Considering Arbitration: The Benefits, Risks And Recommendations

Monday, March 1, 2004 - 01:00

Introduction

Pre-dispute arbitration clauses recommended by the American Arbitration Association (the "AAA") have become increasingly common in commercial contracts. Because of the efficiency, expediency and cost-effectiveness associated with arbitration, lawyers frequently assume - without engaging in any meaningful analysis of a particular contract - that arbitration is preferable to litigation for resolving contractual disputes. There are, however, risks associated with arbitration. Companies and their counsel should carefully consider the nature of the contract, the company's practices and the relevant law on important issues before agreeing to include a pre-dispute arbitration clause in a contract.1

The Benefits Of An AAA Arbitration

Of all the well-known benefits associated with arbitration, its efficiency and cost-effectiveness are most touted. In an AAA arbitration, the discovery process is generally limited to the exchange of documents and the identification of witnesses/exhibits. Therefore, arbitration is typically less burdensome than the drawn-out discovery associated with commercial litigation.2 In addition, pre-trial motions, including discovery motions, are not common in arbitration. The AAA Rules3 give the arbitrator the authority to resolve any disputes concerning the exchange of information,4 and a telephone conference between the attorneys for the parties and the arbitrator is usually all that is necessary to resolve a discovery-related dispute.

In addition, arbitrations typically move faster than judicial proceedings, which can, in some cases, span the course of several years. Notably, the AAA rules provide special Expedited Procedures in cases involving claims less than $75,000 (or when the parties agree).5 If the dispute is governed by the Expedited Procedures, the hearing is usually limited to one day and is scheduled to take place within 30 days of confirmation of the arbitrator's appointment.6 In smaller cases, where no claim exceeds $10,000, if the parties agree, the arbitrator will resolve the dispute solely by submission of documents.7

As important as the speed and the cost-effectiveness of an AAA arbitration is the fact that arbitrations frequently preserve business relationships. Usually less contentious in nature, arbitrations can result in a more creative determination that does not necessarily terminate a business relationship.8

In addition, arbitration proceedings, unlike court proceedings, do not become a matter of public record. Therefore, when confidentiality is a concern, arbitration offers a significant advantage over litigation. Similarly, arbitration may be preferable if a company is looking to avoid setting a bad precedent that may have a future impact on an important area of a company's business.

The Risks Associated With An AAA Arbitration

There are risks associated with an AAA arbitration that companies and their counsel should consider before including a pre-dispute arbitration clause in a commercial contract. First, unlike in judicial proceedings, the arbitrator is neither bound by the law, nor the terms of the parties' contract. Rule 43 of the AAA Rules simply provides: "The arbitrator may grant any remedy or relief that the arbitrator deems just and equitable and within the scope of the agreement of the parties, including, but not limited to, specific performance of a contract."9 Therefore, an arbitrator may fashion an award that is based on simple notions of equity, rather than the facts or the relevant law. Similarly, even if a contract is clear and unambiguous, there is a danger that an arbitrator will ignore the contract in favor of a more "equitable" result. Litigants often refer to this concept as "rough justice" or the "splitting of a baby."

Another concern is that the AAA does not necessarily employ lawyers as its commercial arbitrators. Due to unfamiliarity with the law, non-lawyer arbitrators may be more likely to rely on their own notions of fairness, rather than legal precedent or express contract terms. And, even where a "lay arbitrator" purports to defer to the law or the terms of a contract, there is still a risk of an "incorrect" decision.

Arbitrations are also risky because the Rules only require that the award be in writing and signed by the arbitrator (or a majority of the arbitrators if more than one). An arbitrator is not required to render a reasoned award.10 In fact, the AAA actually discourages written opinions because they "open avenues for attack on the award by the losing party."11

A concomitant problem is that federal and state laws make it very difficult to overturn or vacate an arbitration award. Courts will not review arbitrators' decisions on the merits of the case. Typically, a court will vacate an award only if the requesting party can demonstrate some egregious error by the arbitrator. For example, the United States Supreme Court states that arbitrators' decisions are not subject to judicial review for error in interpretation, except for "manifest disregard" of the law. Wilko v. Swan, 346 U.S. 427, 436-37 (1953).12 Likewise, the Federal Arbitration Act, 9 USCA § 10(a), provides only limited grounds for vacating an arbitration award: (1) "award was procured by corruption, fraud, or undue means"; (2) "partiality or corruption in the arbitrators"; (3) "arbitrators were guilty of misconduct in refusing to postpone the hearing, upon sufficient cause shown, or in refusing to hear evidence pertinent and material to the controversy; or of any other misbehavior by which the rights of any party have been prejudiced"; (4) "where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made."13

Recommendations

Recognizing that there are both advantages and risks associated with an AAA arbitration, companies should take other factors into consideration (including the type of contract, the company's practices and the relevant law) in deciding whether arbitration would be preferable. Or, a company can modify a pre-dispute arbitration clause in a contract so that it addresses the company's specific needs and concerns.

Consider, for example, the following scenario: Company A (Advertising Agency) is re-drafting its standard agency/client agreement. The previous version of the agreement had the model AAA arbitration provision:

Any controversy or claim arising out of or relating to this contract, or the breach thereof, shall be settled by arbitration administered by the American Arbitration Association under its Commercial Arbitration Rules, and judgment on the award rendered by the arbitrator(s) may be entered in any court having jurisdiction thereof.

Counsel for Company A has to decide whether to keep this provision in the new agreement or to excise it. Counsel may first consider whether there have been previous disputes under the form contract that have been arbitrated. If so, and the outcome of such disputes were favorable to the company, arbitration would likely be preferable to the more expensive and time-consuming judicial process.

The company or its counsel should also consider whether the law or the custom in the industry is more favorable to the company. Custom and practice may play a large role in the rendering of an arbitral award; therefore, if a company is operating in conformity with custom and practice, arbitration may be preferable. For example, it is customary in the advertising industry that a client provide notice to the agency before termination of the agreement, during which time the agency will still collect a fee from the client. If Company A knows that a 90-day notice period is typical in the industry and its contract contains a 90-day termination period, arbitration would probably be a wise choice, particularly if disputes concerning this provision are common. If, however, the law in the jurisdiction is well defined on this issue, then the company may decide to forgo an arbitration provision in favor of a litigation that may render a more predictable outcome. In addition, a party with the law on its side has a good chance of getting a case dismissed before trial - an unlikely scenario in arbitration. A little research may be necessary to make this decision.

If these considerations do not necessarily result in a clear choice, counsel can tailor an arbitration clause to the company's needs. First, counsel may consider revising the model AAA provision so that the parties agree that the arbitrator will be a lawyer with a certain number of years of practice in a relevant area of law. Further, the parties can agree in the arbitration clause that specific laws or specific contractual terms bind them. Or, the parties can agree to limit the arbitrator's authority to deciding limited factual issues - i.e., the duration of a notice period in an agency/client agreement. The parties can also agree that the arbitrator be required to render a written opinion, thereby providing possible grounds for a motion to vacate an award.

Conclusion

In sum, companies or their counsel should not reflexively choose arbitration. Due consideration should be given to the benefits of an arbitration (i.e., the potential up-front savings, the more user-friendly process and the absence of potential bad precedent), as well as the risks (i.e., the likelihood of an arbitrary result and the difficulty in reversing an award). Ultimately, a company or its counsel should not hesitate to negotiate a modification to a standard arbitration provision to better suit the needs of the company's business.1 A similar analysis may be employed when a party brings litigation, despite the fact that a contract contains an arbitration clause, and the adverse party must decide whether to seek to enforce the arbitration clause.
2 AAA Commercial Arbitration Rules, R-21(a) and (b).
3 Unless otherwise indicated, all references to the AAA rules will be to the AAA's Commercial Arbitration Rules.
4 AAA Commercial Arbitration Rules, R-21(c).
5 Rule 1(b) of the AAA Commercial Arbitration Rules provides:
Unless the parties or the AAA determines otherwise, the Expedited Procedures shall apply in any case in which no disclosed claim or counterclaim exceeds $75,000, exclusive of interest and arbitration fees and costs. Parties may also agree to use these procedures in larger cases. Unless the parties agree otherwise, these procedures will not apply in cases involving more than two parties.
6 AAA Expedited Procedures, Rule E-7 and E-8(a)
7 AAA Expedited Procedures, Rule E-6.
8 AAA Commercial Arbitration Rules, R-43(a).
9 AAA Commercial Arbitration Rules, R-43(a).
10 AAA Commercial Arbitration Rule 42 provides: "The arbitrator need not render a reasoned award unless the parties request such an award in writing prior to appointment of the arbitrator or unless the arbitrator determines that a reasoned award is appropriate."
11 A Guide For Commercial Arbitrators, p. 11 (American Arbitration Association 2004).
12 The Second Circuit, in Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Bobker, 808 F.2d 930, 933 (2d Cir. 1986), held that "manifest disregard" is limited to an error of law which "must have been obvious and capable of being readily and instantly perceived by the average person qualified to serve as an arbitrator."
13 State laws are similar. See, e.g., N.Y. CPLR 7511(b) and Cal. Civ. Proc. § 1286.2(a), both of which include fraud, corruption, arbitrator misconduct, partiality and the exceeding of powers as grounds for vacating an arbitration award.

Jennifer Tafet Klausner is a Partner with Davis & Gilbert LLP. The author would like to thank Elizabeth Yoo, an Associate with Davis & Gilbert LLP, for her research and advice with respect to this article.

Please e-mail the author at jklausner@dglaw.com with questions about this article.