Seven Things You Should Know About Arbitration Clauses

by Goodwin

Arbitration clauses are routinely added to commercial contracts, but often with very little reflection on the many strategic and tactical issues that should be considered. Further, there is a great deal of misunderstanding of the relative benefits and detriments of arbitration as compared to resolution of disputes in the courts.

An arbitration clause is an opportunity to craft a dispute resolution mechanism that meets your precise legal and business needs and that opportunity should not be squandered with a “naked” arbitration clause that fails to think through basic tactical and logistical issues. The fundamental question that each party to a business contract should ask is “why arbitration?”—what benefits are you seeking, and/or what risks are you hoping to avoid? The following is a non-exhaustive list of issues that may help answer these questions, and which one should consider when drafting and agreeing to an arbitration clause:

1. Cost, speed and efficiency. Many incorrectly believe that arbitration is “cheaper” than litigation. It can be, as it frequently involves relaxed evidentiary rules, more flexible scheduling and discovery that is potentially more limited than in a court proceeding. But without contractual language that limits the time frame and extent of arbitration proceedings, it is possible for arbitration expenses and delays to equal or even exceed those of litigations in some jurisdictions. Consider carefully whether your arbitration clause should limit discovery, prevent depositions, and direct the arbitrator or arbitrators to complete the proceedings within a circumscribed time frame. Consider also whether a time frame for wrapping up the entire proceedings should be laid out in advance, to ensure that matters cannot drag on.

Of course, many parties fail to give thought to whether arbitrating is to their advantage at all, given the likely relative situations of the parties. Having a fast-tracked and inexpensive proceeding may be a disadvantage if you perceive that a more expensive and drawn out proceeding would be a significant disadvantage to your future adversary. Or it may be the case that arbitration is too broad a tool for your needs. If your dispute would likely be litigated in an efficient and fast-tracked jurisdiction, for example, consider whether a simple jury waiver would be more beneficial than an arbitration clause. Conversely, if you are likely to be the plaintiff and access to a jury would be beneficial (for example, because you want to argue for punitive damages or because you believe you would have more leverage in a more protracted jury case), perhaps you would prefer a contract with neither an arbitration clause nor a jury waiver.

Note that the administrative fees of many arbitral forums vastly exceed those of the courts, and sometimes scale with the amount claimed in the controversy, such that they can sum to hundreds of thousands of dollars. Similarly, in an arbitration, the parties must pay for the fees and costs of the arbitrators, whereas the taxpayers underwrite the costs of the judicial system. In recent years, the dockets of many courts have clogged significantly as budgets have been slashed, resulting in longer waits for cases to be resolved. Thus, the price to the parties of not paying the full cost of the litigation is that you are at the whim of the pace that the judicial system will permit.

2. Discovery. Discovery is a key source of expense in any dispute, and if cost reduction is an important consideration, an arbitration clause that limits discovery could be therefore valuable. As the parties to a contract have a free hand in agreeing to what discovery would be permitted or prohibited, consider whether you can streamline matters by eliminating depositions, reducing document discovery, and addressing likely discovery disputes in advance. In an international arbitration, consider the legal culture of the likely arbitrators as well: for example, arbitrators from outside the United States, without direction from the parties’ agreement, might not be as likely to grant broad American-style discovery. If such discovery is likely to be needed, make sure your arbitration clause grants the right to such discovery in advance.

Deciding in advance the extent of discovery available in arbitration proceedings is important not only to address efficiency, but also for tactical reasons. There are often asymmetries in the parties’ positions vis-à-vis the information necessary to adjudicate a dispute. For example, if you are the buyer in a transaction, you may be the party with all of the discovery relevant to any future dispute—especially if you bought their computer systems. Limiting discovery in an arbitration clause would not only reduce costs but provide tactical leverage. On the other hand, the seller in a transaction may need discovery and hence might be better off in court or, at least, with an arbitration clause that provides ample discovery rights.

Finally, thought should be given to whether important information is in the hands of third parties. Obtaining information from third parties is a fairly routine matter in the courts, but substantially more complicated in arbitration. This factor may weigh on whether to litigate or arbitrate in the first place.

3. Arbitrator Selection. One benefit of arbitration is that you can more carefully choose who will decide the dispute. Parties that submit their dispute to the courts give up significant control over the identity and qualifications of the person who will decide the case. By contrast, contracting parties can require that the arbitrator have specified credentials, such as training and experience in the appropriate industry. The arbitration clause can also provide other mechanisms to ensure a reasonably suitable arbitrator, such as involvement by party arbitrators. This can be particularly important if your business operates in a niche industry or the issues confronting you are highly technical.

On the other hand, because the ability to challenge an adverse arbitration award is so limited, there is always a chance that you come to regret your choice of arbitrator. This concern often leads parties to agree to multiple arbitrators, under the theory that selecting three arbitrators, for example, will mitigate the idiosyncrasies of any one individual. Parties often fail to consider whether the likely disputes that may arise from a transaction could be more efficiently and quickly addressed by a single arbitrator, as opposed to a panel of three arbitrators, for example. Although a multi-arbitrator panel can mitigate concerns of a “rogue” arbitrator, scheduling hearings with and compensating three arbitrators adds significantly to the costs and delays of arbitration.

In addition, the arbitrator selection process itself, if not clarified by the arbitral forum’s rules or the parties’ contract, could be a significant source of disagreement among the parties, and require lengthy trips to the courts to resolve. It is therefore preferable to set forth the precise mechanism by which arbitrators will be chosen, or adopt the rules of an arbitral forum with clear and efficient rules.

4. The Jurisdiction of the Arbitrators. Parties who agree to arbitrate sometimes later come to disagree about what types of disputes should be arbitrated, or whether certain types of issues should be reserved for the courts. Consider carefully whether your agreement should make clear that the arbitrator or arbitrators are entitled to decide the extent of their own jurisdiction, or grant injunctions or give other special relief. Note that some arbitral forums’ rules provide that arbitrators have these powers, and choosing those rules may give the arbitrator those powers, even where the contract is silent on the topic. If you choose to reserve some authority for the courts—for example, some parties prefer potential access to the courts for emergency relief—it may be beneficial for the parties to agree in advance on which courts would be available for that purpose.

If there are matters the arbitrator should not consider, those matters should be set forth in the contract. Or if there is a specific way in which the arbitrator’s work is to be conducted—for example, if the arbitrator is to perform a calculation or valuation—providing agreed upon definitions and instructions to the arbitrator in advance can avoid uncertainty, delay and cost. For example, some arbitration clauses that seek to resolve accounting issues will specify that an accounting arbitrator will be appointed, but that that arbitrator will not have the power to conduct an independent audit of the accounting matters at issue.

Note that arbitrators are not typically limited to the procedural rules of the courts, such as the rules of evidence. This means that choosing arbitration may mean that certain types of evidence would be admitted which would not be available in a trial before a judge or jury. Often parties prefer this flexibility, as it reduces the cost to try a case, but many parties fail to consider in advance whether more rigid rules would be likely to favor or disfavor them in the kinds of disputes likely to emerge in the future. Similarly, the parties have flexibility in what the hearing will consist of; while many arbitration hearings look and feel like trials conducted in conference rooms, the parties could agree to short summary presentations from each side where that might be more suitable.

5. Appellate Rights and Enforcement. Arbitration awards are subject to extremely limited review by the courts, which is among the reasons arbitrations tend to be faster and more cost effective than trials. Although this is often helpful, many a losing party has come to regret the absence of appellate recourse. Arbitrators, like judges, can make mistakes, but unlike judges, arbitrators’ decisions are typically not subject to a challenge on the ground that they are merely “wrong.” Instead, a party must show bias or a manifest refusal to apply clear law, among other things, to have any prospect of vacating an arbitral award. Certain arbitral organizations, like the AAA, either have or are implementing optional albeit limited appellate arbitration rules that, if agreed to in negotiations, may help to mitigate this risk. The parties must therefore weigh the costs of benefits of being done quickly against the prospect that an arbitration panel gets it wrong.

Unless the arbitrators are directed by the parties’ contract or the arbitral forum’s rules to issue a “reasoned award”—that is, a written explanation of their decision—the award’s bases may remain unknown to the parties. In situations where the parties want the arbitrator to make a simple decision, or prefer that the justifications for an award be obscured to avoid future disagreements, that may suffice, but where the parties have continuing dealings or further related interactions, the absence of an explanation could lead to confusion down the road.
An arbitration award needs to be enforced in the courts, and although that is intended to be a summary proceeding, choosing which court can make important differences in terms of the review of the award and the ability to obtain quick relief after the award is issued. If the Federal Arbitration Act applies (that is, if the matter involves interstate commerce), you may have access to the federal courts, as well as strict rules seriously curtailing the ability to challenge an award relative to what state law may provide. Similarly, certain types of relief may be unavailable in an arbitration governed by state law, such as punitive damages or sanctions. On the other hand, certain federal courts have held that third party discovery in advance of a hearing is not available under the Federal Arbitration Act, and thus the applicable law matters not only in terms of enforcement, but also as to the conduct of the arbitration proceedings.

6. Confidentiality. Court proceedings are presumptively public, and the ability to keep the proceedings out of the public eye may be limited in many jurisdictions. Arbitrations, in contrast, typically take place in private, and are subject to rules or agreements concerning confidentiality. There is no “public record” in an arbitration, even though the proceedings may be transcribed. This can be highly valuable to companies that prize privacy. Those that are likely to require the ability to use aspects of the arbitral process in a non-confidential manner should consider whether the arbitration clause should reflect that right, or whether you are better off in the courts.

7. International Arbitration Considerations. Increasingly, arbitrations are becoming international, by involving parties, witnesses and subject matters all over the globe. Arbitration is often an attractive alternative to unknown or quixotic local courts. Different arbitral forums have arisen to cater to international disputes, and these do not necessarily operate the same way arbitrations or litigations in the United States do. For example, arbitrations in Europe or Asia are likely to involve much more limited discovery, more limited ability to cross-examine witnesses (and no ability to re-direct a witness), and, some would argue, more willingness to follow equitable principles as compared to hard principles of law. In addition, the pool of arbitrators available for arbitrations in different locations across the globe will be influenced by their own location’s legal cultures and practices. In many instances, evading the vast extent of U.S.-style litigation may be valuable almost in any circumstances, but in others, care should be given to whether the arbitration clause should be customized to ensure that the proceedings conform to expectations.

Also note that immense amounts of time, money and effort can be devoted to arguing about logistics of arbitration that parties often overlook when drafting a contract. Matters such as the location of the arbitration, the nationality of the arbitrators, governing substantive law, and the language in which the arbitration will be conducted must be decided. Although parties to a contract are always advised to consider these matters, in an international arbitration context, their resolution can have immense impact on the expense and ultimate outcome of the arbitration.

Final Thoughts. With just a few sentences, the parties can draft an arbitration clause that will dramatically change how their disputes will be resolved. Arbitration clauses can save years of distraction and potentially millions of dollars in legal fees. But it is essential to consider what the likely leverage of the parties will be after the transaction closes. Who will have the funds or means to fund a fight? Who will have the evidence? Where will the witnesses be located? Who is going to be willing to fight it out, and who will need peace? Arbitration, like so many legal tools, is valuable but must be applied thoughtfully. An arbitration clause that neglects strategic and tactical considerations, or which is mere boilerplate, is a lost opportunity and one that is easily remedied.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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