Avoiding The Arbitration From Hell

In-house counsel beware: If you’re thinking about slashing litigation costs by agreeing to arbitration, a few lines in the contract could be the difference between arbitration (resolving disputes between parties via a chosen intermediary) and plain old arbitrary (unleashing uncertain, costly results).

Consider the following scenario.

Following the Hades Company’s budget meetings in fall 2000, the CEO gave his general counsel a mandate to cut outside litigation expenses by 30 percent. One of the cost-cutting steps the GC undertook was to require an arbitration clause in all contracts with outside vendors. The GC located a boilerplate provision calling for binding arbitration before the American Arbitration Association under its Rules for Commercial Arbitration.

At the GC’s insistence, the arbitration clause was inserted into a software license and development contract the Hades Company was in the process of finalizing in early 2001. The contract called for the software vendor to customize its online ordering, inventory control and fulfillment system.

Pursuant to the contract, the software was to be fully developed, tested and debugged in order to go live by mid-October 2001 in time for the year-end holiday season, when the Hades Company does 40 percent of its annual online sales.

Then, of course, all hell broke loose.

The software vendor turned out to be understaffed and undercapitalized, and, consequently, the vendor failed to meet any of the performance milestones. The project fell behind schedule. Given the time-sensitive nature of the project, the Hades Company was forced to fire the vendor and bring in a new programmer to finish the project.

The Hades Company then invoked its right under the contract to terminate. The GC sent a demand letter to the vendor to release the source code. At the same time, she initiated an arbitration to recover damages, since the project was now going to cost twice the original price. The vendor, however, refused to turn over the source code.

From Bad To Worse

As a result, the Hades Company was forced to bring a court action seeking an injunction to obtain the source code. After a full-blown hearing, the vendor was forced to release the code. As a consequence, the project was further delayed, and, eventually the costs for the project tripled over the original price.

The GC at least expected to get a quick decision from the arbitrator. But that proved wrong.

The selection of an arbitrator took two months, in part, because the vendor was doing whatever it could to delay the process. Unbeknownst to the GC, the other side was in the midst of another round of financing and wanted to push off any litigation for fear an adverse ruling would negatively impact its prospects of obtaining new funding.

To boot, the Hades Company got hit with a significant filing fee from the AAA since the amount of the fee is directly proportional to the value of the claim.

An arbitrator was finally assigned. However, it turned out he was a business lawyer from a small firm with virtually no experience in either software development disputes or commercial litigation. He was also overworked, and was unable to focus on the dispute and carve out the necessary time to manage the case properly.

Overkill

The software vendor filed a flurry of discovery and procedural motions, all of which the arbitrator permitted to be filed but was slow to decide. He constantly asked the parties to brief everything. The other side pressed for and was allowed to take full-blown discovery.

The vendor’s lawyer also sought to implead the software programmer whom the Hades Company brought in to replace the vendor on a theory of intentional interference with contract and trade secret misappropriation. The arbitrator allowed the motion. The new programmer, however, objected on the basis that it was not a party to the arbitration clause.

Therefore, the vendor initiated a separate court action against the software programmer. The programmer, in turn, brought the Hades Company into the case. Thus, the Hades Company found itself a party to both a lawsuit and arbitration.

After wading through the morass of discovery and procedural motions, the arbitrator finally was ready for a hearing. The arbitrator, however, announced he could only make himself available on Tuesday and Friday afternoons for three hours at a time.

While the Hades Company felt one day was sufficient to conduct what should have been a straightforward breach of contract and warranty case, the other side insisted it needed 16 full trial days. Its witness list included 22 names.

The Hades Company objected that this was overkill and argued the proffered evidence was either irrelevant or cumulative. The arbitrator, however, indicated he was inclined to let everything in and then decide whether anything should be excluded.

Finally, the AAA sent the Hades Company a bill for $50,000, half of the anticipated hourly charges of the arbitrator for 16 hearing days.

It is now 18 months later, and the arbitrator has yet to make a decision. Moreover, the costs are already far greater than what it would have cost to bring the action in either state or federal court.

The CEO sees the legal bills and hits the roof! He wants to know how this happened and who is to blame. The answer, unfortunately, is the GC.

Why? Arbitration is a creature of contract, and, as such, the parties are free to set the procedures, terms and conditions. However, the GC blindly agreed to the AAA rules on the assumption that arbitration is necessarily a streamlined and less expensive than resolving disputes in court.

Assuring A Cost-Effective Resolution

What could the GC have done differently to ensure that her expectations were met? The answer is plenty. Consider these practical suggestions for avoiding an arbitration from hell: