth Science commenced a state-court action in Florida that was removed to federal court and stayed (paused) pending the outcome of the arbitration. Three years later – 2017 – an arbitration panel ruled in favor of Cromogen and awarded it about $3.9 million—most of which was for Cromogen’s tort claims. After the arbitration panel entered its award, Cromogen asked the district court to confirm the award and Earth Science moved to vacate or modify the award. The district court confirmed the award and Earth Science appealed.

The Eleventh Circuit ruled in favor of Cromogen in all respects. Although an unpublished decision (meaning the Eleventh Circuit does not deem it binding precedent), the ruling has persuasive value and the takeaways from this case are valuable to any company engaging in international commercial dealings that concern hemp-derived CBD.

The appellate court held the Panama Convention precluded Earth Science’s argument that Cromogen’s tort claims were not subject to arbitration

Earth Science argued that Cromogen’s tort claims—which comprised the bulk of the $3.9 million in damages—were not subject to arbitration. The Court disagreed. The Court first explained that the Federal Arbitration Act (“FAA”) provides that awards arising out of commercial relationships that are not purely domestic fall under the Convention.

The Panama Convention, formally known as the Inter-American Convention on International Commercial Arbitration, came into effect in 1975 after many Latin American countries refused to sign the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards.  Nineteen countries have signed and ratified the Panama Convention–see here for a complete list–including El Salvador and the United States. Generally speaking, the Panama Convention provides the “when and whether” a commercial dispute between citizens of its signatory states may be arbitrated pursuant to its rules and how the arbitration proceeds.

Article 5 of the Panama Convention gives seven exceptions that a party may invoke to object to the enforcement of an arbitration award. In a prior case, the Eleventh Circuit had held that the New York Convention provides the exclusive grounds for vacating an award under that Convention. That holding, ruled the Court, also applies to the Panama Convention.

Earth Science had moved only to vacate the award under Section 10(a)(4) of the FAA and had not argued any of the seven grounds for vacating an award provided under the Panama Act.  This was fatal to Earth Science’s argument that the tort claims were not arbitrable. Even absent that basis, said the Court, it would reject Earth Science’s argument that Cromagen’s tort claims were not arbitrable because the parties agreed to submit the issue of arbitrability (i.e. whether the arbitrator could decide the tort claims) to the arbitrator. The parties adoption of the UNCITRAL rules constituted “clear and unmistakable evidence” that the parties agree to submit the issue of arbitrability to the arbitrator – which ruled that Cromogen’s tort claims were arbitrable.

The appellate court rejects Earth Science’s argument that the damages should be modified

Earth Science next argued that even if the tort claims were arbitrable, the amount of damages should be modified under Section 11(a) of the FAA. Section 11(a) permits modification where there was an “evidence miscalculation of figures or an evident material mistake in the description of any person, thing, or property referred to in the award.” Earth Science made several arguments which aren’t worth repeating here because the Court quickly disagreed.

“The attentive reader knows that argument is also a nonstarter,” said the Court. The argument was a nonstarter because the grounds for modification provided in Section 11(a) are not one of the exclusive seven bases for challenging an arbitration award governed by the Panama Convention.

The appellate court rejects Earth Science’s argument that confirming the award would be inconsistent with the Controlled Substances Act

Finally, Earth Science argued that confirming the award would be inconsistent with federal law. Even though it was a party to the Distribution Agreement, Earth Science argued that when the contract was signed in 2014, the Controlled Substances Act (“CSA”) proscribed all products containing any THC, including CBD oil. In other words, Earth Science argued that the subject of the contract was illegal and, therefore, that confirming the arbitration award would be tantamount to enforcing a contract whose subject was illegal under federal law.

The Court rejected this argument for two reasons. First, the Court found it unclear whether Earth Science’s CBD oil was proscribed by the CSA when the parties executed the Distribution Agreement in 2014. The burden to prove it was fell upon Earth Science. But in 2014, Earth Science’s own website said its products were derived from the “federally legal industrial hemp plant” and that is CBD oil was “legal everywhere in the USA.” Taking these statements into consideration, the Court concluded, “We will not assume that Earth Science would so flagrantly conduct its operations and advertise them if it believed the product was illegal.”

Next the Court ruled that the 2018 Farm Bill mooted Earth Science’s illegality argument. As we all know, the 2018 Farm Bill Act removed hemp (and hemp-derived CBD) from the federal Controlled Substances Act unless the product contains a greater than .03% concentration of THC. Here, Earth Science’s purchase orders called for CBD oil with less than .03% TCH or less. “So even if the CBD oil at issue under the Distribution Agreement once fell within Schedule I’s list of controlled substances, it no longer does.”

Takeaways

1. If your company finds itself in an international arbitration, make sure you know which convention and which rules apply and the defenses available under that convention and under the rules. Do not rely solely on domestic grounds to challenge an international arbitration award.
2. Consult with your attorneys before entering into an agreement to arbitrate with an non-U.S. company so that you understand what rules and defenses will apply. Agreements to arbitrate can be the subject of negotiation and ensuring that your interests are not disfavored by the applicable arbitration rules is well-worth your time.
3. Challenging the validity of a hemp-CBD contract that pre-dates the 2018 Farm Bill on the ground that its subject is illegal may be a losing argument. This is an excellent development, in our opinion.