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Generic Arbitration Clauses Are Bad Medicine

28 April 1999
Corporate Counsel Weekly

Contract drafters too often take the easy way out when it comes to arbitration provisions. Rather than craft a clause that makes sense in the context of the particular transaction at hand, they simply plunk down some generic boilerplate:  "Any and all disputes arising out of or related to this agreement or the breach thereof shall be arbitrated . . ."

That’s fine if you’re sure you really want to arbitrate anything and everything, don’t care that discovery may be unavailable, and have no interest in limiting the risk of runaway damages. Of course, most companies do have preferences when it comes to arbitration, but these are generally far from the top of the priority list at deal time. Only when a dispute develops does the inadequacy of the arbitration boilerplate become evident.

The time to plan for arbitration is when you negotiate and draft the agreement, not when the dispute breaks out. By that time, it may be too late — the warring parties probably won’t be able to agree on anything, leaving resolution of vital procedural matters to the arbitrator, who may be inclined to do things in the "usual" way. Simply incorporating the rules of an arbitral institution does not solve this problem because those rules rarely contain meaningful provisions with respect to such concerns as the scope of discovery and limits on punitive damages.

The fact is that the "usual" arbitration clause is a dangerous myth. Parties have almost absolute freedom to shape arbitration provisions to their particular needs. Here are a few suggestions:

First, determine the type of issues you want (and don’t want) to arbitrate. Will you really want to arbitrate a defamation claim arising out of your joint venture? That’s the type of claim for which a meaningful appeal (generally not available after an arbitration) may be highly desirable. So if the resolution of particular claims will benefit from the kind of protections that only judicial resolution provides, proscribe the arbitration of those claims in your arbitration clause.

Second, try to foresee the nature of likely disputes and what that means for discovery. If your company is entering a franchise agreement as a franchisee, it likely will need information in the hands of the franchisor in the event of a dispute. Thus, it may want an express provision guaranteeing the right to exchange documents or take a reasonable number of depositions, at least if the amount in dispute is sufficiently large. The franchisor, on the other hand, may want a provision precluding depositions and otherwise limiting discovery. The party that looks ahead will come out ahead.

Third, think about remedies. One reason companies often prefer arbitration is their expectation that an arbitrator is less likely than a jury to award exorbitant damages, whether compensatory or punitive. That’s generally true, but arbitrators have a lot of flexibility when it comes to remedies, and a rogue award rarely can be cut back on appeal. So if you want to preclude the award of lost profits or punitive damages, say so.

One obstacle to the limitation of punitives is that the other side may be reluctant to agree. A more subtle means of obtaining the same limitation is to choose the arbitration law of a state that forbids or limits the authority of an arbitrator to award punitives. For example, Illinois arbitration law, according to several Illinois appellate courts, precludes an arbitrator from awarding punitives unless the parties have expressly authorized it to do so. See Ryan v. Kontrick, 1999 WL 167522 (Ill. App. Mar. 26, 1999); Edward Elec. Co. v. Automation, Inc., 593 N.E.2d 833 (Ill. App. 1992). If you choose to go that route, make clear that the arbitration clause itself (as opposed to the substantive contract provisions) is governed by the preferable state law. Otherwise, federal arbitration law, which is more deferential to arbitral punitive damage awards, may apply. See Mastrobuono v. Shearson Lehman Hutton, Inc., 514 U.S. 52 (1995). For example, you might consider the following:

The arbitration law of Illinois shall govern this contract to the fullest extent permitted by law, excluding the Federal Arbitration Act and the arbitration law of all other states, irrespective of the location of the arbitration proceedings or of the court in which any related judicial proceedings may take place.

Fourth, consider what is probably the biggest failing of arbitration, the inability to obtain effective review of an erroneous decision. You may want to expand the scope of judicial review, for example, by authorizing de novo review of legal determinations and "clear error" review of factual findings. If so, be sure to require a written opinion by the arbitrator, so that the reviewing court will have some findings to review. Some jurisdictions, including the Fifth and Ninth federal circuits, have upheld parties’ expansion of judicial review; others, including the Seventh and Eighth Circuits, have indicated skepticism on the ground that the scope of judicial review is up to Congress. Compare Lapine Tech. Corp. v. Kyocera Corp., 130 F.3d 884 (9th Cir. 1997); Gateway Tech., Inc. v. MCI, 64 F.3d 993 (5th Cir. 1995) (parties may expand) with UHC Mgmt. Co. v. Computer Sciences Corp., 148 F.3d 992 (8th Cir. 1998); Chicago Typographical Union v. Chicago Sun-Times, Inc., 935 F.2d 1501 (7th Cir. 1991) (parties may not). One way to obtain review but avoid the courts altogether is to provide for an appellate arbitration panel in your arbitration agreement. If you do so, be sure to specify the appellate procedures.

Finally, if you want the arbitration agreement to bind a third party — such as the other party’s guarantor or surety — be sure to say so expressly and have the third party sign the arbitration provision separately. The guarantor’s written agreement to guarantee a party’s contractual obligations as a whole may be insufficient to bring it within the reach of the arbitration clause. See Grundstad v. Ritt, 106 F.3d 201 (7th Cir. 1997).

These are but a few options, offered to encourage creative thinking on the part of counsel drafting arbitration provisions. The point is to tailor your arbitration provision to your company and the particular transaction. The arbitration clause should not be a hasty postscript to an agreement, but rather an essential part of transaction planning. Prudent anticipation can avoid anguish down the road.

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