26 Apr Questioning Conventional Wisdom: Be Careful What You Wish for with Mandatory Arbitration Clauses
Questioning Conventional Wisdom:
Be Careful What You Wish for with Mandatory Arbitration Clauses
Brian AntweilSenior Counsel
For many years, it was generally accepted among many lawyers and frequent litigation participants that mandatory arbitration provided a simpler, cheaper, and faster dispute resolution procedure than traditional judicial forums. It was a rare exception to see agreements without an arbitration provision.
That may be changing. It is becoming increasingly recognized that arbitration falls short of its supposed benefits, and litigants have expressed growing dissatisfaction with resolving litigation through arbitration. This article takes a closer look at what appears to be a courthouse renaissance and a corresponding decline in arbitration’s standing as the preferred method to resolve disputes.
The Stated Case for Arbitration
Lower costs and fewer and more contained risks are the principal advantages touted by arbitration proponents. Other supposed advantages include a greater control over sensitive information and a less disruptive process. These benefits primarily relate to the parties’ expectation that they can design an agreed upon dispute resolution procedure to fit a controversy that may arise several years in the future. The record, as developed by various studies, is mixed on this front. Empirical studies have generally supported the case for arbitration. These studies have for the most part found that arbitration can provide an efficient means for resolving certain types of disputes and that in many instances arbitration results in lower legal fees and expenses.
The Fallacy in the Data
There are several weaknesses in this data, however, that become apparent on closer examination. First, arbitration studies have tended to be heavily weighted toward consumer and employment cases when compared to those dispute’s percentage representation in litigation generally. While arbitration may be advantageous in these lower stakes, recurring circumstances, larger commercial disputes are not readily comparable as the discovery and time needed to develop each side’s respective case can be much more difficult to anticipate where the eventual dispute is unknown at the time of contracting. Furthermore, arbitration studies have largely compared disputes that are subject to arbitration to cases that have actually proceeded all the way to trial and have failed to compare whether one process is more likely to produce a settlement.
The Emerging Reality
A growing number of attorneys and litigants are questioning the benefits of arbitration at the same time that many are becoming increasingly comfortable with litigation in traditional judicial venues. Among the main complaints is the cost of the arbitrators themselves. In higher-stakes matters especially, the arbitration panel will be composed of three arbitrators, each of whom is generally a lawyer of some renown. Although some attorneys may agree to reduce their hourly rate or a fixed fee structure in arbitrations, the cost of the three-panel members can easily become a significant portion of the parties’ litigation expense. Having a panel of in demand lawyers can also create scheduling issues that can frustrate the parties and lead to protracted delays.
In addition, arbitrators who are ultimately employed by the litigants may go too far in attempting to keep all of the parties happy. This may lead to a tendency to accommodate scheduling issues causing further interruption, and in litigation, delay usually equals higher costs. Arbitration has also become as discovery intensive as a trial court case. This fact on its own tends to eliminate any expected cost savings over the courthouse and can be negatively impacted by arbitrators who are overly deferential to a party’s request. By erring on the side of maintaining the parties’ goodwill, arbitrators may avoid granting meritorious summary judgments in favor of permitting the parties to have a full hearing on the evidence.
At the same time, state and federal courts have benefited from improved standing among litigants in recent years. Numerous states have enacted tort reform to greatly restrict a jury’s ability to grant excessive damages awards and have provided for increased appellate scrutiny of trial court results. These statutes have taken one of the major fears of corporate defendants off the table and made a return to the courtroom more palatable. The judicial system has the added benefit of well-established discovery and procedural rules that have been extensively developed over time to provide greater predictability and reliability of process. Moreover, the powers of the judiciary allow for third-party discovery and joinder that is simply not available to arbitration participants.
Judges also are less beholden to the parties and therefore to act with greater authority in discovery disputes and with regard to dispositive motions. While an arbitrator’s financial interest is generally aligned with a longer, and thereby more fee intensive, process, trial judges are motivated to maintain a lean docket with cases moving promptly and efficiently through the system. Forum selection clauses are also an attractive way to obtain the benefits of a judicial venue while avoiding certain high-risk jurisdictions. Parties have the additional capability of adding contractual waivers to the jury trial and punitive damages to further narrow potential litigation risks. Even the potential of going before a jury has certain added benefits, given that parties tend to move toward settlement as the specter of a trial before six to twelve jurors draws nearer.
Despite the conventional wisdom that arbitration predominates, traditional litigation appears to have a significant edge. A recent study of practices of SEC reporting revealed that a mere 11% of material contracts contained compulsory arbitration provisions. The incidence was surprisingly low even in international contracts at 20%; double that of domestic contracts (10%), but still lower than most would think.
Arbitration proponents and practitioners have made adjustments to address shortcomings in the arbitral process. For instance, JAMS has moved toward a default system that is much more court-like. The JAMS rules provide for a single arbitrator, a presumption in favor of limited discovery, summary disposition of disputes, and the option for an appellate procedure. These changes have made JAMS arbitrations decidedly more similar to judicial proceedings and aim to eliminate some of the issues discussed above.
Case in Point
I recently participated in an arbitration that typified many of the troubling characteristics discussed in this article. The dispute at issue involved a very complex implementation contract for supply chain software. The parties had multiple licenses and agreements governing the business deal. Some, but not all, of these agreements contained arbitration provisions.
From the outset, the three-arbitrator panel showed no interest in narrowing the claims as the panel refused to grant summary disposition on several claims that were clearly not legally cognizable. The discovery process was equally inefficient and costly as the arbitrators had refused to narrow the parties’ claims and also did not act to enforce a disciplined focus on the relevant issues. Eventually, the arbitrators reached a compromised decision after a two-week hearing on the merits that neither party found satisfactory or appropriate. After suffering through the expensive and frustrating process, one in-house counsel stated that he “would not do this again in a million years.”
Weigh the Options
Despite its problems, arbitration remains an attractive option in many circumstances, and an important part of any contract negotiation should include a determination of whether a compulsory arbitration provision is appropriate.
Several factors drive this analysis. For instance, contracts across national borders and between parties involved in businesses abroad commonly lead parties to opt for the neutrality and certainty of an arbitral panel. Likewise, recurring, predictable disputes that involve minimal relative exposure, such as employment and consumer disputes, make strong candidates for arbitration. Arbitration may be especially beneficial in these circumstances where a corporate client is able to impose an arbitration provision on an employee or customer who has little to no ability to negotiate. Certain other contexts that favor arbitration are disputes involving highly technical matters that may be submitted to a panel of expert arbitrators, disputes involving litigants that are especially vulnerable to bias and prejudice, such as lawyers and banks, and contracts where the parties contemplate a long-term relationship.
On the other hand, arbitration provisions can become troublesome where the nature of the potential dispute is difficult to predict at the time of contracting. In addition, arbitration may be unworkable if a great deal of the evidence will be beyond the parties’ custody and control or if a third party’s presence is essential to resolve the dispute. These factors can cause even the best-crafted arbitration provision to go awry.
Safeguards to Consider
Where the parties choose to mandate arbitration, they should consider a variety of factors to avoid a potentially unsatisfactory future result. First, they should assess the scope and breadth of the arbitration clause. It should not be a foregone conclusion that any disputed matter between parties should be subject to an exclusive election of a judicial or arbitral venue. Instead, contracting parties should discuss whether arbitration is appropriate for certain disputes based on the size and subject matter of potential issues.
It is advisable that parties take the time to review and understand the default rules of the primary arbitral governing bodies, including the American Arbitration Association and JAMS. Parties should not assume that the rules of these organizations will be appropriate simply because they are the standard-setters. A full review of these rules allows parties to specify improvements that may fit the specific circumstances better, and informed lawyers may develop their own standard set of revisions for particular clients and industries.
The selection of the governing law, location of the arbitration, and method for selecting the arbitrator(s) are practical elements that could greatly impact the provision’s success. The location of the arbitration may not cause great difficulty in early stages of the dispute but could prove to be a major impediment to international business operations if a litigant’s employees are summoned from abroad to appear at an arbitration or deposition. Parties should ensure that the choice of law is consistent with the manner of arbitrator selection so that the arbitrator(s) is a practitioner well-versed in the law applicable to the dispute. The arbitrator selection process becomes especially important when a single-member panel is elected, and parties should ensure that the selection method chosen ensures neutrality and provides for a workable backup plan.
Pre-determined discovery limits are an additional means to narrow the uncertainty associated with arbitration. However, these limitations can prove difficult to craft for indeterminate conflicts that may occur years in the future. Other options for structuring an effective arbitration provision may include limiting or specifying the recoverable damages, requiring the arbitrator to issue a certain form of award, and requiring pre-arbitration dispute resolution procedures.
Arbitration appeals are a final consideration that has gained increasing interest in recent years. Although the United States Supreme Court has foreclosed the option of consensual appeals from arbitral panels to the federal appellate courts, some states, including California, have found that their state arbitration statutes provide an avenue for appellate review of arbitration proceedings. Alternatively, parties may contractually agree to a method of review outside of the courts.
No system of justice provides a perfect dispute resolution procedure. However, parties that are well-informed of the potential pitfalls of arbitration, the circumstances under which litigation through the court system is advantageous, and the potential to control and nan-ow the risks of litigation should be able to better assess and select the appropriate dispute resolution procedure, whether that procedure is in front of an arbitration panel or a state or federal court.
Brian Antweil is a thirty-year trial lawyer and Senior Counsel to Rapp & Krock, PC in Houston, Texas.
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