Arbitration provisions have become commonplace in commercial agreements throughout a wide variety of industries. They are often inserted into contracts as part of the standard dispute-resolution language, sometimes with relatively little discussion between the parties.
That can be a mistake.
Whether arbitration is advantageous depends heavily on the nature of the transaction, the parties involved, the types of disputes that are most likely to arise and the business objectives that would matter most if the relationship breaks down. For some companies and some disputes, arbitration can provide substantial advantages over litigation. In other situations, an arbitration clause can eliminate important procedural protections, significantly increase costs, and make an otherwise straightforward dispute more difficult to resolve such as where only certain parties involved in a dispute are actually bound to arbitrate.
The better approach is to treat the dispute-resolution provision as a negotiated business term rather than boilerplate.
Why businesses choose arbitration
One of arbitration's principal attractions is privacy. Court proceedings are generally public. Complaints, motions, judicial opinions, and sometimes sensitive exhibits may be accessible to competitors, customers, investors, employees and the press. Arbitration is typically conducted outside the public court system, which can be particularly valuable when a dispute involves confidential business information, pricing, customer relationships, intellectual property or allegations that could create reputational concerns.
Arbitration can also provide the parties with greater control over the decision-maker. In court, the parties generally have little control over which judge will hear the case, and a jury may ultimately decide disputed factual issues. In arbitration, the parties can often select an arbitrator with relevant experience in a particular industry or type of transaction. That can be particularly beneficial in technically complicated disputes where industry knowledge may reduce the time necessary to educate the decision-maker.
Another frequently cited benefit is efficiency. Arbitration can eliminate some of the procedural layers associated with traditional litigation. The parties may be able to limit discovery, avoid lengthy motion practice, establish firm hearing dates and obtain a decision more quickly than they would through an overburdened court system.
Arbitration may also provide greater finality. Judicial review of arbitration awards is generally quite limited. For a business seeking closure, that can be an advantage because the dispute is less likely to continue through years of appellate proceedings.
But many of those same features can become disadvantages depending on the dispute.
The potential downsides of arbitration
Arbitration is not necessarily inexpensive.
The parties ordinarily must pay the arbitrator or arbitration panel, as well as administrative fees charged by the arbitration forum (e.g., AAA, JAMS, or FINRA). In a substantial commercial case involving three arbitrators, those expenses can become significant. In court, the parties do not pay the judge by the hour.
The expectation that arbitration will involve streamlined discovery can also prove inaccurate. Large commercial arbitrations increasingly resemble traditional litigation, including document production, electronic discovery, depositions, expert witnesses, dispositive motions and lengthy evidentiary hearings. When that occurs, a business may incur many of the costs of litigation while also paying substantial arbitration fees.
Limited appellate rights are another double-edged sword. Finality is attractive when the arbitrator reaches the correct result. It is considerably less attractive when a party believes that the arbitrator misunderstood the contract, improperly excluded evidence or made a significant legal error. Courts generally will not overturn an arbitration award merely because a judge might have reached a different conclusion.
Arbitration can also create complications when a dispute involves multiple parties or related agreements. A commercial controversy may involve customers, vendors, lenders, owners, guarantors, insurers, subcontractors or affiliates. If some parties are subject to arbitration agreements and others are not, related disputes may proceed simultaneously in court and arbitration. Instead of simplifying the dispute, the arbitration provision may fragment it.
Similarly, arbitration may be less desirable when a party expects to need immediate judicial remedies such as an injunction, attachment, receivership or other emergency relief. Although arbitration rules often provide mechanisms for emergency relief, court procedures may offer broader or more readily enforceable remedies in certain circumstances.
When arbitration often makes sense
Arbitration can be particularly attractive in commercial relationships where confidentiality, specialized expertise, and speed are more important than broad discovery or appellate review.
Examples may include:
· Technology and licensing agreements involving proprietary information or technical issues.
· Intellectual-property or trade-secret disputes where confidentiality is critical.
· Joint ventures and closely held business disputes where public litigation could damage the underlying enterprise.
· Construction and engineering disputes that may benefit from an arbitrator with industry experience.
· International commercial agreements where the parties may prefer a neutral forum rather than the courts of either party's home jurisdiction.
· Transactions in which the parties expect disputes to involve relatively narrow contractual or accounting issues that can be resolved efficiently by an experienced commercial arbitrator.
In those circumstances, carefully designed arbitration procedures may significantly improve the dispute-resolution process.
When court litigation may be preferable
Traditional litigation may be preferable where a party anticipates needing broad discovery, meaningful appellate review, extensive third-party participation or powerful judicial remedies.
For example, litigation may be more attractive in disputes involving allegations of fraud, fraudulent transfers, complex financial transactions or misconduct involving multiple entities. Those cases frequently require subpoenas to banks, accountants, former employees, lenders, business partners and other third parties who never agreed to arbitrate.
Court proceedings may also be preferable when establishing legal precedent matters. Arbitration decisions ordinarily do not create published precedent. A company seeking a definitive judicial interpretation of contractual language, intellectual-property rights, restrictive covenants or another recurring legal issue may benefit from a public court ruling.
Businesses should also think carefully before agreeing to arbitration when they are likely to be the plaintiff in disputes involving unpaid invoices or straightforward breaches of contract. Filing a collection action in court may sometimes be simpler and less expensive than initiating an arbitration and paying administrative and arbitrator fees.
The arbitration clause matters as much as the decision to arbitrate
One of the most important lessons for businesses is that arbitration clauses are highly customizable.
The relevant question is not simply, "Should this contract require arbitration?" The more useful question is, "If a dispute occurs, what should the arbitration actually look like?"
Among other things, the parties can address:
· Whether one or three arbitrators will decide the dispute.
· The qualifications the arbitrator should possess.
· Where the arbitration will occur.
· Which arbitration rules will apply.
· Whether discovery will be limited.
· Whether depositions will be permitted.
· Whether dispositive motions may be filed.
· How quickly a hearing must occur.
· Whether the arbitrator must issue a reasoned written decision.
· How arbitration costs will be allocated.
· Whether attorneys' fees may be awarded.
· Whether certain claims, such as requests for injunctive relief or collection actions, may still be filed in court.
· Whether disputes involving multiple related contracts or parties may be consolidated.
These details can dramatically affect the cost and outcome of a future dispute.
For example, a contract may provide that disputes below a certain dollar amount will be heard by a single arbitrator using expedited procedures, while larger disputes receive more extensive discovery. Another agreement might require arbitration for most disputes but expressly permit either party to seek emergency injunctive relief in court.
Thoughtful drafting can capture many of arbitration's advantages while reducing some of its risks.
Avoid treating dispute resolution as boilerplate
When parties negotiate a commercial agreement, considerable attention is usually devoted to pricing, performance obligations, representations, warranties, indemnification and termination rights.
The dispute-resolution provision deserves the same attention.
At the time a contract is signed, neither party expects the relationship to fail. But the terms governing how a future dispute will be resolved can become some of the most consequential provisions in the entire agreement.
The best arbitration clause is therefore not necessarily the broadest arbitration clause - or even an arbitration clause at all.
It is the dispute-resolution mechanism that fits the transaction.
Before including an arbitration provision in a significant commercial agreement, businesses should consider the likely nature of future disputes, the need for confidentiality, the importance of discovery and appellate rights, the potential involvement of third parties and the remedies that may ultimately be required.
A few minutes spent analyzing those issues when the agreement is negotiated can substantially affect the cost, speed and strategic landscape of litigation years later.
This article is for general informational purposes only and does not constitute legal advice. Whether arbitration is appropriate, and how an arbitration provision should be drafted, depends upon the particular transaction, applicable law and the parties' objectives.