Things To Consider Before Including An Arbitration Clause In Your Contract

[¹This article is adapted from other articles by the author appearing in Lawyers' Mutual Insurance Company Bulletin (A Report on Legal Malpractice Prevention Issues), Vol. 13, No. 1, April, 1998 ("Clauses in Attorney-Client Retainer Agreements Requiring Arbitration of Legal Malpractice Claims"); and in ADR Report (published by Pike & Fischer, Inc., a subsidiary of The Bureau of National Affairs, Inc., 4600 East-West Highway, Suite 200, Bethesda, MD 20814-1438), Vol. 1, No. 12, June 10, 1998 ("Arbitration Clauses in Attorney-Client Fee Agreements"); and in The Docket, the official magazine of the San Mateo County Bar Association, Vol. 34, No. 3, November/December, 1998 ("Things to Consider Before Including an Arbitration Clause in Your Retainer Agreements").]

Arbitration can be a very effective forum for the resolution of disputes - but only under the right circumstances. In this article I discuss ways to avoid the pitfalls of arbitration, as well as ways to take advantage of its positive features.

The effectiveness of any Alternative Dispute Resolution ("ADR") session depends on three factors: (a) choosing the right procedure, and tailoring that procedure to fit the parties and the dispute; (b) choosing the right neutral; and (c) engaging in your chosen ADR process at the right time in the life of the dispute.

Getting each of these aspects right requires understanding a good deal about the context of the dispute, e.g., what type of dispute it is, the psychology of the parties involved, the economic situation, and so on. So when it comes to deciding whether or not to include an arbitration clause in a contract, ask yourself the following questions: Is it better to make this critical decision in a vacuum, before you have a grasp of what the dynamics of the dispute are going to be? Or is it better to see what shape the dispute takes, who the parties and players are, etc., before committing to one dispute resolution process or set of rules over another?

The obvious advantage of including an arbitration clause in your contract before the dispute arises is that once the dispute does arise, you can force the dispute out of the court system, and you can force the other side to arbitrate. But the good news can also be the bad news, if you're not careful. As often as not, I've seen situations where being bound to take a particular dispute to arbitration turned out to be a disadvantage. But how do you tell beforehand?

The answer to this question is that there is no easy or single answer that covers all situations. As a general rule, though, I think in the long run it's better to turn to arbitration after the dispute has arisen, than before.

Deciding whether or not to have a mediation clause in your contract isn't as critical as deciding whether to have an arbitration clause, because many cases end up in mediation anyway, even without a pre-dispute agreement. Also, if you mediate a case under the wrong circumstances, or with the wrong neutral, etc., generally the most you stand to lose is the time and money you put into the sessions.

But if you make the same mistake with arbitration, you can wind up with a result that is not only difficult to accept, but binding and final as well, and with an almost non-existent right of appeal.

Proponents of arbitration say the real issue is not so much whether to arbitrate at all as it is when to enter into the agreement to arbitrate, what procedural rules will govern the resolution process, who will decide the case, and so on. But before dealing with whether or not to include an arbitration clause in your contract, it may help to first review some of the upsides and downsides of engaging in arbitration in general.

The Advantages of Arbitration over Traditional Litigation and Trial

There are several reasons why choosing to arbitrate a dispute can sometimes be a good decision:

1. The decision-maker(s) can be hand-picked, usually for special expertise, but also for temperament and other qualities.
2. With relaxed rules of pleading and evidence, it is often easier, less time-consuming and thus less expensive to put on the case.
3. An arbitration can be scheduled, conducted and concluded more quickly and conveniently than a court or jury trial.
4. An arbitration can be held in private, without public scrutiny, and transcripts of sworn testimony or other proceedings are not made except pursuant to agreement.
5. For defendants, there is usually less chance of a 'runaway verdict.'
6. The decision-maker generally will focus on the merits of the case and will make a decision based upon what's fair, which means there is less chance of a harsh result based on a technicality or procedural fluke.
7. You can 'hand-craft' an arbitration procedure that fits the dispute. For example, arbitration allows the parties to agree to certain limitations on the amount or nature of the award beforehand (such as a 'high-low' cap on total damages, or a limit on one type of damages, such as attorney's fees or punitive damages). It also allows for unique procedural rules, such as 'baseball' arbitration (where each side provides a number and the arbitrator can only choose one or the other number), or 'night baseball' (where the arbitrator is not informed of each side's number), and so on. The fact that your procedural options are unlimited is one of the biggest advantages of arbitration, but it is an advantage that many attorneys don't think about often enough.

   If an arbitration is designed properly, with eyes wide open as to what the procedures and rules of the arbitration are and what effect they're going to have, you can eliminate or at least minimize just about every negative aspect of trial before a judge or jury. Arbitration works best where the parties in dispute either have a long track record of handling disputes that arise between them, and everyone is familiar with the drill (such as in the construction industry), or where past or ongoing relationships will provide the impetus for the parties to craft mutually beneficial procedural rules (usually in business settings). Drafting the right kind of arbitration agreement before the dispute arises is usually easier in such contexts, because you have a better handle on what your client is getting into.

In other settings, however, arbitration can present a number of problems.

The Disadvantages of Arbitration

As the cynic would say, arbitration is always a good idea -- as long as you win. There is some truth to that, but unfortunately many of the judgment calls we attorneys make can never be anything more than educated guesses. The problem with deciding whether to include an arbitration clause in any agreement is how to accurately foresee, before the dispute arises, whether arbitration is going to be beneficial or not. Here are some reasons why arbitration may not always be a good idea:

1. There is rarely if ever any right to appeal or vacate an arbitration award if a mistake is made, even a gross mistake which could not have been anticipated. (Calculational mistakes can be corrected, but not mistakes which stem from the arbitrator exercising his or her discretion. In general, even if you have a clause which commands the arbitrator to follow the law, you still have little practical recourse if he or she doesn't.)
2. The arbitrator or panel of arbitrators can be every bit as arbitrary as any judge or jury. Whether consciously or not, sometimes they can be even more subject than a judge or jury to outside influences (such as favoritism, the desire not to offend, lack of accountability, etc.). These subtle tendencies become all the more critical when you consider that an arbitrator by law is expressly allowed to exercise much more discretion than a judge or jury, yet the grounds for overturning an arbitrator's decision are few, and the chances of succeeding slight. Also, depending on the forum or procedural rules you choose, the arbitrator may or may not have much subject matter expertise, and may not even be a lawyer.
3. It can be much more difficult to get adequate discovery in arbitration proceedings, especially if the other side is not cooperative. You can (and almost always should) tailor an arbitration agreement to provide clear rules for discovery, but no matter how much you try to fine-tune this, it can still be a trap. Once you've articulated one special provision, you haven't articulated a host of others -- yet drafting many specific provisions isn't necessarily an automatic tonic either, because ambiguity can arise from saying too much just as easily as it can arise from saying too little.
4. One cannot effectively demur or obtain summary judgment or adjudication in an arbitration. Many claims are defeated on statute of limitations or other legal grounds, such as a lack of duty or causation, so taking away the ability to demur (which means to get the case thrown out at the pleading stage, before the merits are addressed) or to get summary judgment based on a legal proposition is a definite disadvantage. Technically an arbitrator can rule based solely on written submissions, but as a practical matter it rarely happens. Thus even if arbitration may usually be less expensive when compared to a full trial, the flip side is that there is rarely any way to avoid going through with a full-blown arbitration hearing, because as a practical matter there is no resort to summary proceedings.
5. Depending upon the rules under which you are proceeding, it can sometimes be difficult to control improper or unethical behavior by the other side. This is especially true with clients representing themselves in pro per. There is no person with a robe and gavel to turn to in order to keep litigants and their attorneys in line.
6. Arbitration typically lacks many of the procedural safeguards with which we are so familiar in the civil courts. Arbitration's lack of procedural formality can be a positive factor (e.g., in limiting preparation and presentation time, and in limiting the expenses of litigation generally), but it can also become problematic when, for example, your opponent becomes so enamored of the informal nature of the proceedings that he conveniently forgets he shouldn't tell the arbitrator that six months ago your client had already offered to settle this case for $50,000, or some other such inadmissible, irrelevant bit of evidence. Sometimes it can be more difficult to 'unring the bell' in arbitration than in the civil courts. Technically an arbitrator has the power to declare a 'mistrial,' but in practice it rarely if ever happens.
7. Constitutional, public policy, or other 'cutting edge' legal issues often do not fare as well in arbitration as they do in court, for the same reasons.
8. One is less likely to prevail with so-called 'procedural' or 'technical' defenses, such as the statute of limitations, partly because of human nature, and partly because arbitrators are allowed to focus on fairness, without having to follow the letter of the law.
9. Solomon only threatened to do what arbitrators have a bad reputation for doing frequently: 'splitting the baby.' This reputation may not be as deserved as some think, but if you have a strong procedural or legal defense, or if victory for you is going to mean a harsh result for the other side, you may be better off in court.
10. Arbitration is not always quicker than going to court. The informality of arbitration can often speed cases to resolution, but it can also allow a case to drift -- and once that starts to happen, it can be difficult to get it back on track. I have seen arbitrations that would have been a three-day court trial last for nearly a year.
11. Sometimes arbitration can become every bit as expensive as proceeding in court, particularly with a three-arbitrator panel. By the time you pay your own arbitrator and half the neutral arbitrator's bill, rent the office space for the arbitration to take place, and pay your attorney for reviewing his or her notes from the last three sessions which have taken place in bits and pieces over the last six months because of everyone's busy schedules, the bills can mount nearly as high as they might for a trial. This is a frequent client complaint, and something to watch out for when touting the benefits of arbitration to a client.
12. The rules under which you are proceeding (or lack of understanding or consensus as to such rules) can often lead to unexpected results, delays and other procedural logjams (such as a detour in court to fight over just what is arbitrable and what is not). The rules of the road for court proceedings, as cumbersome as they are, are at least well-defined, more predictable and more familiar to all involved.
13. Depending upon a number of factors, an arbitration award often will not operate as collateral estoppel or res judicata. The legal principles of res judicata and collateral estoppel general refer to the ability to have a lawsuit thrown out because the issue (or certain issues) have already been litigated. Arbitration often lacks formal pleadings, and a verbatim record is almost never made (and in fact in some circumstances is prohibited), so it can sometimes be difficult to prove exactly what was litigated, or ruled upon.

Obviously, the optimum would be to be able to decide whether or not to arbitrate (and if so, what the particular rules of the arbitration are going to be) after the dispute has arisen, i.e., after you know the basic contours of the dispute, who the parties are, what your best and worst claims or defenses are going to be, and so on. But you can't compel the other side to arbitrate if you haven't agreed to it in advance, so there are trade-offs involved in having or not having an arbitration clause in any contract.

Since theoretically both sides can agree to arbitration at any time in the life of the dispute, the only real advantage to having an arbitration clause in a contract is the ability to force the other side to arbitration even if they don't want to go, or to force the other side to abide by a particular procedural rule. So before you put that arbitration clause in the contract, you have to make a judgment call as to whether it is more likely than not that you would want to be able to force the other side to arbitrate, or force them to accept any particular rules or procedures for the arbitration. And even if you draft the cleverest clause or procedural rule imaginable, you should first think through what the ramifications could be if you were to find yourself on the wrong end of your own clever clause when a dispute actually arises.

Special Considerations for Arbitration Clauses

1. If a dispute arises, how likely is it that the other side will represent him or herself? It is much more difficult to deal with an in pro per litigant in an arbitration context than in superior court.
2. Do you want to specify a particular organization to conduct the arbitration, such as the American Arbitration Association (AAA), Judicial Arbitration and Mediation Service (JAMS), or Center for Public Resources (CPR)? The benefit is that you buy into a fairly specific set of procedural rules, you have some enforcement abilities, and you have a decent chance of getting a good arbitrator. The downside can be extra administrative expense, getting blind-sided by unfamiliar procedural rules, or being limited in choosing the best arbitrator or otherwise tailoring the procedural rules to best fit the dispute.
3. If your arbitration clause does not specify that you will be proceeding under the rules of a particular organization, your arbitration proceedings will be governed by the California Code of Civil Procedure (section 1280, et seq.), or the Federal Arbitration Act (9 U.S.C. section 1, et seq.). Whichever set of rules you choose to bind yourself to, you absolutely should read them before drafting any arbitration clause. There are some quirks in the different statutory and private arbitration schemes that could either help you or hurt you (particularly with regard to the ability to get discovery, and jurisdictional issues for enforcement).
4. Regardless of what basic set of rules you are proceeding under, do you want to specify any other particular procedural rules beyond those already spelled out? You can tailor language to fashion specific rules concerning how discovery can be conducted, or how closely the arbitrator must follow the rules of evidence, or the law in general. You can put limits on what powers the arbitrator will or will not have to award certain types of damages, and you can specify whether the arbitrator must render a "reasoned opinion" (like a statement of decision), or whether you just want an award that says who wins, and how much money if any is awarded. But if you do attempt to customize your arbitration clause in any respect, consider how easy or difficult it may be to enforce those rules if the other side balks. An inexpensive arbitration can quickly turn expensive if you end up in court trying to determine threshold procedural issues, such as what disputes the arbitrator may rule upon, what power the arbitrator really has, what types of damages he or she may award, and so on.
5. One of the biggest fears people have about arbitration is the inability to appeal, and you will often see arbitration clauses which purport to establish a right of appeal in the parties. If you think you can do that, you should first read Old Republic Ins. Co. v. St. Paul Fire & Marine Ins. Co. (1996) 45 Cal.App.4th 631. That case held that parties cannot simply stipulate to confer jurisdiction by the Court of Appeal over their arbitration award. The rationale given by the Fourth District was that the Court of Appeal only has jurisdiction to decide whether a judgment was entered in error, and in that case there was nothing wrong with the judgment -- the trial court had simply entered the judgment upon the arbitration award which the parties had jointly asked it to enter, and since that judgment was "correct," it was not appealable. Despite the holding in this case, there still may be ways to get into the Court of Appeal after an arbitration. For example, noted arbitration expert James R. Madison has suggested that since one of the statutory grounds for vacating an arbitration award arises when the arbitrator exceeds his or her power (California Code of Civil Procedure section 1286.2), if your arbitration agreement expressly states that the arbitrator's power is limited to rendering an award in conformity with law, you could theoretically move the court to vacate an 'incorrect' award that did not follow the law, and the trial court's decision on such a petition could be appealed. Or you might consider drafting an arbitration clause requiring the arbitrator to render a proposed statement of decision to which the parties can respond before the final award is issued -- a sort of poor man's appellate process, if you will.
6. If the contract in question is a retainer or fee agreement with an attorney, be careful about the distinctions between arbitrating fee disputes and arbitrating legal malpractice claims. The law is currently in a state of flux on this issue. There are cases that say it's okay for an attorney to enforce an arbitration clause which covers malpractice claims (Lawrence v. Walzer & Gabrielson> (1989) 207 Cal.App.3d 1501, and more recently Powers v. Dickson, Carlson & Campillo (1997) 54 Cal.App.4th 1102, mod. at 55 Cal.App.4th 923b); but there is one case which says it's against statutory and public policy to have a pre-dispute binding arbitration clause over feedisputes between the attorney and the client (Alternative Systems, Inc. v. Carey (1998) 67 Cal.App.4th 1034, which discusses the unique, non-binding arbitration process administered by the California State Bar which attorneys must offer to their clients by law before they can sue their client over unpaid fees). If this is an issue which interests you, you should consult an attorney about it, as there are important considerations too detailed to cover in this article. This "Mandatory Fee Arbitration" procedure is set forth in the California Business & Professions Code beginning at Section 6200.

Mediation Clauses in Contracts

Mediation clauses, on the other hand, do not carry nearly the baggage that arbitration clauses do, primarily because of the non-binding nature of the process. Although there can be problems with mediating a case before everyone is ready, in the long run there is probably nothing much wrong with including a mediation clause in a fee agreement. Usually the most that can be lost is the time and expense involved in conducting a failed mediation (although sometimes one must also be careful not to discuss a case too candidly with the other side before the players have been pinned down with sworn testimony).

Aside from wasting time or tipping one's hand too early, another possible downside of a mediation clause is simply the procedural logistics, if the other side balks. Mediation clauses are difficult to 'enforce,' and for some the very notion of 'forcing' someone to mediate is something of a non sequitur. You could draft a clause which says (as some statutes and contracts do) that a complaint filed prior to a bona fide attempt to mediate can be subject to a motion to strike -- but think realistically about your chances of success on such a motion if striking the complaint would result in the other party's loss of the entire claim.

On balance, there is probably no harm in including a mediation clause in your contract, and it may even help. If nothing else, a mediation clause in a fee agreement at least shows your good faith, and that alone can sometimes create a climate more conducive to eventual settlement, regardless of whether or not the dispute is actually mediated early, as contemplated by the mediation clause. Having a mediation clause can create a good starting point for discussion or negotiation, which might help avoid a lawsuit. But in this day and age where nearly every case goes to mediation anyway, there is nothing urgent about including such a clause.

Conclusion

While as a general matter it is always a good idea to use ADR techniques to resolve disputes, one must still exercise caution when drafting pre-dispute contract clauses requiring the use of ADR, particularly arbitration clauses. Willing parties can always agree to arbitrate any issue they want at nearly any stage of a dispute, so just because you don't have an arbitration clause doesn't mean you can never arbitrate the case.

A carefully crafted arbitration agreement can often be an effective way of dealing with many different types of disputes - but it's almost always better if the agreement to arbitrate is entered into after you know what the dispute involves, who the parties are, and what types of considerations are raised by the overall dynamic of the dispute.