An Arbitration Clause Mind Experiment - When More is Less
Arbitration clauses are often an afterthought—tacked onto the end of a contract during late-stage negotiations. It’s tempting for one side to insert language they hope will shield them from future claims. But these attempts to limit exposure could backfire, turning what was meant to be a fast, inexpensive dispute resolution process into a protracted legal battle. Let’s try this thought experiment:
A Commercial Dispute
Assume a commercial dispute between two fictional companies. NutriMega Corp., is a large food processing firm. Machinovation LLC is the seller of a high-capacity peanut processing machine called the P-Nutter™
NutriMega purchases the P-Nutter under a contract that includes an arbitration clause with two key provisions. The first says, “any claim arising from or related to this agreement must be resolved by binding arbitration. The second limits the arbitrator’s authority. It says, “The arbitrator shall have no jurisdiction over tort or statutory claims and is limited to interpreting the terms of this agreement.”
After delivery, NutriMega alleges the machine significantly underperforms. Among other things, it claims Machinovation falsely stated that five units were in operation processing over 1.5 million peanuts per hour. In fact, it later learns no units were yet in use, and internal testing of prototypes showed output at only a third of that rate. Internal emails reveal that the salespeople wanted it to go that fast to beat competitive machines, but the engineers were doubtful that rate could be achieved any time soon.
First, the Arbitration; then the Lawsuit
NutriMega initiates arbitration, raising both breach of contract and fraud claims. The arbitrator declines jurisdiction over the fraud claim due to the contractual limitation. NutriMega then files the fraud claim in court. Machinovation moves to dismiss, citing the arbitration clause.
The Court Must Weigh In
This raises a fundamental legal question: Can a party bar relief by requiring arbitration but forbidding the arbitrator from considering it?
Federal courts generally favor arbitration under the FAA, but they will not enforce arbitration clauses that eliminate meaningful access to legal remedies. For example, in Paladino v. Avnet Computer Technologies, Inc., 134 F.3d 1054 (11th Cir. 1998), the Eleventh Circuit refused to enforce an arbitration clause that excluded all meaningful statutory relief under Title VII. The court said, “When an arbitration clause has provisions that defeat the remedial purpose of the statute, the arbitration cannot be compelled.”
In our scenario, if the arbitrator is contractually forbidden from addressing fraud, and arbitration is the only forum permitted, the clause may effectively preclude a remedy—undermining its enforceability. So, if NutriMega had started in court, it may have been able to stave off a motion to compel arbitration. But a court might possibly decide that a fairly sophisticated party – as opposed to an employee relying on a statute – can give up a remedy. Parties are, after all, after enforce limitation on damages and use merger clauses to foreclose some fraud claims in some jurisdictions. There would be plenty to argue about.
But in our mind experiment, NutriMega started in arbitration. Would that allow exclusion of the fraud claim? Probably not. In Dean Witter Reynolds Inc. v. Byrd, 470 U.S. 213, 217 (1985), the Supreme Court held that courts must compel arbitration of arbitrable claims even if this results in piecemeal litigation. So, if the contract denies the arbitrator authority to hear tort claims, a court well might allow the contract claim to proceed in arbitration while retaining jurisdiction over the fraud claim. Again, the parties could be expected to spend time in court arguing all this out.
And so . . .
Our thought experiment underscores the importance of drafting arbitration clauses carefully and evenhandedly. When a clause mandates arbitration but limits the arbitrator's power too strictly, it may be unenforceable. Or you may end up with piecemeal litigation. Some claims may be in arbitration and some in court.
I haven’t found a case that addresses this exact issue authoritatively. But we can be sure that, if enough is at stake, plenty of time and energy will be devoted to straightening this all out. A dispute that might might have been resolved in a matter of months, will likely be in the courts for years.
So, instead of creating a way to resolve disputes quickly and inexpensively, this overreach on an arbitration clause potentially creates a new, expensive dispute about who will resolve the dispute. That defeats the whole point of agreeing to use arbitration to resolve disputes.