Arbitration Nightmare

Every inside counsel knows the drill.

After months of arduous negotiations over the details of a long-term supply agreement with an important customer, the final draft of the contract is ready for signature when someone remembers that it should include an arbitration clause.

No one, of course, thinks there will ever be any dispute between the parties, especially since the parties have been doing business for years, and neither has any interest in fighting with the other. But as a precaution, everyone agrees that if there is a dispute, it should be resolved quickly, cheaply, and informally.

The lawyers add a boilerplate clause requiring arbitration of any disputes before a single arbitrator under the American Arbitration Association’s Rules for Commercial Arbitration and Mediation. The clause seems uncontroversial – and no one is willing to break the deal over an arbitration clause anyway.

Several years later the relationship unravels and the parties find themselves in a multi-million dollar dispute. Suddenly, arbitration before a single arbitrator seems risky. Nor does it appear that arbitration will be quick or inexpensive, because the AAA’s rules may require more discovery than either side would have been entitled to take had they elected to pursue their claims in federal court.

With increasing regularity, arbitration is the preferred forum for resolving both simple and complex business disputes. Because arbitration is “a creature of contract,” an arbitration can be as simple or complex as the parties choose.

This flexibility, however, comes with a responsibility. Because the arbitration agreement will have a critical impact on the benefits available in arbitration, the failure to pay careful attention to it can result in undesirable surprises. As a result, businesses should be sure that the arbitration clauses included in their contracts are tailored to ensure that they get the arbitration proceeding they want.

Getting what you want

Regardless of the approach taken in any particular circumstance, every arbitration agreement should be drafted with the client’s goals in mind. Typically, parties choose to arbitrate disputes in order to promote efficiency (both in terms of time and cost), finality, and confidentiality.

An arbitration clause that is not carefully considered, however, can have just the opposite effect. Here is a check-list of issues to consider. Decisions about each will likely influence whether the agreement to arbitrate will promote or hinder these goals.

Scope of the clause: An arbitration clause can be narrow, limited to specific issues, or broad, potentially drawing in every dispute that the parties may have involving their business relationship. Broad clauses tend to complicate arbitrations, impeding efficiency and increasing cost.

Choice of law and governing rules: Both state and federal governments have enacted statutes setting forth rules and procedures for arbitration. In addition, many private alternative dispute resolution organizations (most notably, AAA) have adopted extensive rules for arbitrations. The choice of applicable law and rules may have a dramatic impact on the efficiency of any arbitration proceeding.

Choice of forum: Parties can agree to arbitrate their dispute in any forum. If the parties reside in different states, the forum selected may have a dramatic impact on the proceeding. Consider using a “neutral” forum to ensure a full and fair process.

Pre-hearing negotiation and mediation: Many arbitration agreements require the parties to engage in pre-arbitration negotiations or mediations. These clauses may assist the parties in reaching a negotiated resolution before commencing an arbitration. Often, however, the clauses impose additional procedural hurdles to commencing an arbitration, delaying efficiency and increasing cost.

Pre-hearing procedures: Most business people think of arbitration as a quick, informal proceeding. In some cases, however, arbitrations can involve pre-hearing procedures, such as motion practice and extensive discovery, that are anathema to the goals of efficiency and limited expense.

Although more formal procedures intended to ensure a full and adequate hearing may be desirable when the amount in controversy is significant, parties should be careful not to make choices that make onerous procedures the expectation rather than the exception.

This is particularly true when the parties intend to adopt the AAA’s rules for commercial arbitrations – without more, such an agreement includes adoption of the AAA’s rule for large, complex cases, defined as cases where the amount in controversy exceeds $500,000. These rules permit wide-ranging discovery practices (at the discretion of the arbitrators) that increase cost substantially.

Hearing procedures: An arbitration hearing can be as formal or informal as the parties want. Absent a specific provision to the contrary, the presumption is that the rules of evidence will not apply and that the hearing will be relatively informal.

Post-hearing procedures and appeal: Most arbitration awards are considered “final” and can be overturned on appeal only in very limited circumstances, such as fraud or arbitrator partiality. The limited scope of review promotes the goal of finality.

Sometimes, however, “finality” is less important than safeguarding against arbitrary results. Parties can agree to “private review” and may (depending upon the jurisdiction) be able to agree to expand a reviewing court’s “scope of review.” In either case, private or expanded review adds uncertainty and delay while protecting against arbitrary or irrational results.

More drafting suggestions

When preparing an arbitration clause, consider whether it relates to a complex business relationship that may give rise to complicated large-dollar disputes. In such instances, most businesses are well-served by carefully tailored arbitration agreements that strike a balance between the desire for a quick and cost-efficient proceeding with the need for procedural safety valves to ensure a full and fair hearing.

Special attention should be paid to the choice-of-law and forum clauses and the rules governing the proceeding – from discovery to appeal. Be sure you are comfortable that the forum will be neutral and that the applicable law and rules will ensure that you will have an adequate opportunity to develop and prove or defend against the claims that are in dispute.

If you are concerned about arbitrary or irrational awards, include language requiring a “reasoned award” and consider a clause permitting “private review” or “expanded review.”

If, however, you anticipate that any likely dispute will be relatively straightforward, then a simple clause will likely be the best choice. Simple arbitration agreements incorporating the rules of the AAA or another ADR organization usually promote the quickest and least expensive arbitrations.

In these situations, avoid adding language to the agreement intended to describe procedural rights that are normally available even in the absence of an express agreement (such as the right to seek injunctive relief in aid of the arbitration proceeding). Unnecessary contract language often promotes procedural disputes that cause delay and increase costs.

In all cases, make sure you pay attention to the actual language used in the arbitration clause. Once a dispute arises, the clause may be as important as a contract’s substantive terms in determining whether you obtain the desired result in arbitration.

James W. Matthews is a partner in Sherin and Lodgen LLP’s litigation department and has extensive experience representing commercial enterprises and developers and owners of real estate in a wide variety of complex business disputes. He has tried cases in federal and state courts throughout the United States and represented clients in arbitration proceedings and mediations. Mr. Matthews can be reached at [email protected] or (617) 646-2220.