Let’s Talk About Arbitration Clauses – Again

I’m a big believer in arbitration for the right case. I have seen, when representing parties in arbitrations and acting as an arbitrator that, done right, arbitration can save time, money, and frustration, and provide a fair resolution. For that reason, I keep coming back to one of the easily avoided problems I have seen arise in too many arbitrations: bad arbitration clauses.

Arbitration gives the parties a chance to fashion their own way to resolve disputes that arise in their business dealings. Because arbitration provisions are creatures of contract, courts are bound under the Federal Arbitration Act – and under most if not all state counterparts to that act if federal law doesn’t apply – to honor those contracts. This lets parties customize their arbitration process.

Which is great. Until it’s not.

Consider this case

Let’s look at a scenario that illustrates the point.

One of the parties has had good experience with arbitration. It won the last one it was in. It found it was less expensive and faster than litigation normally is. It liked the idea that an arbitrator who is familiar with business issues – rather than an overworked judge and a jury –would decide the case.

The other party reluctantly agrees to arbitration, but wants a few “protections.” First, it wants to be sure the arbitrator only decides contract issues and not tort or statutory issues. Second, if they are going to save money by being fast, it wants to be really fast. The arbitration must be completed within 60 days of filing, with a decision ten days later. To save more money, it sees no reason to pay an arbitration administrator. The parties will just pick a suitable arbitrator. Finally, it is a fan of mediation, so it puts in a mediation provision.

So, after negotiation the parties come up with and arbitration clause that says:

Any controversy or claim arising out of or relating to this contract, or the breach thereof, shall be settled by arbitration under the rules but not the jurisdiction of the American Arbitration Association before a single arbitrator. Before invoking arbitration, the parties shall first mediate their dispute. The arbitration shall take place within 60 days of a party providing the other an arbitration demand. The arbitrator shall have authority only to interpret and apply the terms of the parties’ contract and shall not have the power to apply tort law or statutory law.

The hearing shall be in Minneapolis, Minnesota. The arbitrator shall issue an award within 10 days of the end of the hearing. Judgment on the award rendered by the arbitrator may be entered in any court having jurisdiction thereof.

Is there a problem here?

Let’s assume the parties have a dispute. Seller designs and installs a software enterprise system buyer will use to run its manufacturing and sales operation. Buyer has, it claims, nothing but trouble with the system. It is unable to come to any agreement with the seller and has claims for breach of contract, breach of warranty, and fraudulent inducement. As to the latter, the seller’s sales force assured it that the system was perfect for the buyer’s needs, while in fact buyer has learned that many of seller’s customers have had the same types of problems it has. It claims its employees simply can’t get the system to operate as promised. The seller says buyer has failed to train its employees properly and has not cooperated in working with it to address bugs, which all software has at first. Buyer has gone back to the old system and even just relying on spreadsheets and e-mail to get things done. It has stopped paying its monthly maintenance fees. The seller has, therefore, stopped answering the buyer’s angry calls demanding a fix.

What could go wrong under the above clause when the buyer decides to pursue a claim? Let’s make a list.

First, what if the seller refuses to mediate in a timely way? Off to court they go.

Second, what if the parties can’t agree on an arbitrator? Back to court to appoint one.

Third, what if a party thinks the appointed arbitrator isn’t impartial because she used to work at the other parties’ firm? Who will decide that one since there is no administrator to decide whether to replace the arbitrator? The arbitrator? The court?

Fourth, what if one party won’t pay an arbitration deposit? Will the hearing go forward without one?

Fifth, what happens to the buyer’s UCC (statutory) and fraud (common law) claims? Presumably, the seller can’t just avoid them.  Will there be a separate case in court for those claims? Are the facts found in the arbitration binding regarding the other claims? Will they even be presented? If they are, what if there is a standard award – i.e., just an award that says who wins and who loses and what any damages are --  from which one cannot discern underlying the facts?

Sixth, is there any realistic chance the parties can have a hearing within 60 days? For a case of any size or complexity, is that at all likely? If one side insists, does the arbitrator have authority to hold a hearing after 60 days? Is a decision from a late-held hearing subject to attack for being outside of the arbitrator’s authority?

We could list more likely problems, but you get the idea. Any time you have to litigate to realize the benefits of arbitration, you have lost many of the benefits. And creating nuanced issues about authority of the arbitrator can be expensive. Somebody has to figure them out.

Bad clauses are bad

So, does this mean arbitration is a bad idea? Not at all. Bad arbitration clauses are a bad idea.

Less is more

You are far better off with a simple arbitration clause based on what arbitration providers suggest on their websites. In a business case, you will get something like this:

Any controversy or claim arising out of or relating to this contract, or the breach thereof, shall be settled by arbitration administered by the American Arbitration Association under its Commercial Arbitration Rules before a single arbitrator. The hearing shall be in Minneapolis, Minnesota. Judgment on the award rendered by the arbitrator may be entered in any court having jurisdiction thereof.

Add a choice of law clause if the contract doesn’t already have one.

This type of clause has been reliably putting disputes into arbitration for decades. Normally, you are better off having a skilled arbitrator work with the parties to fashion a fair process that will fit the dispute than trying to work around arbitration provisions that cause problems.

Being a little more complicated

To be sure, you can be a little more detailed in your clause if you are careful. AAA has a tool called ClauseBuilder® that you can access online to build some things in. You can require a mediation before bringing a demand and have a process for enforcing the requirement. You may want to have a panel of arbitrators for matters over a certain dollar amount, for example. You can do that too.

But be careful. If you create something too elaborate you can create unnecessary problems that an arbitrator – or a court – must decide.