Alternatives to Arbitration: Reconsidering the Use of Arbitration Provisions in Contracts

Posted: November 22nd, 2013

by Adam J. Eckstein and Matthew P. Gabriel

Contract provisions requiring parties to arbitrate their disputes are ubiquitous, and almost always, these clauses are ancillary to the contract’s purpose. For that reason, it may be tempting to let a boilerplate arbitration clause remain in a contract and not waste time or resources negotiating its inclusion or exclusion. We caution otherwise.

Contrary to popular belief, arbitration may cost more and take longer to resolve a dispute than litigation. This is not to say that arbitration is never useful. Nor is it to say that contract drafters must accept unrestricted litigation as the only avenue available to resolve contract disputes. A contract creates a specific relationship for a specific reason. Contracting parties should consider the unique risks of the disputes that might arise from the contract. The parties then can replace the boilerplate arbitration clause with an alternative that avoids the costly components of litigation while retaining its benefits.

The Case Against Arbitration

Evidence suggests that arbitration costs meet or exceed litigation costs. A comparative study of nine single-plaintiff cases resolved through arbitration to ten single-plaintiff cases resolved in court showed that, on average, the total cost of counsel and fees for arbitration was $102,338.02 while the total cost for litigation was $70,490.82. The extra cost did not reduce the time to resolve the dispute. The nine cases in arbitration took an average of 21 months to resolve while the ten cases in litigation took an average of 19 months to resolve.[1]

This is not surprising. Arbitration includes costs not found in litigation, including filing fees that may rise with the amount in controversy, hourly rates for the arbitrator(s), and costs for the hearing room. Moreover, arbitration frequently uses discovery in the same manner as litigation, so arbitration no longer enjoys that cost savings compared to litigation.

Arbitration provides some benefits unavailable in litigation. First is confidentiality; except in extenuating circumstances, documents filed with the court are matters of public record. Arbitration can be entirely confidential. Second is experience of the decision-maker; litigants cannot select their judge. Parties to arbitration may require that the arbitrator have certain experience in the field in which the cause of action arose. Third, arbitration provisions are useful in avoiding unfavorable jurisdictions. Finally, arbitration can be effective at avoiding class action litigation.

These benefits may be offset, however, by myriad detriments and risks. Foremost is that arbitrators have authority only over the parties to the contract. If your dispute involves a third party to the contract who has not agreed to arbitration, the arbitrator cannot require that party to participate in arbitration. In such cases, you may have to proceed against one party in arbitration and another party in court and risk inconsistent results. Or, if your dispute turns on the testimony or documents of third-parties who are not bound to the arbitration agreement, the arbitrator may have limited ability to subpoena the witnesses or their documents.

Furthermore, arbitrations do not adhere to the rules of civil procedures used in courts. Some boast this as a benefit to arbitration – avoiding strict procedural rulings so arbitrators can get to the meat of the conflict. We disagree. Procedural rules, which permit motions to dismiss or motions for summary judgment, help combat frivolous claims and require an actual controversy of facts for a case to go to trial.

Finally, arbitration is subject to very limited review. A court may overturn an arbitrator’s ruling only under certain circumstances. Arbitrators undoubtedly perform their role with best intentions and provide a result they think is correct, but without supervisory authority, the result is often less predictable than with litigation. Federal and state laws require that a court uphold an arbitrator’s ruling even if there is clear error. The U.S. Supreme Court recently stated,

All we say is that convincing a court of an arbitrator’s error – even his grave error – is not enough. So long as the arbitrator was “arguably construing” the contract – which this one was – a court may not correct his mistakes. The potential for those mistakes is the price of agreeing to arbitration.[2]

The parties therefore should exercise great caution before agreeing to divest themselves of their right to appellate review.

Alternatives to Arbitration

That arbitration is costly and risky does not make litigation more palatable. In some instances, litigation presents the risk that the cost of resolving the contract dispute will eliminate the benefit the party received from entering the contract. Fortunately, you do not have to choose between arbitration and unfettered litigation. 

Much of the cost involved in litigation is associated with the breadth of discovery permitted under the rules of civil procedure. In many cases, parties are forced to spend thousands on legal fees and expenses in responding to discovery requests and producing voluminous documents. At the same time, litigation is effective at resolving conflicts because the parties are compelled by a higher authority – the court – to share information and have their problem solved for them. The fear of the result makes mediation, often conducted after substantial discovery, effective. 

Thus, parties desiring to achieve a cost effective middle ground between arbitration and unfettered litigation should consider including provisions in the contract that retain the fruitful components of discovery and litigation. Here are a few ideas that may be helpful to accomplish this result:

  • Adopt a procedure for initiating claims outside of court or arbitration. Perhaps require that the aggrieved party send a demand letter setting forth with reasonable specificity the basis for the claim, and require the opposing party respond with reasonable specificity within a certain number of days. If you require that the letters be made under oath or the penalty of perjury as appropriate, the parties’ rationale can be testimony should alternative dispute resolutions fail.[3]
  • Include a provision addressing the statute of limitations for any claims. Lengthening or reducing the time a party can initiate a court proceeding after sending a demand letter could facilitate negotiations.
  • Mandate meaningful mediation. Mediation is an opportunity for the disputing parties to consider the net present value of the conflict. Consider requiring pre-mediation disclosures akin to those the parties must provide required in the Federal Rules of Civil Procedure; the contract can require broad or narrow disclosures. Also consider requiring the exchange of pre-mediation submissions. The information exchange will facilitate settlement at mediation.
  • Authorize alternate uses of the mediator. In some instances, mediation cannot resolve the conflict, but a mediator can narrow the conflict to a few issues of fact or one issue of law. Permit use of a mediator to set forth proposed stipulations of fact to reduce the scope of the trial if there is no other way to resolve the dispute.

Some contractual disputes can only be resolved through a trial: genuine factual disputes, genuine legal disputes, and disputes in which the parties’ principles are at stake. In such cases, there is no alternative to a jury for a factual dispute or a judge for a legal dispute, and no shortcut for a trial of the parties’ principles. Consider incorporating the following provisions in the event litigation is necessary following an unsuccessful mediation:

  • Limit the parties’ filing discovery with the court until necessary. Depending on the local court rules, discovery may be conducted between parties but not filed with the court until offered as evidence. That way, sensitive information can remain confidential until the case proceeds to trial. Also consider requiring the parties to jointly propose a protective order to keep sensitive information filed with the court confidential to the extent permitted.
  • Require that the parties establish a proposed scheduling order or set forth a scheduling order the parties will propose to the court. The court may not adopt the proposal, and you cannot control how quickly a court determines an issue. However, you can facilitate the court’s determination by requiring the parties to proceed according to stringent pre-trial deadlines.

Finally, include enforcement provisions. Requirements will only be as successful as the contract’s enforcement provisions. Consider shifting attorneys’ fees in the event litigation is necessary to enforce these provisions.

Conclusion

Parties should carefully consider their particular needs before agreeing to arbitration provisions. There are certainly instances in which arbitration better serves the needs of the contracting parties compared to litigation. For parties desiring to achieve a middle ground, we hope the above suggestions allow you to craft an alternative to arbitration that will prevent the cost of any dispute from eviscerating the value of the contractual relationship. Remember that the best time to make rules to resolve your dispute fairly is before the dispute occurs. 

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