Arbitration Agreement Explained

Drafting the Perfect Arbitration Agreement

What does the perfect arbitration agreement look like? If you are seeking one agreement that will be ideal across the board, there is no such thing. Of course, there are provisions that should be in your arbitration agreement.

Before discussing how to draft the perfect arbitration agreement, we should consider some of the arbitration’s imperfections.

1. The arbitration system

Beginning in the last half of the 20th century, businesses of all kinds sought relief from litigation. The public trial had become a beast. Participants were burdened by high costs, endless delays, and untold disruption.

In response, Fortune 1000 companies, began institutionalizing the use of alternative dispute resolution, particularly arbitration and mediation,  praising their self-determination, confidentiality, cost savings, speed, and the preservation of relationships. Use of arbitration and mediation are often required by contract, but may also be chosen after litigation begins.

Congress, faced with huge case backlogs in the Federal courts, responded by more closely monitoring case progress and requiring the use of court-connected mediation and arbitration.  State courts soon followed suit.  Additionally,  Congress and the Federal courts strongly supported the use and enforceability of alternative dispute resolution. Even then, the validity of arbitration provisions is usually upheld.

State courts, faced with the same overwhelming burdens of protracted litigation, have been equally supportive of arbitration when construing analogous state law.  Internationally, treaties concerning arbitration mean that arbitration awards are often more easily enforceable abroad than judgments of a United States court.

Arbitration traditionally had neither discovery nor motion practice.  Approximately 50% of the cost of litigation is caused by document discovery alone.  Producing electronically stored data can add millions of dollars to the cost of a case.

Sadly, all of this effort and expense is of limited utility:  The ratio of documents produced to documents admitted as evidence is roughly 1000 to 1.  Nevertheless, arbitration counsel continues to push for more and more discovery,  sometimes even insisting that the Federal Rules of  Civil Procedure be applied.

Although the United States Supreme Court rejected attempts to contractually confer jurisdiction under the Federal Arbitration Act, Federal and state courts considering other statutes have sometimes allowed such expanded review.   However, review by other arbitrators is far most common.

Such a review adds to the cost and complexity of arbitration. While arbitrators could rein in the so-called “judicialization” of the arbitration process, most do not, both to protect the award from later vacatur and to avoid offending valuable clients.  Arbitration has become the “new litigation,” often as complicated as civil litigation.  The promise of arbitration as a speedy alternative has been broken.

2. The role of the perfect arbitration agreement

What do arbitration’s failings have to do with the perfect arbitration agreement?  Arbitration is a matter of a contract, and a carefully drafted arbitration agreement defines who will administer the arbitration, what disputes will be decided by arbitration, the powers, and duties of the arbitrator, the law to be applied, what relief may be awarded, the choice of venue, costs when court determinations are required during the arbitration. While the courts will demand fundamental fairness, otherwise party autonomy is paramount.

Arbitration agreements are generally negotiated at the pre-dispute stage.

The arbitration process is flexible because the law stresses party autonomy.  It also emphasizes the ability to tailor a process that suits them given their goals and the business realities they face.  Some thought about what disputes might arise and how those likely disputes interact with the client’s goals before a dispute arises can help preserve the utility of arbitration and its advantages.

3. Business goals in drafting the arbitration agreement.

Inserting a form arbitration clause into a contract at the pre-dispute stage, doing so may overlook the client’s business goals.

Clients also have a strong interest in controlling costs. Ballooning legal costs tied to out-of-control discovery drove corporations to arbitration in the first place.  Largely because of this, a significant proportion of respondents to a survey of business-to-business arbitration users by the RAND Corporation (38%) said that arbitration has become no better or actually worse than litigation.  Curtailing discovery, or at least tailoring it to the dispute, is clearly critical. Other important interests that can be damaged by unduly adversarial proceedings or the failure to properly draft the arbitration agreement are:

  • Maintaining a cordial ongoing business relationship despite disputes over some matters.
  • Fitting the dispute resolution process to the conflict
  • Selecting the right neutral
  • Retaining the right to self-determination
  • Advancing efficiency and shortening the lifespan of disputes
  • Avoiding uncertainty and controlling unreasonable arbitration awards.
  • Preserving options in “do-or-die” conflicts.
  • Maintaining positive brand perceptions and avoiding a reputation for litigiousness or unfairness.
  • Controlling court involvement in the arbitral process.
  • Ensuring the enforceability of the arbitration award

Each of these interests can be impacted by the arbitration agreement between the parties.

4. Critical provisions of the perfect arbitration agreement.

A. Selection of the arbitration administrator.

Selection of the arbitration administrator technically falls to the party demanding arbitration but is generally made by the arbitration provider from their staff.  On rare occasions, independent administrators are used.  The administrator performs the functions of a court clerk, with some notable additions.  He or she is responsible for ensuring that the demand for arbitration, arbitration agreement, description of the claim, supporting documents, response, and counterclaims filed are sufficient to confer jurisdiction on the arbitrator.

The administrator also coordinates hearing dates and other deadlines between the parties and the arbitrator, provides the hearing facility and certifies the text of the arbitration award; and reviews the award for compliance with local format and disclosure requirements, so the awards may be docketed in court for judicial confirmation.

Competent administration makes the arbitration process flow more smoothly. But inept administration can lengthen the dispute, as the administrator fails to keep the parties on schedule or properly coordinate hearing dates. Even worse, failure to treat parties impartially or comply with disclosure or formatting requirements can delay confirmation or even invalidate an award, resulting in tremendous waste. Concerns about the quality of administration should be brought to the provider immediately for resolution.

B. Keeping the court out of arbitration agreement

Despite the fact that arbitration is a private alternative to the court system, there are a significant number of issues that can require court if the arbitration agreement is not carefully drafted. These include the enforceability of the arbitration agreement, the arbitrability of the dispute, compliance with any contractual preconditions to arbitration, and waiver of the right to arbitrate.

Although some of these questions have been generally resolved in favor of arbitral determination, the courts are split on other things.  But where the arbitration agreement clearly and unmistakably states that questions of enforceability, arbitrability, preconditions, and waiver are for the arbitrator to decide the intent of the parties as expressed in the arbitration agreement.  A strong clause favoring arbitral decision-making (called a  delegation clause) is a critical part of the “perfect” arbitration agreement.

C. The scope of arbitration — right-sizing dispute resolution.

Both because of the incredible variety of claims dealt with and because of the principle that everyone must be treated equally under the law, rules controlling litigation tend to take a “one size fits all” approach.  Notably, small claims and economic litigation statutes emphasize streamlined processes for smaller cases.

Because it is a consensual, contractual process, arbitration need not be “one size fits all.” Yet, form book arbitration clauses frequently provide simply that “the parties shall arbitrate any and all disputes arising out of or relating to the contract.” This approach may be appropriate for a simple contract.

Given the importance of maintaining a working relationship and the wide variety of disputes that could arise, the “one size fits all” approach is inappropriate.  Some thought should be given to what types of disputes might occur and what alternative dispute mechanisms might best serve the client’s interests. Alternatively, parties could be required to negotiate or mediate disputes before submitting them to arbitration.  While such multi-step processes might seem to escalate the cost and complexity of a dispute rather than simplifying them, parties working in good faith will undoubtedly settle some disputes in negotiations.

Disputes that involve mainly number-crunching and arise fairly frequently, could be turned over to a neutral appraiser without a hearing, with the stipulation that the appraisal is final and binding.  Although a hearing is a central feature of classic arbitration, there is the authority that no hearing is required.

What about more serious disputes? First, it seems even more prudent to use multi-step processes here, given the high probability that negotiations or mediation will succeed, their low cost, and the potential for highly adversarial arbitration to ruin important business relationships and destroy future profitable opportunities.

Second,  both parties have the option at the beginning of the relationship to craft rules to minimize the risk of outsized or untenable awards. While courts have generally invalidated remedy-limiting provisions in mandatory pre-dispute arbitration clauses, especially those excusing the drafting party’s future torts. But these cases involved contracts of adhesion.  The author has not found any cases in which limitations by freely contracting,  sophisticated parties have been invalidated.  So if both parties chose to limit the risk of bankruptcy by capping awards at a certain level or agreeing that no punitive damages could be awarded by the arbitrator, it seems likely that such limits would be enforced.

Another possibility is to require a panel of three arbitrators rather than a single arbitrator in cases above a certain amount. Finally, there is the possibility of carving out or allowing the parties to opt out of certain large or critical case types of the arbitration agreement, though this would forgo the other advantages of arbitration in order to preserve the right to review.

Designing the “perfect” arbitration agreement for your clients means making careful interest-based choices and tailoring the process to your client’s needs.

D. An example of interest-driven drafting.

A good example of tailoring the arbitration agreement to the essential needs of the clients is Abbot Labs’ multi-step ADR program for its long-term distributorship contracts. Both parties needed to know how to move forward quickly. So Abbott designed a process emphasizing speed, economy, a quick decision, and the preservation of relationships. The process featured:

  • No discovery
  • Twenty- eight days for senior executives to negotiate
  • Failing successful negotiations, 56 days to hold an arbitration
  • Submission of exhibits, witness lists, and briefs not exceeding twenty pages.
  • Two days of hearings, with no more than five hours for each party to present its case.
  • A proposed resolution by each party.
  • Mandatory selection by the arbitrator of one proposed resolution.
  • Recovery of fees and costs by the prevailing party.

The Abbot Labs program is not likely to be used in other contexts, but it is an excellent example of the interest-driven tailoring of ADR in ongoing business relationships.

E. Should the arbitration agreement provide for a reasoned award?

There are three kinds of arbitration awards available. The first is a “standard” or “bare” award, stating the outcome with no discussion, the second is a “reasoned award,” which analyzes facts and evidence and makes a connection between them and the award. The third and most demanding is that the arbitrator makes detailed findings of fact and conclusions of law. The default of most American arbitration administrators appears to be the bare award. In contrast, most international arbitration providers require a reasoned award unless otherwise agreed. The more detailed the award, the more cost and delay it will entail.

The choice should be made mindfully.  If there is a possibility the client will want to challenge the award or engage in some form of the appeal process, a bare award is insufficient because it leaves nothing for the appellate panel to review. But the bare award ensures confidentiality. Conversely, on review, dispositive documents, including a reasoned award or findings and conclusions, become part of the record regardless of a private agreement to maintain secrecy. If confidentiality is key, a  bare award should be agreed to.

F. Employment arbitration agreement:The class-wide arbitration waiver

Many arbitration clauses in consumer and employment contracts both contain mandatory arbitration clauses and class-wide arbitration waivers. That is, plaintiffs must arbitrate their claims, but may not do so using class action procedures.  The inability to aggregate claims was labeled unconscionable and therefore unenforceable by several states because it made smaller claims impractical to pursue. However, the general trend in both state and federal courts was to uphold such waivers, even for statutory claims.

The United States Supreme Court eventually sided with the majority and upheld such waivers. Later research showed a resulting jump in arbitration claims. But while a few law firms filed hundreds or thousands of arbitration cases against the same defendants, the overall effect was to drastically limit claims by employees and consumers with smaller claims. The potential disaster of nationwide class actions with millions of claimants no longer looms over potential defendants who include this clause in their arbitration agreements. Therefore, if there is some chance that might face class-wide arbitration, the clause should be included.

G. Confidentiality in arbitration

Though there is little statutory support for arbitration confidentiality, a confidentiality provision should be included in the arbitration agreement and a confidentiality agreement should be signed by all participants in the hearing. First, voluntary disclosure of information from the hearing would give rise to an action for damages, deterring disclosure.

Second, at least under California law, a confidentiality agreement implicates Constitutional privacy rights, meaning that the evidence sought must be directly relevant and serve a compelling public need before discovery will be ordered. This is a much higher standard than is usually needed to authorize discovery.

The lack of statutory support for arbitration confidentiality is another reason to include negotiations and mediation in a stepped dispute resolution clause since both settlement communications and mediation are statutorily privileged against disclosure and admissibility. Resolution by one of these processes will better protect the client’s interest in confidentiality.

H. Provider channeling and incorporation by reference

It has been suggested that the reason arbitration has become so much like litigation is that litigators don’t know any other rules to go by. Arbitration providers were called to develop alternative rules and procedural protocols beginning about ten years ago. If parties have not chosen a set of rules, they will likely be channeled into one by the administrator based on the type of dispute and the amount claimed. But you absolutely must review the rules in detail, and not assume that they will be appropriate because they were selected by an experienced provider, or that you will easily be able to alter them (though this may be true.

Pay particular attention to discovery. A good example is the treatment of depositions. Some arbitration rules default to one deposition per party, with additional depositions at the arbitrator’s discretion.  Others only permit depositions in exceptional cases. If the existing rule fits with your client’s needs, good. If not, know what kind of showing the arbitrator requires and prepare to make it. Alternately, negotiate the rule change with opposing counsel. The arbitration may, as surveys suggest, have morphed into the mirror image of litigation, but the rules as written do not reflect this. Any metamorphosis took place at the instigation of counsel, and with the cooperation of the arbitrator.  So knowing what the rules provide is critical, if only as a starting point for negotiations.

5. Conclusion

No arbitration agreement will be perfect in every case. Instead, perfection depends on designing a dispute resolution process that promotes the client’s important interests. The discussion of Abbott Labs’ distributorship ADR program is a good example of that.  However, some provisions should be in the arbitration agreement unless there is a strong reason to the contrary:

  • A process that right-sizes disputes, treating different kinds of conflicts differently.
  • A strong delegation clause keeps the courts out of the arbitration proceedings.
  • A multi-step ADR program that gives parties the opportunity to negotiate and mediate the dispute before arbitration is necessary.
  • A confidentiality agreement
  • A bare award if confidentiality is critical. Otherwise a reasoned award.
  • A focus on the client’s identified interests
  • Detailed knowledge of the arbitral rules

If you’re looking for the “perfect arbitration agreement” – ADR Times screened arbitrators can help!

Scott Van Soye
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