Investors in a Texas self-storage facility believed they had suffered about $10 million in damages because of the behavior of the guy who put the deal together, and were understandably upset.   But that didn’t give them the right to recover more than $30 million by slipping in a claim for punitive damages just 24 hours before the case went to arbitration, an appellate ruling has held.

The investors had sued Stephen Kaplan, alleging he breached his fiduciary duty in the self-storage project. They sought the return of $2.3 million they had invested, plus $8 million for lost “future and projected profits” and other damages. Notably, their complaint did not ask for punitive damages.

At the request of Kaplan and the investors, the trial court granted permission for the dispute to be handled in a private arbitration.

The arbitration hearing was delayed while Kaplan faced criminal prosecution for his conduct in soliciting and handling investments in this and other self-storage facilities.

In his criminal trial, Kaplan pled guilty to wire fraud. A few weeks later he was sentenced to one day in jail, a $100 fine, and three years of supervised release.

An arbitration hearing, conducted by telephone, was scheduled for the interval between Kaplan’s guilty plea and the time he was due to be sentenced. That gave the parties two and a half weeks’ notice of the hearing.

The day before the hearing, the investors for the first time added a request for punitive damages to their claim, and asked for a total of more than $30 million rather than the $10 million they had initially sought.

The revised brief was sent by email to the arbitrator less than 24 hours before hearing, with a copy to Kaplan.

The new brief did not highlight the fact that the claim for punitive damages had been added. The cover email sent to the arbitrator and Kaplan made no mention of the new punitive damages claim.

Kaplan did not participate in the arbitration session, and the arbitrator awarded the investors over $30.8 million. The arbitrator did not specify the grounds for the decision, nor the nature of the award – for example, how much was for actual losses versus punitive damages.

Kaplan went back to court, asking the trial judge to set aside the arbitrator’s decision. He lost.

As Kaplan acknowledged in his petition to the Fourth Appellate District Court of Appeal (Emerald Aero LLC v. Stephen Kaplan), courts have limited authority to review arbitration awards.

But Kaplan argued that in this case the arbitrator’s decision violated the rules of arbitration as well as fundamental principles of procedural fairness.

The Court of Appeal ruled in Kaplan’s favor.

The decision noted that the arbitration agreement specified that any hearings would be conducted under the rules of the American Arbitration Association.

The three-judge panel pointed out that these rules – along with fundamental principles of fairness – require that an opposing party be given reasonable time to review and understand a notice related to a hearing.

Emailing a brief less than a day before a scheduled arbitration that for the first time asked for punitive damages violated the requirement for fair notice.

“Under the totality of the circumstances and recognizing our narrow review authority, we conclude this award cannot stand,” the appellate judges concluded.

The moral of the story in this case is that, although it is typically very hard to overturn an arbitration award, fundamental fairness and due process can still outweigh rules and procedures, particularly when the facts are egregious.

By M. Laurie Murphy