Biggs, Adams, and Max Rosenn, Circuit Judges.
In this case, a purchaser of printed cloth is suing the finisher of the cloth for damages resulting from defects in the goods, despite the fact that in an arbitration proceeding between the purchaser and the seller of the cloth, the seller was granted an award for the purchase price and the purchaser's counterclaim based on defects in the cloth was "denied in its entirety." We must decide whether the arbitrators' award precludes relitigation in the federal district court of the issue regarding the quality of the cloth.
Plaintiff, Lynne Carol Fashions, Inc. (Lynne Carol), is a Philadelphia producer of ladies' garments. In 1968, Lynne Carol purchased approximately 20,000 yards of material from Soptra Fabrics Corporation (Soptra), a New York converter of cloth. This cloth had been printed and finished by defendant, Cranston Print Works Co. (Cranston), a Rhode Island corporation. The goods were delivered by Soptra to Lynne Carol, but problems then arose when Lynne Carol attempted to sew the cloth to make dresses. Lynne Carol claimed that the difficulties were caused by defects in the material. Soptra asserted that the problems could be alleviated by altering Lynne Carol's incorrect sewing techniques. Eventually, Lynne Carol refused to pay for the goods.
On May 20, 1969, pursuant to the written contracts between them, Soptra sought arbitration of its claim against Lynne Carol for the purchase price. Lynne Carol defended on the ground that the goods were defective, and counterclaimed for loss of profits and other damages. Soptra also raised two other grounds upon which the arbitrators could base an award to Soptra: that Lynne Carol had failed to comply with contractual terms regarding notice to Soptra of defects, and that Lynne Carol was precluded by the terms of the contracts from asserting any claim for goods it had cut or otherwise processed. On February 17, 1970, the arbitrators awarded Soptra $22,063.61, the balance due on the goods delivered plus interest and costs, and denied Lynne Carol's claim "in its entirety." The award was confirmed by the Supreme Court of the State of New York, judgment being entered by default on March 20, 1970.
While the arbitration proceedings were underway, Lynne Carol filed a diversity action in the district court alleging that as a result of the defects caused by Cranston, Lynne Carol was damaged, and that Cranston breached its implied warranties of fitness and merchantability. Cranston first filed its answer, and then moved for summary judgment on a variety of grounds. The district court granted the motion for summary judgment solely on the basis that Lynne Carol was estopped from relitigating the issue as to the quality of the goods.
A federal district court in a diversity action must, under the principles of Erie R. Co. v. Tompkins, 304 U.S. 64, 58 S. Ct. 817, 82 L. Ed. 1188 (1938), apply the substantive law of the state in which it sits. The first question which must be resolved, then, is whether, for the purpose of applying the Erie doctrine, the issue of collateral estoppel by an arbitration award is substantive, that is one of substance as distinguished from one of procedure.
Proponents of the theory that collateral estoppel is procedural assert that a state rule of collateral estoppel merely operates to outlaw certain causes of action in the state courts but does not eliminate the underlying rights, as contrasted with res judicata which operates to destroy causes of action by merger or bar. Therefore, so the argument goes, since collateral estoppel controls only access to the courts, it is procedural and not substantive, the federal courts are not bound by the state rule in this regard but should be able to adopt their own rules, and the adoption of such rules by the federal courts should be based on policy considerations, convenience, and practicality.
A similar contention that a statute of limitations is procedural only and that therefore the state rule is not binding on the federal courts was considered and rejected by the Supreme Court in Guaranty Trust Co. v. York, 326 U.S. 99, 65 S. Ct. 1464, 89 L. Ed. 2079 (1945). In Guaranty Trust, the narrow question was "whether, when no recovery could be had in a State court because the action is barred by the statute of limitations, a federal court in equity can take cognizance of the suit because there is diversity of citizenship between the parties." Id. at 107, 65 S. Ct. at 1469. In deciding whether the state statute of limitations had to be followed by the federal district court, the Supreme Court enunciated the test that a rule of law would be deemed substantive and binding on the federal courts for the purpose of applying Erie, if "it significantly affect[s] the result of a litigation for a federal court to disregard a law of a State that would be controlling in an action upon the same claim by the same parties in a State court." Id. at 109, 65 S. Ct. at 1470. Thus, the approach of deciding these issues in terms of labels was disapproved.*fn1
Another instructive case in deciding whether state law of collateral estoppel must be adopted by a federal court is Bernhardt v. Polygraphic Co., 350 U.S. 198, 76 S. Ct. 273, 100 L. Ed. 199 (1956), coincidentally involving an arbitration dispute. There, plaintiff's Vermont state court action for breach of contract was removed to a federal district court. Defendant's motion for a stay of the action pending arbitration in New York was denied by the district court, which held that under Vermont law the arbitration provision was revocable prior to the making of an award. In upholding the district court, the Supreme Court noted that the differences between an arbitration proceeding and a trial, and the nature of the review following each, were such that they substantially affected the cause of action. Therefore, the Supreme Court stated that although "a federal court enforces the state-created rights by rules of procedure which it has acquired by the Federal Government and which are therefore not identical with those of the state courts," Id. at 202-203, 76 S. Ct. at 276, an arbitration that could not be compelled in the state courts could not be compelled in the federal court.*fn2
In Byrd v. Blue Ridge Elec. Corp., Inc., 356 U.S. 525, 78 S. Ct. 893, 2 L. Ed. 2d 953 (1958), the Supreme Court again considered the question whether state or federal law should be applied in the federal courts. The plaintiff had brought a diversity action for injuries caused by defendant's negligence. Defendant interposed the defense that if plaintiff were an employee as defined in the state workmen's compensation act, plaintiff's sole remedy was as that act provided. State courts had ruled that the question whether a plaintiff was an employee had to be decided by the trial judge alone. The Supreme Court held that the state rule was not so bound up with state-created rights and obligations as to require the federal courts to apply the state rule, that the policy underlying Guaranty Trust does not necessarily prevail over the "strong federal policy" favoring jury determinations, and that the federal practice need not yield where there was no strong possibility that the outcome of the action would be affected by a jury determination whether plaintiff was an employee under the act.
In the present case, however, we are in a "gray" area of the law with regard to how closely collateral estoppel is tied to state-created rights. Lynne Carol's cause of action is based on Pennsylvania law, that allows recovery for breaches of implied warranties even though there is no privity between the purchaser and the remote manufacturer. Kassab v. Central Soya, 432 Pa. 217, 246 A.2d 848 (1968). The defense of collateral estoppel, asserted here by Cranston, is a judge-made doctrine designed to terminate litigation. Unlike a statute of limitations, the doctrine of collateral estoppel is not closely related to the state cause of action; but like a statute of limitations once the conditions precedent to its invocation have been satisfied, parties may rely thereon and guide their conduct accordingly. The Third Circuit has adopted a rather expanded view regarding the application of collateral estoppel, and has, in many situations, dispensed with the requirement of mutuality.*fn3 Pennsylvania law, on the other hand, favors full litigation except in narrow circumstances.*fn4 And the Pennsylvania policy is even more pronounced where the first determination was not made by a court. Philadelphia v. Stradford Arms, Inc., 1 Pa.Cmwlth. 190, 274 ...