Contract Time Bomb #3: The Arbitration Clause

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This is the third and final article in the series “Contract Time Bombs,” where I address common contract terms that could leave your company financially and legally exposed.  These articles address where they are, what they mean, and ways to help fix them.

As I wind up my little mini-series about common contract terms that business owners and managers should be wary of, I felt that I needed to give a shout-out to arbitration.  Arbitration clauses are very common, especially when businesses interact with other businesses.

Here is your typical vanilla arbitration clause used by businesses that is usually upheld by courts:

Any controversy or claim arising out of or relating to this Agreement or the breach thereof, or any dispute that arises with regard to the interpretation of any provision of this Agreement, shall be settled by arbitration administrated by the American Arbitration Association under its Commercial Arbitration Rules, and judgment on the award rendered by the arbitrator(s) may be entered in any court having jurisdiction thereof.

Most lawyers feel that arbitration is the most economical alternative to going to court, so including similar arbitration clauses in contracts are generally encouraged.  Among many benefits, arbitration involves less discovery, less chances of a ruling being overturned, and fewer motions being thrown over the fence by the opposing attorneys, which all add up to lower legal fees.

But just like everything in life, there’s the good, and there’s the ugly.  So would it surprise you if I told you that arbitration sometimes is more expensive and takes longer than litigation?   In one case study, the fees spent on arbitration were more than 45% higher than those spent on litigation, which equated to the average cost of litigation being over $30,000 cheaper than its counterpart.  Plus, the arbitration cases on average took longer to resolve by about two months.

Arbitration clauses are not a one-size-fits-all solution, so customization of the the clause is absolutely vital in order to maximize its economic advantages.  Arbitration clauses that are lazily written and aren’t flexible enough to accommodate different situations, could end up costing your company more money and time than going the litigious route.

Let’s explore some tips on ways to trick those arbitration clauses out.

Tip #1: Specify the Number of Arbitrators

Under the default rules of the American Arbitration Association (AAA), disputes under $1,000,000 will be heard by one arbitrator.  For disputes greater than $1,000,000, three arbitrators are used.   Having a single arbitrator has its advantages because it makes the decision process more streamlined and efficient.  But some businesses may find that a single arbitrator may not be the wisest choice, especially if the issue is a very complex one that spans across several areas of expertise.

Keep in mind that you will have to pay for every arbitrator used, and their rates vary widely depending on the arbitrator’s credentials.  I have seen arbitrator fees for as low as $300 per day, to as much as $650 per hour.

Also keep in mind that the more arbitrators you use, the harder it is to coordinate schedules.  The harder it is to coordinate schedules, the longer the resolution process will take, and you guessed it–more fees will be assessed.

To balance these concerns, you may want to incorporate a custom clause that increases the dollar threshold for more arbitrators.  Here is an example of the clause that incorporates a $1.5M threshold:

Any controversy or claim arising out of or relating to this agreement shall be settled by arbitration administered by the American Arbitration Association in accordance with its Employment Arbitration Rules and Mediation Procedures and judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof.
Claims shall be heard by a single arbitrator, unless the claim amount exceeds $1,500,000, in which case the dispute shall be heard by a panel of three arbitrators.

Tip #2: Specify the Selection Method

Unless the parties specify otherwise, the default rules of the AAA specify that a single arbitrator is selected by AAA.  For more than three arbitrators, the process used is the list method.  The list method gives a list of AAA selected arbitrators to each party, and each side strikes out a certain number of candidates.  The remaining candidates are ranked in order of preference, and those that are the most acceptable to both parties are then chosen.

This default method may be inadequate if the parties want more control over who is chosen.  The list provided by AAA is generated from its internal database and is based on what the AAA feels the necessary qualifications are.  Because the parties have no control over which names make it on the list, they may find that the arbitrators they must choose from don’t have a very specific skill set needed for the task, especially if the issues are complicated.

One way to overcome this is to include wording that specifies the minimum qualifications each arbitrator must possess, and allow each party to choose one arbitrator who satisfies these minimum qualifications if a three member panel is needed.  The two selected arbitrators would then select the third member, or AAA would decide if the two could not come to an agreement.

Here is an example that could be found in an intellectual property contract that illustrates this qualification requirement:

Any controversy or claim arising out of or relating to this agreement shall be settled by arbitration administered by the American Arbitration Association in accordance with its Employment Arbitration Rules and Mediation Procedures and judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof.  Claims shall be heard by a single arbitrator, unless the claim amount exceeds $1,500,000, in which case the dispute shall be heard by a panel of three arbitrators.

Within 15 days after the commencement of arbitration, each party shall select one person to act as arbitrator and the two selected shall select a third arbitrator within ten days of their appointment. If the arbitrators selected by the parties are unable or fail to agree upon the third arbitrator, the third arbitrator shall be selected by the American Arbitration Association. The arbitrator(s) shall be licensed as a Patent Attorney by the United States Patent and Trademark Office, and have at least seven (7) years of experience working with patents.

Tip #3: Specify What Rules Apply

The thing that I absolutely LOVE about arbitration is that you have the freedom to choose what rules will govern your agreement.  You don’t have to be bound by the rules of evidence, procedure, or any other laws that govern suits filed in the courts.  You can literally choose another organizations’s bylaws as those to apply to any dispute.   For companies involved in specialized niches, or who are members of a larger organization or guild, this could be a significant benefit if those rules are relevant to the business at hand.

But most businesses don’t take advantage of this, and are therefore bound by the default rules of the AAA.  Currently, there are seven main sets of rules that the AAA use: Commercial, Construction Industry, Consumer, Employment, Labor, International Dispute Resolution, and Optional Appellate.  For most disputes among businesses, you can probably imagine they fall under the Commercial Rules.  Again, this one-size-fits-all approach may not be the best thing for highly sophisticated interactions.

So, in keeping with my IP theme above, below is the clause designating an organization’s rules as the governing body of laws:

Any controversy or claim arising out of or relating to this agreement shall be settled by arbitration administered by the American Arbitration Association in accordance with its Employment Arbitration Rules and Mediation Procedures and judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof.  Claims shall be heard by a single arbitrator, unless the claim amount exceeds $1,500,000, in which case the dispute shall be heard by a panel of three arbitrators.

Within 15 days after the commencement of arbitration, each party shall select one person to act as arbitrator and the two selected shall select a third arbitrator within ten days of their appointment. If the arbitrators selected by the parties are unable or fail to agree upon the third arbitrator, the third arbitrator shall be selected by the American Arbitration Association. The arbitrator(s) shall be licensed as a Patent Attorney by the United States Patent and Trademark Office, and have at least seven (7) years of experience working with patents.

Arbitration shall be governed by the rules and regulations of the World Intellectual Property Organization.  If those rules are silent as to a disputed issue, the Commercial Arbitration Rules of the AAA shall apply.  

 

There are a other factors to consider when writing or negotiating an arbitration clause, such as duration of the proceedings, discovery, locale, and remedies, but these tips will help to get you thinking in the right direction.  With an arbitration clause, customization is the key to maximizing cost savings.  Remember to try and think of different ways the deal could go wrong, and draft around those scenarios.

Now, go fix those contracts!

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