Drafting the Perfect Arbitration Agreement

Drafting the Perfect Arbitration Agreement
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 probably should be in your agreement, but not as many as you might think. For example, what about a loser-pays attorneys’ fees provision? It depends. Can your small-business client afford to pay the corporate defendant’s outside counsel if you lose?  In an era when big-firm partners sometimes bill over $1,000 an hour, the answer may be no.

How about the choice of law? The most popular choice of law for commercial contracts in New York, even when neither party does business there. But you can’t advise using New York law without knowing how it affects your client’s case. The point is that what is perfect must depend not only on what disputes your client’s faces but on what his or her interests are.

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

1. The arbitration system is dysfunctional

Beginning in the last half of the 20th century, businesses of all kinds sought relief from litigation. The public trial had become a beast.  It was publicly damaging, a take-no-prisoners affair with endless discovery and appellate processes. Participants were burdened by high cost, endless delays, and untold disruption to daily operations and important relationships. The 1990s, in particular, saw a ninefold increase in legal costs, a lack of effort at case management, and a perceived decline in legal professionalism.

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, only stepping in on limited grounds to ensure fairness.  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.

All of this means that mediation and arbitration are now part of every lawyer’s practice.

Law school curricula generally have not caught up with the developing reality.  Despite a decades-long decline in civil trials and the fact that most cases end in settlement, legal education still has trial and trial preparation as its centerpieces.  The lengthy, costly, public nightmare of trial, and its invasive and overwhelming discovery process, has become the monster in the shadows— seldom seen but used to frighten parties into settling.

Unfortunately, the continued focus on litigation has corrupted the arbitration system that was supposed to serve as an alternative to it.   As arbitration is used in larger and more complex cases, lawyers habituated to the litigation system have turned it into litigation’s mutant sibling.

They insist on the intensive discovery, complex motion practice, and sometimes even  review on the merits of an arbitrator’s award by the courts or arbitral appellate panels

Arbitration traditionally had neither discovery nor motion practice.  This was one of its attractions.   Approximately 50% of the cost of litigation is caused by document discovery alone.  Retrieving, reviewing, and 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 moot common.

Of course, such a review adds significantly to the cost time, and complexity of arbitration. While arbitrators could conceivably 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, costly, and time-consuming as civil litigation and trial.  The promise of arbitration as a speedy and economical alternative to trial has been broken.

2. Reviving arbitration’s promise — the role of the perfect arbitration agreement

What do arbitration’s failings have to do with the perfect arbitration agreement?  Simply this: Arbitration is a matter of contract, and a carefully drafted arbitration agreement defines (or rather can define) who will administer the arbitration, what disputes will be decided by arbitration, the powers and duties of the arbitrator or arbitrators, the applicable law to be applied, what relief may be awarded by the arbitrators, the choice of venue, who bears costs, when (if ever) court determinations are required during arbitration, what discovery (if any ) is to be allowed, what law and motion practice will be permitted, and perhaps a mechanism for reviewing the award on the merits. While the courts will demand fundamental fairness, otherwise party autonomy is paramount.

Arbitration agreements are generally negotiated at the pre-dispute stage, usually at the time of contract formation. Presenting a potential business partner with an extremely detailed arbitration agreement is unusual. Since It would certainly raise eyebrows and potentially interfere with a budding business relationship by implying distrust, most contractual arbitration clauses are short-form affairs with little detail that leave everything but the need for arbitration and (perhaps) the provider organization to later negotiation. Where the user is somewhat more sophisticated, a set of rules (usually promulgated by the provider) is incorporated by reference. But leaving everything for later leads arbitration counsel to follow their natural instinct to litigate, with the dysfunctional results discussed above.

The point here is not that every eventuality should be covered.  It is that the arbitration process is extremely 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 the advantages of economy, speed, and simplicity that made it so attractive as an alternative to litigation in the first place.

The remainder of this article will review various possible provisions, discussing how each could affect the client’s possible business goals and impact the benefits of arbitration.

3. Considering the business goals of the client in drafting the arbitration agreement.

Despite the attractiveness and ease of inserting a form arbitration clause into a contract at the pre-dispute stage, doing so may overlook the practical impact of the provisions on the client’s business goals.  Unless the client is consulted ahead of time, charging ahead with litigation-style arbitration may be directly contrary to those goals, leaving the client worse off winning the dispute than conceding to the other side.

For example, every business has a goal of avoiding disruption to its operations. Yet litigation and analogous arbitration can be tremendously disruptive.  Depositions, declarations, hearings, and responding to discovery require the personal attention of the responding party. No matter how senior he or she may be or what other responsibilities may arise, the court or arbitrator is empowered to compel responses or testimony of witnesses with personal knowledge of relevant events, whether by deposition, live testimony or (in arbitration) witness statements.  A glaring example of this is the fact that corporate CEOs spend twenty percent of their time on legal matters – time and energy that could be spent more productively doing other things.

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 of 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 -positively or negatively by the arbitration agreement between the parties.

4. Critical provisions of the perfect arbitration agreement and their impact on business goals.

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 may assist in the selection of a neutral with the desired background and expertise. The administrator ensures that the arbitrator is free from conflicts of interest, and oversees disclosure of such conflicts as required by law..He or she sets deadlines and briefing schedules for hearings serves as a notice of appointment of the arbitrator, requires agreement to and payment of fees, and may designate the rules under which the arbitration will take place if the parties have not done so. Such rules are subject to modification by agreement of the parties.

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 reviewing 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

Despite the fact that arbitration is a private alternative to the court system, there are a significant number of issues that can require court intervention 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 and processes to be applied — 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 that covers one transaction or type of transaction.

But what about a multi l-year deal that establishes a joint venture between corporations? Given the importance of maintaining a functional 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. For example, in view of the disproportionate cost of arbitration, disputes within the jurisdiction of the small claims court might be excluded from the arbitration clause. (The American Arbitration Association rules already provide the parties may  opt-out of arbitration in these circumstances.)

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.  And 80%-85% of cases submitted to mediation settle there.   Because the disputes never reach arbitration, costs and time are saved, positive working relationships are preserved, and efficiency and party self-determination are promoted.

Disputes that involve mainly number-crunching and are likely to arise fairly frequently, such as the calculation of triple-net lease payments at multiple locations, 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.  Turning over straightforward matters like this to an Impartial expert for determination lowers tension, preserves relationships, reduces costs and frees executives and other employees to focus on more essential things.

What about more serious disputes that involve high stakes? 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 outsize 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. Though more expensive to begin with, this method results in far fewer outlying awards. It also saves time and money compared with using a single arbitrator, then paying for review on the merits either in the Court of Appeals or before an appellate panel of arbitrators, each charging for his or her time and multiplying costs and the difficulty and delay of coordinating schedules.

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.  If the reality of the contract negotiations precludes using a tailored approach, you should at least identify and discuss what impact the chosen form provisions will have on your client’s business interests in the event of the types of disputes that might reasonably arise.

D. The Abbott Labs ADR program — 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 agreement provides for a reasoned award?

There are three kinds of arbitration awards available. The first is a “standard” or “bare” award, stating that 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 requirement is not an exacting one. Not every point must be addressed. 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. 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 attorneys 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. Maintaining confidentiality in arbitration

In a 2011 survey, more than half of Fortune 1000 survey respondents identified preserving confidentiality as a key reason for using arbitration rather than litigation. But this is based on a myth. Arbitration is private, but not confidential. That is, attendance is usually limited to the arbitrator, the parties, and necessary witnesses (who may be excluded when not testifying). The media and the public are excluded.  Proceedings go unreported in most cases. This means that businesses can resolve their arbitrated disputes without anyone outside the hearing room being aware that those disputes even existed.  This strong privacy element allows participants to protect the perception of their brand and preserve their reputation despite embarrassing mistakes that would cause outrage in a public trial.

But privacy is not the same as confidentiality.  Neither the Federal Arbitration Act nor the vast majority of the states provides for anything approaching arbitration confidentiality. Where outsiders do discover the existence of an arbitrated dispute, information concerning it is freely discoverable.

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, which 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 signed by all participants in the arbitration.
  • 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

A continuing focus on the client’s interests is the key to a perfect agreement every time. If you’re looking for the “perfect arbitration agreement” – ADR Times screened arbitrators can help! Simply fill out our contact form and we’ll pair you up with the best arbitrator for your case.

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