Arbitration Clauses: Room for Improvement

By  David R. Dearden, Esq.

The term “arbitration proceeding” carries with it an expectation of a process to resolve disputes that is quick, fair and cost effective.  But does the reality match the expectation?  Like the impact of many contract clauses, the answer to this question can vary greatly depending upon one’s experience with the arbitration process.

Fortunately, in many situations where the parties have agreed to a written contract containing an arbitration provision, the parties never have to resort to arbitration to resolve issues between them.  The advantages and disadvantages of arbitration do not come into clear focus until a disappointed party has made a formal demand for arbitration to ask for an award of damages.

Expenses of Arbitration

Typically, arbitration administrative fees and the fee for the services of an arbitrator are borne equally by the parties.  Depending upon the complexity of an arbitration case, the issues that a party seeks to raise, and the third party designated to administer the arbitration (ADR Options, AAA, American Health Lawyers Association (“AHLA”), DRI and JAMS are examples), the fees and costs of an arbitration proceeding can substantially exceed the flat filing fee that would be required to file the same case in state or federal court. If an arbitration case is prolonged, the arbitrator’s fee can become quite a significant litigation cost, even if each side is only paying half of the total fee. For this reason arbitration may favor the party who can most easily afford the fixed costs of litigation.  In certain consumer transactions, the courts have actually refused to enforce arbitration agreements if the costs impose too great a financial burden on a party who lacks the resources to effectively utilize this dispute resolution mechanism.

Procedural Protections Are Limited

Those who advocate for the use of arbitration proceedings to resolve disputes expect that the legal fees that each party is required to pay will be reduced.  However, by agreeing to the streamlined procedure each party gives up some of the well-established procedural safeguards that are an essential part of American jurisprudence.  For one, the parties forfeit the time honored right to a jury trial and to an automatic right of appeal in the event that a party is not satisfied with the arbitration award.

The right to pre-hearing discovery – interrogatories, document requests and depositions – may be restricted or even disallowed in matters that are arbitrated. In a search for the truth, the inability to obtain discovery may be a significant disadvantage to any party who needs information (inculpatory and exculpatory) from the other party to the arbitration. Arbitrators may also decline to protect certain information from discovery despite the applicability of well-established peer review or other important privileges.

The rights and authority of arbitrators are different than those of a traditional judge. Arbitrators do not have to rule on the admissibility of evidence using the well-established and recognized rules of evidence.  Arbitrators do not necessarily have to issue a reasoned written opinion supporting their awards, which can be frustrating for the parties who would like to know why they either won or lost the case.  Arbitrators may not have the power to grant injunctive relief, issue subpoenas to compel witnesses to attend hearings and/or sanction misconduct by a party with a contempt citation. Arbitrators may not entertain a motion for a mistrial if prejudicial information is “accidently” supplied to the arbitrator by a party.

The rights that a party gives up for the quick, less-expensive and conclusive resolution of a dispute through arbitration are rarely considered or expected by a party signing an agreement with a standard arbitration clause.

Substantive Rights May Also Be Limited

If a party to arbitration proceeding is unable to force the opposing party to produce certain evidence, the party with the burden of proof in a case may simply be unable to successfully prove his or her case.  Similarly, a party may have difficulty defending an action in the absence of sufficient evidence. Many people are unaware of consequences associated with arbitration awards which would not be present in a dispute filed in state or federal court. By way of example, the arbitrator who is selected to hear a dispute may not be familiar with the applicable substantive law. If the arbitrator makes a mistake analyzing the applicable legal principles, this error is generally not reviewable in a court of law.  Further compounding the problem, as previously stated, an arbitrator may not even issue a written opinion with the award for a court to analyze for error.  The finality of arbitration awards, except in the most unique circumstances, is an important reason why disputes are resolved promptly.  But if these disputes are resolved incorrectly due to an error by the arbitrator, the losing party may emerge from the case feeling that the process was fundamentally unfair.

A party may unknowingly waive his or her rights to recover punitive damages by signing an agreement that contains an arbitration clause that requires a particular set of arbitration rules to apply, rules which may alter the damages otherwise available under the common law.  An example of this is a rule published by a respected organization that administers arbitrations. It states: “The arbitrator may not award consequential, exemplary, incidental, punitive or special damages against the party unless the arbitrator determines … that there is clear and convincing evidence that the party against whom such damages are awarded is guilty of conduct evincing an intentional or reckless disregard for the rights of another party ….” (emphasis supplied). Most of us would not expect that by signing an agreement containing an arbitration clause we would be limiting the damages that we could recover in an arbitration proceeding.

Many standard arbitration clauses are plain and simple. An example is as follows:

Any controversy or claim arising out or relating to this contract, or the breach thereof, shall be settled by arbitration administered by [third party] in accordance with its rules and judgment on the award rendered by the arbitrator may be entered in any court having jurisdiction thereof.

It is wise for the party who is asked to sign an agreement containing such a provision to check the rules of the organization named to administer the arbitration to find out what, if any, limitations to the common law exist.

Practical Considerations

There is no doubt that arbitration is a well-respected and important form of dispute resolution.  Arbitrations are generally more efficient and because of this, less expensive than a legal proceeding in court. Many arbitration hearings can be scheduled, conducted, and concluded, more quickly and conveniently than litigation in the courts. Further, arbitration is a private proceeding, unlike traditional litigation, which is public record. However, these benefits do not come without a price.

Arbitrations generally favor the party that can more easily afford the cost of hiring an arbitration company. This process also favors the party that is more likely to control the witnesses and the electronic or documentary evidence. The party defending against claims where the weaker party bears the burden of proof has a clear advantage in an arbitration setting.  Arbitrators deciding cases may not be outraged by the same wrongful behavior that would upset a jury. As a result, awards may be calculated by arbitrators using a sharper pencil than a jury would use.

The limitations introduced through the use of arbitration should be carefully considered by any party who is asked to sign an agreement containing an arbitration clause.  It may not be possible to alter to delete an arbitration provision in an agreement that is presented to a party, especially if the presenting party insists on using arbitration to resolve disputes and has some market power. However, a party should clearly understand what possible effect this clause may have in the event that there is a need to resolve a dispute in the future.

Protective Measures

If a party insists on having an arbitration clause in an agreement, there still may be ways to revise the language of the clause to contractually protect a party’s rights, or at least minimize certain perils associated with arbitration. There is a development in the use of alternative dispute resolution that is relevant to this discussion. In order to reduce the unexpected effect of errors of law by arbitrators, arbitration clauses used by certain parties now include this provision:

The arbitrator shall not have the power to commit errors of law or legal reasoning,

and the award may be vacated or corrected on appeal by a court of competent jurisdiction for any such error.

Without this provision, arbitrators are empowered to base their decision on broad principles of justice and equity. But if an arbitrator is expressly required to decide correctly as to the law, the arbitrator will exceed his or her authority if the decision is not based upon the rules of law. The parties to an arbitration clause may expressly agree, in writing, to accept a broader scope of review of an arbitration and allow the court to correct errors of law made by the arbitrator.

Another provision that has been used to increase the chance of having an arbitrator with knowledge of the substantive law is: “The arbitrator shall be either a retired judge or trained and expert in the area of the asserted claims.”  In addition, to protect the party not controlling documents or information, the parties can agree in their contract that any documents reasonably necessary and requested by either party of the other must be exchanged and that this obligation can be enforced by the arbitrator. A final provision that may add some help to avoid surprises would be: “notwithstanding the arbitration rules, the arbitrator will be instructed to utilize the law of the state in which the controversy takes place.”

This article has mentioned some of the ways that an arbitration clause can be structured to help keep an important and valid dispute resolution mechanism quick, cost-effective and fair. There is every reason to ask for modifications to contract language when a party is considering agreeing to an arbitration clause that will be use to resolve disputes. It is important to the long-term success of arbitration as an alternative dispute mechanism that all parties feel that the arbitration process is fundamentally fair and balanced, even if the resulting award is not viewed with favor by the winning or losing party.

David R. Dearden, Esq. is a shareholder with the health care firm of Kalogredis, Sansweet, Dearden & Burke in Wayne, PA. Mr. Dearden represents licensed professionals in arbitration cases, state and federal court and before the state licensing boards.