Minimizing pre-arbitration litigation

S.C. Justices look at contractually axpanded review clauses

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Avoiding or Minimizing Pre-Arbitration Litigation
by James J. Sentner, Jr.

It is extremely frustrating, if not embarrassing, for transaction counsel to recommend arbitration as an economic alternative to litigation and then find when a dispute arises it takes months, if not years, of litigation to compel the opposing party to proceed with arbitration. Such litigation frequently arises over the following issues:

1. Is there an arbitration agreement?
2. Does the arbitration agreement cover the particular dispute?
3. Did the party signing the arbitration agreement have authority or legal capacity to do so?
4. Do the arbitrators have jurisdiction over the dispute?
5. Can the arbitration agreement be vitiated for fraud, duress, or misrepresentation?
6. Is there a precondition to arbitration that has not been met?

In addition, litigation can arise because

1. One party refuses to appoint its arbitrator
2. The two appointed arbitrators cannot agree on a third acceptable to the parties.

Litigation over these issues can be avoided by careful drafting of the arbitration agreement.  We will put forth suggested wording to keep the dispute out of the courts.

USE A BROAD FORM ARBITRATION AGREEMENT:

While all arbitral bodies offer suggested arbitration clauses that are broad form, they do not provide the kind of detail that is required to cut off pre-arbitration litigation.  Items 1, 2 and 3 above can be kept out of court by granting the arbitrators power to determine those issues.  Language such as: “All claims, disputes, or controversies arising out of, or related to this Agreement, including but not limited to it's validity, scope making, interpretation, enforceability, performance, breach or any challenge to the authority, or capacity of any person signing this Agreement shall be determined by binding arbitration ….”

STIPULATE THE JURISDICTION OF THE ARBITRATORS

The question of the competence of the arbitrators to determine their jurisdiction is dealt within the rules of most major arbitral bodies which grant such power to the arbitrators.  However, there is disagreement among the courts in the United States regarding the effectiveness of incorporation of these rules by merely stipulating the arbitration will be administered by an arbitral body under its rules.  The majority rule is that the parties are free to grant such power to arbitrators but the mere statement that the arbitration will be conducted in accordance with the rules of an arbitral body is not sufficient to empower the arbitrators to determine their own jurisdiction.  The court’s have required a clear and unequivocal grant of power by the parties in their agreement.

A suggested clause is: “The making, validity, scope, interpretation and enforceability of this Agreement, including, but not limited to, who shall be parties to the arbitration, and what issues have been submitted to arbitration shall be determined by the arbitrators chosen in accordance with this Agreement.” 

STIPULATE THE POWER OF ARBITRATORS TO DETERMINE VALIDITY OF THE ARBITRATION CLAUSE

When a party attempts to vitiate its agreement to arbitrate on the grounds of fraud, duress or undue influence, the courts require evidence that the arbitration agreement itself and not just the entire contract was procured by fraud, duress or undue influence.  This is a particularly heavy burden and such a challenge can generally be disposed of in summary proceedings.  However, if there is a concern that an opposing contracting party may, in the event of a dispute, attempt to escape arbitration on one of these grounds, the following language can be employed to provide a parol evidence defense:

“The parties acknowledge that this Agreement to arbitrate has been entered into with the assistance of counsel of each party’s choice and without any fraud, duress, or undue influence.”

KEEP ARBITRATION AND MEDIATION INDEPENDENT

It has become common to contractually provide for mediation and arbitration as consecutive methods of dispute resolution.  However, in doing so, it must be kept in mind that arbitration agreements are enforceable by statutory and treaty mandate.  Mediation, on the other hand (unless court ordered), is strictly consensual. The only way to enforce a contract to mediate is a suit for specific performance which will probably not succeed. If such a suit is successful, a recalcitrant opponent is unlikely to reach a mediated settlement. Therefore, in drafting an agreement calling for mediation and then arbitration, language must be carefully considered in order to avoid an interpretation by the courts that mediation is a condition precedent to arbitration.  If such an interpretation is possible, the arbitration clause may be practically unenforceable.  It is also suggested that the mediation provision be drafted so that if one party refuses to mediate within a stipulated time, the matter can, at the option of the other party, proceed directly to arbitration.  Language that should avoid this issue is as follows: “In the event mediation does not take place or is not successful within 30 days of a demand for mediation, either party may serve a demand for arbitration and proceed as set forth below.”

It may be more effective to move matters forward to provide that during the 30 day mediation period the parties will complete the nomination of arbitrators.  This allows for mediation, but the arbitration is not delayed in the event of an unsuccessful mediation.

MAKE APPOINTMENT OF ARBITRATORS SELF EXECUTING

Once a matter has been referred to arbitration, the Court’s are reluctant to intervene to move the arbitration process along.  It is therefore important to make sure the appointment of arbitrators will be completed even if one party tries to obstruct the process by continual delay in nomination of an arbitrator or in agreeing to a nominated third arbitrator.  This can be accomplished by providing:

Sole Arbitrator: “In the absence of agreement between the parties on appointment of an arbitrator within 15 days of service of a demand for arbitration, the sole arbitrator shall be appointed by the [arbitral body].

Three Arbitrators: “ In the event any party fails to name an arbitrator within 15 days of the service of a demand for arbitration, the party making a nomination may proceed before the arbitrator nominated and that arbitrator is empowered to render interim and a final award binding upon all parties to this Agreement.  Should the two appointed arbitrators be unable to agree on a third arbitrator within 15 days of their nomination, the third arbitrator shall be appointed by the [arbitral body].”

While the foregoing may not resolve all obstructionist tactics used to thwart arbitration and avoid per-arbitration litigation, they will go a long way toward that end.

Supreme Court to Decide Contractually Expanded Judicial Review of Arbitration Awards
by Peter Scaff and Rhonda Weiner

Although results admittedly vary, the primary benefit of c arbitration over litigation is that arbitration proceedings tend to be quicker and less expensive.  An important component towards achieving these goals is the limited judicial review of arbitration awards.  For example, the Federal Arbitration Act (FAA), which governs arbitration clauses contained in transactions involving interstate commerce, stringently limits judicial review to situations involving corruption in the process or procedural defects that go so far as to contravene due process principles.  While undeniably promoting efficiency, the FAA’s limited review affords no relief in situations where an arbitrator has made clear errors of fact or law, even if the errors are patent or egregious.  The U.S. courts have added a limited non-statutory ground of review of arbitrators’ errors of law by enunciating a right to set aside an award where the arbitrators knowingly disregarded the law. 

In an attempt to achieve a more balanced approach between efficiency and ensuring that a just award is made, parties sometimes include provisions in arbitration clauses that allow for expanded judicial review beyond the grounds set forth in the FAA.  One commonly encountered example allows errors of law in the making of the award to be reviewed by the courts (and serve as a basis for vacatur of the award).  Proponents who favor limiting review to the statutory grounds in the FAA emphasize that the essence of arbitration is finality and freedom from judicial interference. On the other hand, proponents of expanded judicial review note that arbitration is a creature of contract and that parties should be afforded the freedom to contract for an arbitration of their own design.

To address a split amongst the federal courts of appeals, the United Supreme Court, in Hall Street Assoc. v. Mattel, Inc., agreed in May 2007 to hear the issue of whether parties can contractually agree to a more expansive judicial review of an arbitration award than the narrow standard of review provided for in the FAA.  For practitioners in the Fifth Circuit, this issue was conclusively addressed by the 1995 case of Gateway Technologies, Inc. v. MCI Telecommunications Corp. 64 F.3d 993 (5th Cir. 1995).  The Gateway court held that the FAA did not prohibit parties from contractually agreeing to more expansive judicial review of the award.  Id. at 997.  The Fifth Circuit explained that contractual modification of the FAA’s limited review of arbitration awards is acceptable because “arbitration is a creature of contract,” and parties should be able to “structure their arbitration agreements as they see fit.”  Id. at 996.  For more than a decade, Gateway has enabled businesses in the Fifth Circuit to confidently include provisions in their arbitration agreements modifying the standards under which an award will be reviewed, a freedom which encourages arbitration by alleviating fear of being bound by a legally or factually erroneous arbitration decision.

The majority of other federal circuits have agreed with the Fifth Circuit’s reasoning in Gateway, also concluding that since arbitration is a creature of contract, parties should be afforded leeway in deciding what and how to arbitrate.  The First, Fourth and Sixth Circuits each have concluded that parties may contractually modify the statutory limits for judicial review of arbitration awards.  See Puerto Rico Tel. Co. v. U.S. Phone Mfg. Corp., 427 F.3d 21, 31 (1st Cir. 2005) (finding that parties can displace the FAA standard of review by “clear contractual language”); Jacada Ltd. v. International Mktg. Strategies, 401 F.3d 701, 710-12 (6th Cir. 2005) (explaining that parties can opt out of the FAA’s standard for vacatur in favor of other standards of review); Syncor Int’l Corp. v. McLeland, No. 96-2261, 1997 WL 452245 at *6-7 (4th Cir. August 11, 1997) (enforcing the parties’ agreement for expanded judicial review, explaining that the contractually agreed upon provisions “supplements the FAA’s default standard of review”). 

In contrast, the Ninth and Tenth Circuit Courts have held that parties may not agree to contractually expand the judicial review provisions found in the FAA.  In both Kyocera Corp. v. Prudential-Bache Trade Servs., Inc., 341 F.3d 987, 994 (9th Cir. 2003) and Bowen v. Amoco Pipeline, Inc., 254 F.3d 925, 936 (10th Cir. 2001), the courts found that allowing parties to contractually modify judicial review would threaten the independence of arbitration. 

Handicapping its eventual decision based on a review of previous decisions, we predict the Supreme Court will likely follow the reasoning of the Fifth, First, Fourth and Sixth Circuit courts when deciding Hall Street Associates.  In multiple opinions the Supreme Court has favored freedom of contracting parties to structure their arbitration procedure.  For instance, in First Options of Chicago, Inc. v. Kaplan, the Supreme Court made clear that “arbitration is simply a matter of contract between the parties.”  514 U.S. 938, 938 (1995).  To that end, the Court determined that if “clear and unmistakable” evidence existed that the parties contractually agreed to submit the question of arbitrability to the arbitrator, then the agreement must be enforced because the “basic objective” is “to ensure that commercial arbitration agreements, like other contracts, are enforced according to their terms.”  Id. 944, 947 (internal citation omitted).  Similarly, the Supreme Court held in Volt Info. Sciences, Inc. v. Board of Trustees of Leland Stanford Junior Univ., that the parties’ agreement to abide by state rules of arbitration rather than the FAA rules was enforceable, explaining that the policy of the FAA “is simply to ensure the enforceability, according to their terms, of private agreements to arbitrate.”  489 U.S. 468, 476 (1989).

In addition to First Options, Volt and other Supreme Court opinions tending to favor contract rights, recently inaugurated Justice Alito’s experience on the Third Circuit indicates that he too will lean towards contract rights.  In China Minmetals Materials v. Chi Mei, Alito in a concurring opinion emphasized the fundamental principal that arbitration is “a matter of contract,” and that in particular, parties can be forced to arbitrate only those issues they agreed to submit to arbitration.  334 F.3d 274, 292 (3d. Cir. 2003).  Given Justice Alito’s emphasis on the contractual nature of arbitration agreements, it is likely in deciding the Hall Street Associates Case Justice Alito will recognize and uphold standards of review in arbitration agreements that are not found within the FAA.

Notwithstanding whether allowing for contractually expanded review is wise, the Supreme Court’s ultimate decision in Hall Street Associates will provide for uniform application amongst the circuits.