(Reuters) - Delaware's legal industry suffered a blow when a federal court found on Wednesday the state violated the U.S. Constitution with its novel system of allowing judges to arbitrate private business disputes, which critics called secret trials.
The U.S. Court of Appeals for the Third Circuit found private arbitrations taking place in Delaware's highly respected Court of Chancery violated the First Amendment of the U.S. Constitution.
"Allowing public access to state-sponsored arbitrations would give stockholders and the public a better understanding of how Delaware resolves major business disputes," wrote Judge Dolores Sloviter in a 2-1 ruling.
The 37-page ruling contained three opinions. Judge Julio Fuentes wrote a concurring opinion, but took a narrower view that secrecy was a problem but involving judges in arbitration was not. Judge Jane Roth dissented and called Delaware's system a "perfect model for commercial arbitration."
A statement from Andy Pincus, an attorney for Mayer Brown who handled the state's case, said an appeal was being considered.
Delaware's arbitration system was shut down in 2012 by U.S. District Court Judge Mary McLaughlin, who found it essentially amounted to civil trials and that the secrecy violated the First Amendment.
Delaware's legislature unanimously adopted the system, which appeared to the be the first of its kind, in 2009 as a way for the state's legal industry to compete with increasingly popular private arbitration for settling business disputes.
Arbitration is usually conducted confidentially before a private attorney or retired judge, and it can be much quicker than litigating in the courts. But critics say arbitrators are more prone to "split the baby" rather than issue a decisive ruling as a court would.
Delaware sought to build a better system by making available its acclaimed Chancery judges. The court regularly handles high-profile cases and recently prevented billionaire investor Carl Icahn from disrupting the Dell Inc buyout.
To use the arbitration process, at least one party had to be a business and the dispute had to involve at least $1 million.
The arbitration process was entirely secret and even the existence of a case was not public. Attorneys for the Court of Chancery have said the process was used six times.
The five judges on the non-jury court were sued by the Delaware Coalition for Open Government, a group that promotes government transparency, for holding what the group said amounted to secret trials.
"We're happy," said John Flaherty, a Coalition spokesman. "It's a victory for everyone who believes in open government and transparency."
The appeals court found that because the Delaware process takes place in a courtroom, a place with a history or experience of openness, the process therefore should be open. The judges rejected the argument that they should consider the history of privacy in arbitration.
The appeals court also said there were few drawbacks of opening the process Court of Chancery already allowed confidential filing of documents. "Public access would expose litigants, lawyers, and the Chancery Court judge alike to scrutiny from peers and the press," Sloviter wrote.
The court also rejected the argument that opening the arbitration would effectively kill it. They noted that the arbitration, even if public, offered expedited proceedings and customized procedures that many parties might prefer.
Pincus, who represented the Court of Chancery judges, said the dissent from Roth was encouraging.
"We feel strongly that it is important to our nation and our state to provide cost-effective options to resolve business-to-business disputes to remain competitive with other countries around the world," said Pincus.
The split decision was "to some extent" an invitation to appeal, said Arthur Hellman a professor at the University of Pittsburgh School of Law. He said Delaware could ask for an "en banc" review of the decision by all of the judges on the Third Circuit or, less likely, appeal to the U.S. Supreme Court.
Barring that, Delaware could rewrite the arbitration law to open the process to the public. Flaherty, of the group that sued to stop the arbitration, said that would go a long way to allay the Coalition's concerns.
"There has to be more to the judicial process than raising money," said Flaherty.
The private arbitration process was popular in Delaware's tight-knit corporate law community and proponents hoped it would provide new legal business.
The law also required one party in the arbitration to be incorporated in Delaware. It was seen as a way to jumpstart the flagging growth in the number of businesses chartered in the state.
That growth is key to Delaware's economy. More than half of the companies in the S&P 500 stock index are incorporated in the state, often for access to its courts, and money related to chartering businesses accounts for 40 percent of the state's general revenue.
The case is Delaware Coalition for Open Government v The Honorable Leo E. Strine Jr et al, U.S. Court of Appeals for the Third Circuit, No. 12-3859
Editing by Maureen Bavdek, Dan Grebler and Gunna Dickson