Crafting the Proper Arbitration Clause Can Save Big
Parties to arbitration frequently complain that the process has become nearly as time consuming and expensive as litigation. Such comments are typically made by people who do not have an accurate sense of the time and expense involved in litigation, but that is not to say that their dissatisfaction with the arbitration process is unfounded.
It frequently is unnecessarily time consuming and expensive. But arbitration is a creature of contract, and if the process is deficient, then the contract is to blame.
A well-drafted arbitration clause can result in enormous savings while still preserving the integrity of the process. Not only can the rights and obligations of the parties in arbitration be dictated and limited, but so can those of the arbitrator.
The important thing to realize is that there is no ideal arbitration clause suitable for all contracts. Rather, the arbitration clause should be tailored to the range of disputes that are most likely to arise under the specific contract.
Of course, once the business terms have been agreed to there is often little appetite to engage in further negotiations over an arbitration clause that everyone hopes and expects will never be invoked anyway. Indeed, even raising the subject can be perceived as a sign of mistrust.
Nevertheless, the temptation to simply cut and paste an arbitration clause from a similar contract should be resisted. Choices as to where the arbitration will take place, which rules will apply, the qualifications and selection process for the arbitrator, and limits on discovery should be guided by the subject matter of the contract, the nature of potential disputes and which party will bear the burden of proof in such disputes.
It may even be advisable to have separate provisions for different types of disputes. For example, in a dispute over the interpretation of the agreement, the preferred venue is likely to be where a company resides, so as to minimize the time and travel burdens on executives and counsel.
But that may not be the ideal venue for arbitrating a contractual breach. If the great majority of the witnesses and evidence are likely to be located somewhere else, that might be the more cost-effective venue for the arbitration.
Similarly, a contract interpretation dispute is unlikely to require discovery, and tight limits are likely appropriate in the arbitration clause.
However, if a company anticipates the possibility of being a claimant in a fact-intensive dispute, and bearing the burden of proof under circumstances where the necessary evidence is held by the other party, broad discovery provisions would be more appropriate.
Where to begin
Having considered the universe of potential disputes that might arise under a particular agreement, the next step is to decide which disputes should be subject to arbitration and whether one or more alternative dispute resolution mechanisms are appropriate.
The options range from no arbitration clause, or a narrow-form clause that only encompasses disputes respecting the interpretation of the contract, to multiple clauses tailored to different categories of disputes, perhaps with a pre-arbitration mediation requirement.
There may be a legitimate reason to exclude some disputes from arbitration and leave them to the courts or an expert referee, but a broad-form arbitration clause covering all disputes “arising from or related to” the contract is appropriate in most cases.
Including a pre-arbitration mediation requirement can often work to the parties’ advantage, and specifying that the mediator will serve as the arbitrator should the mediation fail can encourage parties to take more reasonable positions at mediation, increasing the likelihood of settlement.
There are multiple sources for arbitration clause forms, including the websites of the American Arbitration Association, the International Bar Association and private dispute resolution services such as JAMS, which include useful menus of recommended clauses and options.
It is relatively easy to find appropriate and well-drafted provisions from those sources, which can be used to craft a tailored dispute resolution clause. As a general rule, it is advisable to first decide which organization’s rules will apply to the arbitration and then to work primarily from the model forms offered by that body, as the model forms are generally designed to dovetail with that organization’s rules.
Incorporating by reference the rules that will apply to the arbitration eliminates the need for much of the detail that would otherwise be required in the arbitration clause. However, it is important to carefully review the rules before selecting them and to decide whether any changes are desirable or whether there are any gaps to fill.
One of the most important provisions is the manner of selecting the arbitrator(s).
Appointing one arbitrator, as opposed to a panel, will nearly always result in a faster and less expensive process. However, it puts control in the hands of a single individual who ultimately may prove to have been the wrong choice.
The option of having each party appoint one arbitrator and having those select a third “neutral” arbitrator is of dubious merit, as the two party-selected arbitrators are likely to cancel each other out, effectively giving you all the risk of a single arbitrator process with all the cost and delay of a panel arbitration.
There certainly is less risk of an aberrant result with a panel of arbitrators, and, given the extremely limited appellate options in arbitration, a panel may be appropriate for high-stakes disputes despite the higher cost. However, in such instances it is preferable to select each of the panelists in the same way that a single arbitrator would be selected.
A contract dispute respecting an industry in which custom and usage are important elements of the business relationship, such as construction, should be arbitrated by persons familiar with those business practices.
Some disputes may require expertise in specialized fields, such as accounting or international trade regulations. It is important to specify the minimum qualifications of the candidates from among whom the arbitrator will be selected.
A simple mechanism for selecting arbitrators is to provide that each party will propose five candidates meeting the specified qualifications, each will have the right to strike two of the other’s names, and if no agreement can be reached from among the remaining candidates then a specified neutral organization or individual (and successor, if necessary) will make the selection after reviewing a brief memorandum from each party.
There are other good methods for selecting neutrals, but leaving the choice entirely up to the rules body or depending solely on a consensus of the parties should be avoided.
Limits on discovery are also extremely important. Giving the arbitrator full discretion as to what discovery will be allowed is the most common cause of runaway expense and delay.
As a general rule, the claimant will bear the burden of proof in a dispute and will be the party with a need for discovery. A respondent in arbitration is usually already in possession of all the evidence he will really need to defend himself.
Again, in drafting the arbitration clause, consideration should be given to on which side of the “versus” one expects to be. If a party is all but certain that it will not be the one bringing a claim, discovery can be limited to mandatory initial disclosure by each side of all documents and data relating to the claims and defenses.
Provisions can also be included for the preservation of privileges, the treatment and dissemination of confidential information, and restrictions on the arbitrator’s authority to compel disclosures or rule on issues of privilege.
Depositions, if permitted, should be expressly restricted to both a specified number of witnesses and a maximum of total hours. One may wish to expressly exempt certain individuals from being deposed, such as executives and directors who had no involvement in the negotiation or performance of the contract.
There are several factors to consider in selecting the venue for arbitration. A home court advantage is fine as long as there are not better reasons to hear the dispute elsewhere. Who will be required to testify in the most likely disputes to arise, and where do they reside? In which jurisdictions will the courts issue a subpoena in aid of arbitration? Where is there a sufficient pool of willing and qualified neutrals to hear the dispute? Can an award from the chosen venue be enforced in the jurisdiction where it will need to be enforced?
If one anticipates being the claimant in a dispute and needing discovery and testimony from third parties and hostile witnesses, it will be easier to gather the necessary evidence if the arbitration is held where those witnesses reside.
In international transactions, care should be taken to select a jurisdiction that is party to the 1958 Convention on the Recognition and Enforcement of Foreign Arbitral Awards (the “New York Convention”) and where there is legal and judicial support for arbitration.
One should also specify the language in which the arbitration will be conducted.
A “loser pays” clause, directing the arbitrator to award costs and attorneys’ fees to the prevailing party, is favored by many. This stems from the natural assumptions that 1) the clause functions as a deterrent to the bringing of frivolous claims, 2) any claim brought against you will be frivolous and you will win, and 3) any claim you bring will be meritorious and you will win.
However, the likelihood of a frivolous claim being brought is actually very small. Consequently, the deterrent effect is of questionable value. And while nearly every frivolous claim fails, not every meritorious claim prevails.
Rather than simply include such a clause as a matter of course, consider the disputes that are likely to arise under the contract first. If it is more likely that a party will be a claimant in any dispute, does the party want to face the prospect of paying the other side’s attorneys’ fees if the claim is difficult to prove and is decided against it?
And if the party is the respondent, a “loser pays” clause can also make settlement more difficult or expensive, particularly after substantial costs have been incurred. The party may decide to include such a clause, or a hybrid that simply gives the arbitrator discretion to award costs, but it should be done thoughtfully and not automatically.
Most transactional lawyers do not have experience with arbitration. Indeed, the better you are at drafting contracts the less likely you are to get involved in arbitration.
When negotiating an arbitration clause, consider consulting an experienced litigator — perhaps the one who will be called on to abide by the arbitration terms you are drafting.
Those who regularly litigate contract disputes are frequently in the best position to anticipate what types of disputes are most likely to arise under a given contract, and which dispute resolution provisions would be most appropriate.