The purpose of an arbitration clause is to resolve disputes by means of a private proceeding that is generally perceived as quicker and less expensive than the court system. Yet many contracting parties do not fully analyze the arbitration clauses in their contracts, and so do not draft such provisions in a comprehensive and precise manner. These lapses can lead to costly and time-consuming disputes.
“Any party entering into an arbitration agreement, therefore, would be wise to carefully analyze the arbitration clause thoroughly, with a view to ensuring that it will accomplish all of the party’s goals,” says Courtney D. Tedrowe, a commercial litigation partner at Novack and Macey LLP.
Smart Business spoke with Tedrowe about what it takes to draft an effective arbitration clause.
What are the key considerations in drafting an arbitration clause?
Broadly speaking, there are two categories of issues to consider when drafting an arbitration clause. The first of these concerns the extent to which the court will be involved in pre-arbitration and post-arbitration issues. The second category concerns the parameters and procedures of the arbitration proceeding.
Why consider the court’s involvement in pre- and post-arbitration proceedings?
Just because you have an arbitration clause doesn’t mean that you will avoid court proceedings. Not infrequently, a party will oppose the arbitration demand on the grounds that it does not fall within the scope of the arbitration clause. Under the Federal Arbitration Act, courts are required to ensure that the claim is arbitrable. However, the arbitration clause can specify that the arbitrator decides such substantive ‘arbitrability’ issues, effectively limiting the court’s role from the very outset.
The parties may also restrict the court’s involvement in post-arbitration proceedings. Some post-arbitration judicial action is inevitable, since courts, not arbitrators, have the power to reduce the arbitration award to an enforceable judgment and to decide any challenges to the award. Here, the parties can use the arbitration clause to limit the grounds of appeal, further reducing the chances that the award is vacated, and minimizing the risk of lengthy appeals.
How should the arbitration clause be drafted to provide for procedural matters?
Parties can agree to pretty much whatever they want when it come to procedures. Typically, agreements simply select an organization’s rules, such as the American Arbitration Association, JAMS or ADR Systems.
There are two big pitfalls here. First, most organizations have more than one set of rules with sometimes very different deadlines, discovery options and evidentiary rules. When drafting the clause, be sure that you select not just the organization, but the specific set of rules most favorable to the particular situation.
Second, organizations change their rules regularly, meaning parties will likely be bound to use the rules in effect at the time of the dispute, which may have changed.
Can parties modify the applicable rules?
Yes. For example, although the rules of evidence do not typically apply in arbitration, parties may specify that they will apply, or that only certain rules of evidence apply. Parties also have the ability to craft the discovery process to their particular situation. The arbitration clause can set forth, among other things: whether parties may take depositions and, if so, how many; whether documents requests and interrogatories will be allowed and, if so, how many; and the parameters of any other discovery method.
The clause may also deal with the hearing location; pre- and post-arbitration motions, such as motions to dismiss; and the arbitrator’s power to fashion specific remedies.
How much freedom do the parties have to control the arbitrator selection process?
Parties have complete control over who arbitrates their dispute. The specific arbitrator could be identified in the clause, or the clause can set forth the rules by which an arbitrator is selected, either expressly or by selection of a particular organization’s rules.
Courtney D. Tedrowe is a commercial litigation partner at Novack and Macey LLP. Reach him at (312) 419-6900 or firstname.lastname@example.org.
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Over the past two decades, more and more businesses are including arbitration provisions in their contracts with vendors, suppliers, employees and other counterparties. Behind this trend is the fact that the court system can be slow, cumbersome, very expensive and confusing to business managers. Arbitration generally cuts through all this and delivers a result much quicker and at a lower dollar cost, facilitating decision making by managers because disputes are resolved faster.
However, including arbitration clauses in contracts is not always the right call, says Eric N. Macey, a founding partner at Novack and Macey LLP.
“While arbitration is generally quicker and more cost effective, that is not always the case, and arbitration results are not necessarily generally better,” says Macey. “In fact, they can be very, very mixed.
Smart Business spoke with Macey about the problems that can arise with arbitration and how to avoid them.
What kinds of problems are inherent to arbitration that aren’t necessarily present in a typical court case?
One is the issue of what I call ‘rent-a-judge.’ When you file a lawsuit, the court system assigns a judge to your case, and you don’t pay for that judge. In arbitration, if the parties don’t agree on an arbitrator, you have to have some method to select that person. This can be set out in your contract’s arbitration provision, or you can use third-parties such as JAMS or the American Arbitration System to select an arbitrator.
Sometimes the selection of the arbitrator becomes a long, drawn-out dispute in itself. Moreover, you and your adversary have to pay the arbitrator for his or her time. And in some instances, your arbitration may call for three arbitrators — one selected by you, one selected by your adversary and the third selected by the chosen arbitrators. Now you are contributing to the fees of three arbitrators, and they typically are not inexpensive.
What other problems can arise?
Another concern is that court proceedings offer you a full range of procedural safeguards that you don’t have in arbitrations. There are no rules of evidence in arbitration, and there are no rigorous procedural rules for pretrial disclosures, which can create significant problems.
For example, you don’t necessarily have the right to take depositions of individuals involved in the dispute in arbitrations. Consequently, you can get to the hearing and have no idea what that individual is going to say if he or she is called by your adversary as a witness. This wouldn’t happen in a court proceeding.
Another example is the issue of hearsay. Hearsay is just ‘rumor’ testimony, that is, what someone else told you, and under the rules of evidence, hearsay is inadmissible. The person who told you something must be the one to testify about it. An arbitrator or panel of arbitrators are not bound by these rules of evidence, so they are free to admit hearsay.
Thus, in an arbitration, if your opponent testifies that a supplier in China said one of your managers did something that hurts your case, that testimony may be admissible. A court would doubtfully admit such testimony.
If the arbitrator or arbitration panel makes a mistake, can you appeal, as with a court decision?
Yes, but the rules for modifying or vacating an arbitration award are very, very limited. Courts favor arbitration and give arbitrators a lot of deference in upholding their awards. It typically is not up to a court to determine whether the arbitrator followed rules of evidence or procedure, or even followed the law. What matters to a court reviewing an arbitration award is whether the award was within the scope of the arbitrator’s authority set out in the parties’ contract and whether the award is reasonably consistent with the terms of the contract.
When should businesses include arbitration provisions in their contracts and when should they keep them out?
As a rule of thumb, the more sophisticated the contractual relationship, the less likely I would want to include an arbitration provision. For example, if you are hiring a new CFO and negotiating a three-year employment contract, an arbitration provision makes sense. Alternatively, if you are selling a product line or division with innumerable financial terms and warranties and representations, I would leave out the arbitration provision.
Here is another example. If I am entering a one-off contract to buy product that is not cost prohibitive, I would include an arbitration clause, but if it is a contract to purchase variable amounts of a product over time that is integral to my business with fluctuating pricing and quality standards, I would opt to keep the clause out.
What can business managers do to avoid some of the problems you have raised?
Arbitration is based on a private contractual relationship. The key issue, then, is the arbitration provision in your contract. That provision governs your entire arbitration process. So when you are negotiating the contract, don’t just add a standard arbitration provision and think everything will take care of itself, because it won’t.
You need to consider whether the provision covers such things as the selection of arbitrators, the location of the arbitration, whether any pretrial procedures should be included, whether the provision should prevent the arbitrator from issuing awards for punitive damages or loss profits, whether the arbitrator has to provide reasons for his or her decision and how quickly the arbitrator must render his or her award. These are just some of the items that need to be thought through as part of an arbitration provision.
Eric N. Macey is a founding partner at Novack and Macey LLP. Reach him at (312) 419-6900 or email@example.com.
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Smart Business spoke with Stephen Smith, Managing Partner at Greenberg Glusker Fields Claman & Machtinger LLP about what makes arbitration a better choice for resolving business disputes.
Historically, arbitration was seen as a better means for companies to resolve legal disputes due to speed and cost. Matters could be resolved in months rather than years. Discovery was more limited. Business owners and managers believed that the overall cost (even after including the arbitration fees themselves) would be significantly less.
Having handled numerous arbitrations myself over the last ten years, I have seen firsthand that most of them have not been particularly fast, and extensive discovery was allowed in all but one case. Overall, the cost was probably no less than what it would have been had the dispute been resolved in court.
Nonetheless, arbitration remains a superior venue to resolve the vast majority of business disputes for reasons you may find surprising and perhaps counterintuitive.
In an arbitration, both parties have a lot of control over who is chosen to hear and decide the dispute. In a case I handled a few years ago, my firm represented a French entertainment company in a dispute against a toy company located in California. The California company initiated an arbitration for breach of contract. Had the California company been permitted to pursue a jury trial in California court, it would have gained significant leverage over the French company given the pervasive anti-French sentiment that existed at the time. In the arbitration, on the other hand, we were able to have the matter handled by the International Centre for Dispute Resolution (ICDR) division of the American Arbitration Association (AAA). The ICDR provided us with a well-qualified list of arbitrators who were citizens of neutral countries. In the end, our case was arbitrated in front of a well-qualified English citizen who was the head of the international arbitration practice at a prominent New York law firm. He was fair, diligent and incredibly competent. We were very pleased with the choice, long before he ruled in our favor two years later.
Contrast that scenario to a court where you have almost no control over the choice of decision-maker. Judges are randomly assigned. In California state court, you may have the chance to eliminate the first judge chosen, but then you are randomly assigned again. Many lawyers believe that the second choice is never random despite what the courts promise, because in an uncanny number of cases, the second judge assigned to the case was worse than the first. Randomness hurts because the disparity between a good judge and a bad judge can be case-dispositive. Even if the matter is to be tried before a jury (where you can exercise some control through voir dire), the presiding trial court judge can have a tremendous influence over what the jury hears and sees. If the judge is really bad, the jury will not save you.
Also, speaking frankly, trial lawyers will usually admit that the quality of judging on average has fallen dramatically over the past decade. Judges are grossly underpaid. The best private practice lawyers are less and less interested in becoming judges because the pay disparity is simply too big. Judges are also terribly overworked. With recent budget cuts, the work simply cannot be competently and timely completed by the total number of judge “hours” available in the system. As a result, there has been a corresponding decrease in the attention paid to resolving the complicated and difficult issues that arise in business disputes.
More predictable application of substantive law
Even though arbitrators are not required to follow the law, they usually do and are more likely to reach the right result. Having previously practiced as lawyers or retired judges, arbitrators have an affinity for the law. In my experience, their attention to the law is much more thorough than that of a court. In the aforementioned matter between the French and California companies, the arbitrator’s award was extremely well-reasoned and nuanced.
There are three main reasons why arbitrators follow the law better than trial courts. First, arbitrators are paid for their time, while judges are not. It may be cynical to say, but even the most devoted public servant will spend less time analyzing the issues than a well-qualified arbitrator getting paid $500 or more per hour. Second, arbitrators can schedule a fair amount of time to consider the issue, while judges have too many cases on their dockets to consider any matter for more than a few minutes. Again, with government budget cuts over the last few years, the problem has become much worse. In many Los Angeles state courts, it takes many months to get a hearing date for any type of motion. You can imagine then how much time the court is actually going to spend analyzing it. Third, arbitrators are more qualified in business and civil law than most judges. Fewer and fewer business litigators are being appointed to the state and federal benches. Fewer and fewer business litigators even want to be appointed to the bench because they can make so much more money either practicing law or arbitrating.
You get what you pay for
The best talent follows the money and will spend the necessary time as long as they are paid to do so. As a result, I have found that arbitrators’ rulings are much more thorough and better reasoned than most trial court rulings, even though arbitrators are the ones who are not required to follow the law.
You always get to put on your case
Arbitrators are much more likely to permit the introduction of all of the relevant evidence. Anyone who has ever tried a case in court will tell you that no one understands the rules of evidence and no judge applies them properly. The rules are archaic and riddled with so many exceptions and exceptions to the exceptions that it is anyone’s guess what will actually be allowed into evidence. Courts of Appeal must focus a tremendous amount of effort determining whether the evidentiary error was prejudicial simply because, if they reversed all cases for error alone, every case would be reversed.
On the other hand, while arbitrators generally follow substantive law, they do not follow the rules of evidence, except in the broadest sense. If it is relevant, it is admitted 99 times out of 100, even if it might run afoul of the hearsay rule, for example. Arbitrators are sophisticated enough to understand that such evidence should be entitled to less weight, but they will let it in nonetheless and consider it as far as it goes. This really matters in terms of your ability to predict with confidence that the case you intend to present can really be presented. Often, in trial, a very important part of your case may never come into evidence because of the vagaries of the rules of evidence and the whim of the judge about how to apply them. If that happens, you are then placed in the position of having to restructure your presentation on the fly and are left with a puzzle missing an important piece.
In my most recent jury trial, the defendant, who had licensed my client’s product, was required to run print advertisements to promote it. One of the issues turned on whether the defendant had actually run an advertisement in a particular Sunday newspaper circular. We had an original of that newspaper circular, which contained no such advertisement for the product in question. The judge refused to admit the circular on the ground that it was hearsay, even though it was being offered only to show that the act of advertising had not even occurred. As a result, my presentation proving false the defendant’s statements that it had run the advertisement was dramatically diminished. My best piece of clearly admissible evidence was never allowed in. Such a seemingly obvious error would never have been made in an arbitration because arbitrators would not care whether it was hearsay or not. They would only care whether it was relevant. Given that the issue was whether the advertisement had run at all, one would assume that the original circular in which the licensee claimed the advertisement was run would be pretty darn relevant. So, if you want to be assured of actually being able to put forward your entire case, you should choose arbitration.
The arbitration hearing is a much more efficient use of time (and therefore expense) than a trial. Concurrently with a trial, the judge almost always must conduct other judicial business — most often, law and motion practice in other cases. Also, the public employees who work in state and federal courthouses are subject to strict wage and hour requirements and/or union benefits that significantly shorten the effective length of any given business day. If there is a jury, then the breaks occur more often and last longer. An arbitration hearing, on the other hand, can start at 8:30 a.m. or 9:00 a.m. and go until 5:30 p.m. or 6:00 p.m., with a one-hour lunch break and one short break in the morning and afternoon. As a result, a good rule of thumb is that for each day of arbitration, one can expect two days of trial (or three if it is a jury trial). In the jury trial I mentioned above, in more than one month of trial time, we collectively spent a total of seven full days putting on both side’s cases.
Finally, arbitration proceedings can be kept confidential. In business disputes, one side or the other wants the dispute to be resolved outside of the public eye. It is almost impossible to achieve confidentiality in a judicial proceeding. Our courts are open to the public and, while a court may exclude the public from the courtroom for a short period of time, for example when a trade secret document is being discussed, the courtroom will otherwise remain open to anyone who wants to be present, including others in the industry and the press. Arbitrations are private, and they generally take place on private property in a conference room. Access can be controlled, and by contract the parties can agree that the substance of the dispute must be kept confidential.
In sum, while the historical reasons for choosing arbitration may no longer exist, arbitration does remain the default choice for resolution of business disputes. Greater control, better decision-making, predictability, efficiency and confidentiality create an ideal atmosphere for ensuring your dispute has the best opportunity be resolved fairly.
Stephen Smith serves as Greenberg Glusker’s Managing Partner. His law practice focuses on representing entertainment companies in the motion picture, television and interactive gaming industries, and real estate development companies, and in providing those companies with legal counseling related to all aspects of their businesses. He can be reached at (310) 785-6895 or SSmith@greenbergglusker.com.