Use of Arbritration Clauses in Commercial Agreements

Does it makes sense to use arbitration clauses in commercial agreements? This memo outlines some of the considerations which weigh in the decision to use an arbitration clause. It is intended as a reference for legal counsel. Attorneys may find it to be a useful aid in counseling clients and in drafting an arbitration clause. This is not intended to be exhaustive, and counsel should consider the requirements of applicable law and consult other appropriate authority in advising their clients and drafting arbitration clauses. Nonlawyers should obtain competent counsel before agreeing to an arbitration clause.

1. Why Use Arbitration? There are several good reasons for including arbitration clauses in commercial agreements. Arbitration can be a prompt, and therefore inexpensive, way of resolving business disputes. Also, arbitration can assure that the dispute is decided by a person who is familiar with the commercial context in which the dispute arose. The next time you draft a contract which relates to a particularly complicated matter, consider whether you would rather have a dispute arising under that agreement decided by a member of the judiciary, who may be elected or appointed, and whose experience may be in government, criminal prosecution or criminal defense, or by a businessman or professional well-familiar with the nature of the industry.

Arbitration may also operate so as to reduce the risk of punitive or exemplary damages. If the arbitration agreement authorizes the award of compensatory damages only, it is unlikely that any party to that agreement will be assessed punitive damages. Since the plaintiff will be required to arbitrate his claim, a punitive damage lawsuit will not usually be instituted until after the arbitration is concluded. If the plaintiff prevails in arbitration and receives compensatory damages that party (and more important, his lawyer) will have little incentive to pursue litigation in which he will recover only if he establishes a punitive damage case. Conversely, if the plaintiff loses in arbitration, and receives no compensatory damages, the plaintiff will be barred from pursuing a punitive damage action in
most jurisdictions.

2 . What are the disadvantages to arbitration? Arbitration may no make sense under certain circumstances. Principally, you will want to counsel against arbitration in any case in which you envision that the client will want to pursue extensive discovery. Also, the client may wish to avoid arbitration when it perceives that its potential adversaries will be less able to withstand expensive and protracted litigation. Clients may prefer to go to court if their disputes are apt to involve questions of law and there exists a body of substantial precedents in their favor. Clients may also prefer to go to court if they are apt to wind up with well-qualified jurists. For example, clients may prefer to have corporate governance disputes adjudicated in the Delaware Chancery Court, rather than in arbitration.

3. How Does Arbitration Compare with Litigation?

a. Pleadings. Arbitration avoid entirely all technical pleading requirements. The initial arbitration filing may be as simple as a letter addressed to the arbitration tribunal which briefly explains the dispute in layman's terms, refers to the arbitration contract, and asks for arbitration to be started. Motion practice associated with pleadings (motions for more particular statement and motions to dismiss for failure to state a claim) simply does not exist in arbitration.

b. Filing fees and costs. Arbitration filing fees can be more or less expensive than court filing fees, depending upon the arbitration rules that are invoked. The American Arbitration Association has many different arbitration rules, each of which applies to a different type of dispute. Some of the arbitration rules require a nominal filing fee ($25 or $50), while other arbitration rules require payment of a filing fee which is based upon a percentage of the amount in dispute (such fees can amount to thousands of dollars). Before one drafts an arbitration clause, one should refer to various arbitration rules to be certain that the rules referenced in the arbitration clause do not call for disproportionate filing fees. Of course, arbitration may be completely private (outside of the auspices of an arbitration organization such as the American Arbitration Association), in which case there need not be any filing fees.

c. Arbitrator Fees. When a dispute goes to court, the litigants need not be concerned with paying the judge's salary. In contrast, arbitrators must usually be paid. In some cases, arbitrators will serve at no charge (some Commercial Arbitration Rules provide for arbitrators to volunteer a limited amount of time for smaller commercial disputes). In practice, some arbitrators charge as little as $350 per day, while others as much as $3500 per day. Typically, the arbitrator's fee is split between the parties, unless the arbitration agreement provides otherwise.

d. Attorney Fees. In both litigation and arbitration, the parties can agree that the prevailing party must be awarded attorney fees. In the absence of such an agreement, neither courts nor arbitrators will award attorney fees, unless the governing law provides for an award of attorney fees.

e. Hearing Room Expenses. In litigation, there is no charge for the use of the courtroom. In arbitration, the parties may need to rent a conference room at a mutual location, such as a conference room in a hotel. This cost can usually be avoided by using attorneys' conference rooms, or even unused courtrooms.

f. Pre-Trial Discovery. Most every jurisdiction permits extensive pre-trial discovery. In contrast, few arbitration rules provide for discovery. However, many states have arbitration statutes which can be invoked to permit discovery in arbitration. Also, parties can draft arbitration agreements so as to define the extent of pre-trial discovery that will be permitted. Generally speaking, discovery is freely available in arbitration so long as the discovery is not abusive. Most arbitrators will allow key witnesses to be deposed in advance of the arbitration hearing, and will require opposing parties to make available copies of documents to their adversaries. Parties can confer upon arbitrators the same powers as courts to issue orders compelling discovery and protective orders.

g. Scheduling. Arbitration scores a big advantage in scheduling. Courts schedule matters without regard to the schedule of the litigants. Some judges have been known to schedule trials involving out-of-state parties shortly before holidays, in order to attempt to stimulate settlement interest. In contrast, arbitration hearings are always scheduled with a view toward the convenience of the participants. Courts have substantial backlogs. Cases may take as long as one or two years to come to trial, and appeals by extend the dispute even longer. In contrast, most arbitration hearings take place and are concluded within six months after they are invoked.

h. Privacy. Arbitration can be conducted in private, and arbitration records can be kept private. Litigation is open to the public and documents, unless sealed by the court, become public documents.

i. Number and Quality of Jurists. In court, preliminary matters may be handled by several different judges, or by a magistrate. In arbitration it would be most unusual for anyone other than the arbitrator(s) who will ultimately decide the case to hear any pre-trial matters. Cases are then decided either by a jury of twelve lay persons or by a single judge (in most jurisdictions), or as here in Vermont, by a presiding judge and one or two lay-judges (assistant judges). Arbitration usually involves a single arbitrator, and the arbitration agreement can set forth minimum qualifications for the arbitrator. Or, if the parties prefer, they may choose to use several arbitrators. One common arrangement is for each party to the dispute to select an arbitrator and for the two arbitrators so selected to select a third arbitrator. When more than one arbitrator is to be used, the parties should clarify whether they intend that all of the arbitrators shall be neutrals, or that each party is entitled to select an arbitrator as the party's representative, and one or more "deadlock-breaking" arbitrators who are to be true neutrals.

j. Settlement Encouragement. Some judges and some arbitrators get actively involved in settlement negotiations. Some arbitrators are particularly adept at mediation, and are able to stimulate settlement before cases are heard. The same may be said of some judges. In arbitration agreements, the parties may determine the extent to which the arbitrator will attempt to mediate the dispute.

k. Conduct of the Trial on the Merits. Courts typically use formal rules of evidence. Although modern trends in the law of evidence is to allow most evidence to be introduced, a substantial body of law exists which requires certain formalities in the presentation of evidence. In most cases, witnesses will be required to come to the hearing in order to identify documents so that they may be introduced, hearsay statements will not be introduced, and lawyers will be constrained in the conduct of their examinations to comport with the rigorous requirements imposed by all rules of evidence. A different situation is presented in arbitration. Usually affidavits are accepted (unless the parties agree otherwise), and it is rare that an arbitrator would exclude anything from evidence. Questioning is informal and most arbitrators will tolerate a few objections from opposing counsel. Most arbitrators are sophisticated enough to understand that a question is leading, or that aa question calls for hearsay evidence, and they are apt to permit such questions, allowing them to affect the weight which the arbitrator
will give to the testimony.

l. Post-Hearing Briefs. In most cases tried in court, some form of post-hearing briefs are required. In jury trials, requests for jury instructions are likely to be required and these requests will often require the same sort of legal research involved in preparing a memorandum of law. In cases tried to a judge (trials by court) post-trial briefs are frequently requested by the court. In arbitration, the parties can agree (either in the arbitration agreement, or at the time of the hearing) as to whether they wish to file post-hearing briefs. It would be extremely rare for an arbitrator to request briefs, or to refuse to accept briefs, contrary to the wishes of the parties.

m. Decision Format. In jury trials, the decision is apt to take the form of a general verdict which simply indicates the party who prevailed and the amount owed. Courts may use special interrogatories to the jury which may give more detail to the decision, but will be far short of a complete explanation as to the result.

In cases tried to the court, most courts must provide, upon request, written findings of fact and conclusions of law which explain, in detail, the rationale for the court's decision. Rarely will a court issue an oral decision from the bench at the conclusion of the hearing.

In the arbitration, the parties may dictate the form of the decision. Parties may specify that the arbitrator provide a written decision explaining its rationale, or they may agree that the arbitrator provide no explanation at all. Generally speaking, if the parties truly want the arbitration proceeding to be final, they will prefer to have an arbitrator issue an aware without any accompanying rationale. If the parties agree, the arbitrator will "rule from the bench."

n. Appeal. In most every jurisdiction, every party has the opportunity to appeal as a matter of right. The judgment of the court does not become final until the appeal is concluded. On appeal, the appellate court uses an appellate review standard under which facts found by the trial court will not be disturbed unless there is no evidence introduced in the trial court on the point in question. Appellate courts will, however, review the law as applied by the trial court, and will not hesitate to set aside the trial court's decision if it finds that the trial court was wrong in applying the law.

There is no automatic appeal from an arbitration award. Most arbitration proceedings purport to be "final and binding," with the result that courts are reluctant to review arbitration awards, even if it alleged that the arbitrator found facts unsupported by evidence or misapplied the law. Most arbitration statutes permit an extremely limited review of arbitration awards, and authorize courts to set them aside if they find following four grounds:

1. Corruption or fraud in the procurement of the arbitration award.
2. Evident partiality by the arbitrator.
3. The arbitrator exceeded his powers; or
4. The arbitrator conducts the hearing in a grossly prejudicial manner.

By and large, it is extremely difficult to set aside an arbitration award in court. Similarly, it is very difficult for a party to avoid his agreement to arbitrate. Most arbitration statutes require that courts compel arbitration of any matter that is even arguably within the scope of an arbitration clause.

o. Provisional Remedies. In court, parties may obtain provisional remedies, including property attachment, temporary injunctions, and wage garnishment. The same remedies are generally not available in arbitration, unless the parties provide for provisional remedies in their agreement to arbitrate. If the parties fail to provide for provisional remedies in their agreement to arbitrate, it still may be possible for a plaintiff to bring a law suit to obtain a provisional remedy while arbitration proceeds.

4. Are There Any Statutes that Govern Arbitration? The Federal Arbitration Act (9 U.S.C. §§ 1 et seq.) governs arbitration agreements made in interstate commerce. Generally speaking, it provides that such agreements are enforceable and that federal courts must compel parties to participate in arbitration upon motion made by any party. Under the Federal Arbitration Act a party may waive arbitration by failing to move for an order compelling arbitration within a reasonable period of time. Parties may attempt to avoid arbitration under the Federal Arbitration Act by claiming that they were defrauded into entering into the arbitration agreement, or by claiming that the arbitration agreement is contrary to law. There is a substantial body of federal case law on both points, and federal courts, increasingly, are finding that arbitration does not offend statutes which provide for federal court remedies ( For example, the United States Supreme Court has ruled that the "exclusive remedy" provisions of the 1933 Securities Act are not offended by arbitration. It has also ruled that claims arising under the Racketeer Influenced and Corrupt Organizations Act ("RICO") may be arbitrated).

The Federal Arbitration Act further provides that an agreement to arbitrate is subject to all of the same defenses that may be raised to any contract. The federal courts have, over the years, construed this provision narrowly so as to favor arbitration. The federal courts almost uniformly require that a party establish fraud in the making of the arbitration clause (not merely fraud in the making of the contract in which it is included) in order to allow a party to escape from the obligation to arbitrate a dispute. Federal courts have occasionally invalidated arbitration agreements when they have been found unconscionable or oppressive (e.g., when arbitration is required to be held in a distant locale at great cost to a litigant who could not afford to pursue his claim in that locale).

Many states have their own arbitration statutes, and in a majority of the jurisdictions in the United States, these statutes are modeled after the Uniform Arbitration Act. See, e.g., 12 Vt. Stat. Ann. §§ 5651 et seq. (Supp. 1996). Most every state's enactment requires that courts compel arbitration upon the motion of any party, much like the Federal Arbitration Act.

Be alert for unique provisions in local law. For example, under Vermont law, an arbitration agreement is unenforceable if there is not a prominently displayed "acknowledgement of arbitration" to assure that both parties fully understood that the agreement contained an arbitration clause. 12 Vt. Stat. Ann. § 5652(b) (Supp.1996). This underscores the importance of knowing which state's law will apply to the arbitration agreement, including a choice of law clause in the contract, and thoroughly understanding the requirements of the law that is chosen to govern the dispute.

5. Are Arbitration Clauses Typically Contained in International Agreements? Yes. There are several international protocols governing arbitration agreements and one who prepares an arbitration clause for inclusion in an international agreement should be certain to determine whether there is a treaty or convention which would pertain to the enforcement of the arbitration clause.

Experienced counsel should be prepared to assist clients in any of the following proceedings, and should understand these proceedings well enough to draft the arbitration agreement with the client's objectives in mind:

1. Actions to compel arbitration;

2. Actions to resist arbitration;

3. Actions to set aside arbitration awards;

4. Actions to modify arbitration awards; and

5. Actions to enforce arbitration decisions.

Copyright © 1997

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