The Advantages and Disadvantages of Including Arbitration Provisions in Contracts

March 12, 2014

(c) 2012.  Shanen R. Prout.  All rights reserved.

Conventional wisdom among many business lawyers says that arbitration is usually preferable over litigation in court because it avoids expensive, time consuming, and inefficient dispute resolution.  It has become standard practice for many attorneys to include arbitration provisions in various commercial transactions, employment agreements, intellectual property licenses, and even entertainment related deals.

Absent an agreement to the contrary, the default form of dispute resolution is a federal or state court lawsuit.  Arbitration is a process for the resolution of disputes outside the courts, where the parties refer their case to one or more neutral persons by whose decision they agree to be bound.  The selected arbitrator reviews the matter and imposes a decision that is generally final and binding.  The advantage of including an arbitration clause in your contract is that, once the dispute on or connected to the agreement arises, the aggrieved party can compel arbitration.  This is more difficult to do after the dispute has arisen, because absent a contractual provision for arbitration, such a process is merely voluntary and for various strategic reasons, the other party may not agree to arbitrate.

Despite the somewhat accepted practice among many of using arbitration provisions, however, is it prudent to always include them in contracts as a matter of course?  Is it wise to use standard form arbitration provisions across deals?  As seen below, there are important considerations that should be undertaken with the assistance of an experienced attorney to determine if including an arbitration provision in a contract is desirable.

Preliminary Considerations to Make Before Determining Whether to Submit Disputes to Arbitration

Before agreeing to arbitrate, one needs to analyze many questions.  Some include: What are the parties’ rights and duties under the contract?  What remedies are provided for in the contract?  What potential liabilities do the parties have under the agreement?  Do the parties want to craft tailored rules for pleadings, discovery, dispositive motions (e.g., demurrers, motions to strike, or motions for summary judgment), enforcement of judgment, and vacating, correcting or appealing the arbitration award?  If an arbitration provision does not specify how the parties will proceed under the rules of a particular arbitration service or under specifically tailored rules, the arbitration proceedings will be governed by the California Code of Civil Procedure or the Federal Arbitration Act.

Some Advantages of Using Arbitration Instead of Litigating in Court

1.  Arbitration can sometimes move faster and be less expensive that court litigation.  But, this will generally only be true if the parties prepare an arbitration provision that is tailored to the circumstances surrounding the deal and the parties’ relationship, as well as to their needs and willingness to litigate.

2.  Arbitration can provide more flexible options in how a dispute proceeds and the types of awards the arbitrator can make; for instance, by crafting a tailored discovery process and limiting or eliminating punitive or consequential damages.

3.  The parties can agree to make the arbitral proceedings and award non-public and confidential.  Generally, the arbitration service does not create transcripts of sworn testimony or other proceedings, except by agreement of the parties.

Some Potential Pitfalls of Arbitration

1.  Arbitration can be every bit as expensive as litigation in court.  Clients who choose to arbitrate must pay fees to the arbitration service, pay the arbitrator(s) by the hour (usually at $300+ per hour), and pay to rent the arbitration service’s facilities for the arbitration … and pay their attorney’s fees.

2.  With some exception now, there is rarely a right to appeal or vacate an arbitration award—they are more or less final and binding.  This includes even gross errors in judgment or misapplication of the law by the arbitrator.  Arbitrators are given great discretion in adjudicating disputes.

3.  The procedural rules for arbitration are less well-defined, less predictable, and less familiar to attorneys and clients, than those for civil litigation in a court of law.

If you are considering arbitrating disputes over your commercial relationship with another party, we encourage you to contact us to discuss more issues relevant to choosing arbitration.

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