The Fifth Circuit Court of Appeals recently held that an arbitrator did not exceed his powers when he expanded an eight-year license to use a video game’s trademarks into a perpetual license to use all the intellectual property rights associated with the game. See Timegate Studios, Inc. v. Southpeak Interactive, L.L.C., ___ F.3d ___, 2013 U.S. App. LEXIS 7184, No. 12-20256 (5th Cir. Apr. 9, 2013).

Under the Federal Arbitration Act, an arbitrator does not exceed his powers unless “he has utterly contorted the evident purpose and intent of the parties—the ‘essence’ of the contract.” Timegate Studios, slip op. at 9. The Fifth Circuit found that the arbitrator’s remedy of a perpetual license was “rationally rooted” in the agreement between the parties and therefore reinstated the arbitrator’s award after the district court had vacated it.

The Agreement

In 2007, Timegate Studios, Inc. (“Timegate”) entered into a 46-page video game publishing agreement with Gone Off Deep, L.L.C. d/b/a Gamecock Media Group (“Gamecock”). The agreement obligated Timegate to develop a futuristic military-style video game entitled “Section 8,” and it obligated Gamecock to publish the game. As the publisher, Gamecock agreed to provide most of the investment funding for the game’s development and to manufacture, market, distribute, and sell the game after its development.

The agreement provided that Timegate remained the “exclusive owner” of all the intellectual property rights in the Section 8 game. The agreement also prohibited Gamecock from preparing any derivative works or otherwise exploiting the game except in accordance with the rights provided to it in the agreement.

The agreement did grant Gamecock a non-exclusive right and license to use the trademarks, trade names, themes, characters, designs, and likenesses “solely in connection with the packaging, sale, marketing, advertising and distribution” of the Section 8 game and of any add-ons or sequels to the game. The term of the license was for eight years following the game’s first release or five years following the release of an add-on or sequel, whichever was later.

The agreement also contained a binding arbitration provision:

Except for a suit seeking injunctive relief with respect to Confidential Information or infringement of intellectual property rights of a party hereto, any dispute hereunder shall be submitted to binding arbitration pursuant to the rules of the American Arbitration Association (the “AAA”), applying Texas law, without regard to choice of law provisions, with a single arbitrator appointed by AAA. ? A final arbitral award against either party in any proceeding arising out of or relating to this Agreement shall be conclusive.

Timegate Studios, 860 F.Supp.2d 350, 353 (S.D. Tex. 2012).

The Arbitration

Approximately two years after the parties entered into the Agreement, the Section 8 game was released. The parties’ relationship deteriorated soon after sales of Section 8 failed to meet expectations and Southpeak Interactive, L.L.C. (“Southpeak”) acquired Gamecock. In December 2009, Timegate filed a lawsuit against Gamecock in the Southern District of Texas alleging breach of contract. Gamecock counterclaimed and sought to enforce the arbitration clause. The district court stayed the suit and submitted the case to arbitration.

After an eight-day evidentiary hearing, the arbitrator found that out of the $7.5 million Gamecock provided to Timegate for the development of Section 8, Timegate spent only $6.76 million of it and pocketed the rest. Timegate also failed to spend any of the $2.5 million of its own money that it agreed to spend on Section 8’s development. The arbitrator also found that Timegate never intended to invest its own money and failed to use its best efforts to develop a high quality video game in accordance with the agreement. The arbitrator also found that Timegate failed to provide Gamecock with an opportunity to publish a port of the game for Play Station 3 and to publish a sequel entitled “Section 8: Prejudice.” The arbitrator also found that Timegate induced Gamecock to enter into the agreement by fraud and induced Gamecock to continue to perform under the agreement by fraud.

As a result of Timegate’s material breaches of the agreement and fraud, the arbitrator awarded Gamecock $7,349,733.57 in reliance damages and $831,479.55 in attorneys’ fees. The arbitrator also found that the money damages failed to compensate Gamecock fully for Timegate’s misconduct and therefore decided to amend the agreement to provide Gamecock with a perpetual license for all of Timegate’s intellectual property rights in the game. The arbitrator further ruled that Gamecock had no obligation to account for any future profits earned from the use of any of Timegate’s intellectual property rights in the game, or to pay any royalties to Timegate for the use of those rights.

The district court vacated the arbitrator’s award. According to the district court, the arbitrator exceeded his authority because his creation of the perpetual license was not a remedy rationally rooted in the agreement. The district court found that the perpetual license was “inconsistent with the fundamental purpose of the contract” because the license “takes what was a temporary licensing agreement, which required collaboration and coordination between the parties, and expands it into a permanent contract under which the parties are able to develop competing products.” Timegate Studios, 860 F.Supp.2d at 362. The district court also noted that the perpetual license conflicted with at least two provisions in the agreement and that Gamecock did not even request this relief. Id. at 355-56, 362.

The Appeal

On appeal, the Fifth Circuit emphasized that it was bound by the arbitrator’s factual findings and that its review of an arbitrator’s award is “very deferential.” Slip op. at 8. “We must sustain an arbitration award even if we disagree with the arbitrator’s interpretation of the underlying contract as long as the arbitrator’s decision ‘draws its essence’ from the contract.” Id. Moreover, “the arbitrator’s selection of a particular remedy is given even more deference than his reading of the underlying contract.” Id. at 9. “The remedy lies beyond the arbitrator’s jurisdiction only if ‘there is no rational way to explain the remedy handed down by the arbitrator as a logical means of furthering the aims of the contract.’” Id. at 9-10.1

Applying this standard of review, the Fifth Circuit concluded that the perpetual license furthered the general aims of the agreement. The Fifth Circuit reasoned that the only way to give Gamecock the opportunity to benefit from the future development of variations of Section 8 was to completely sever the parties’ relationship and allow Gamecock to independently pursue game marketing efforts. Slip op. at 11. According to the Fifth Circuit, “Timegate committed an extraordinary breach of the Agreement, and an equally extraordinary realignment of the parties’ original rights [was] necessary to preserve the essence of the Agreement.” Id. at 16 (emphasis in original). Thus, the Fifth Circuit reversed the district court and remanded with instructions to confirm the arbitration award.

The Takeaway

This case shows why it is important for contracting parties to carefully consider whether the subject matter of their contract is appropriate for arbitration in the event of a dispute. While there are certainly good reasons for including a mandatory arbitration clause in a contract even if intellectual property rights are involved, many contracting parties simply agree to boilerplate arbitration clauses without thinking through what the parties’ goals are in choosing binding arbitration over the courts and how the arbitration clause should be drafted to meet those goals. As demonstrated by the outcome of Timegate Studios, a losing party has limited bases for seeking to vacate an arbitrator’s award. Moreover, expected benefits such as confidentiality, cost savings, and a quicker disposition may not be realized, especially if court action is needed to compel arbitration and then to enforce the arbitrator’s award.