Drafting Arbitration Agreements With Third Party Service Providers

Oct. 1, 2003
Done right, an arbitration agreement is like a well-tailored suit that feels comfortable and can last for years with only an occasional repair or alteration.

In addition to running their own operations, many managers find themselves managing their company’s relationship with a number of third party logistics companies, contract manufacturers and other service providers. Over the course of a relationship, disputes invariably arise, and in many cases, the handling of such disputes determines whether or not the relationship survives.

By dragging disputes out over a long period of time and creating an adversarial relationship, litigation is proving to be a last recourse for resolution. To resolve disputes more quickly and amicably, many companies are turning to arbitration and writing arbitration and “dispute resolution” agreements into their contracts with third party providers. In a recent study of U.S. corporations, 90 percent viewed dispute resolution as a critical cost-control technique, and 80 percent considered alternative dispute resolution (ADR) as a more satisfactory process than using the courts.

Writing such agreements is proving to be something of a high-wire balancing act. On the one hand, if a company writes an agreement that gives it an unfair advantage over its service providers, the courts throw it out. So, instead of resolving their disagreement quickly through mediation or arbitration with a minimum of rancor, the parties wind up doing exactly what they wanted to avoid: they sue and countersue, drag their dispute out over a period of years, poison their relationship, and pay hefty legal fees.

On the other hand, if a company uses an off-the-shelf, plain-vanilla agreement, it is unlikely to accomplish its goals. Good agreements are very specific and spell out obligations clearly. An agreement tailored for a warehousing service will be very different from one for a contract manufacturer. A “one size fits all” approach won’t work.

In crafting an effective arbitration agreement, a logical first step is to ask general counsel or the company’s law firm to review a variety of agreements — those that have been successful and those that have either failed to get the job done or not stood up to court challenges.

Crafting the actual agreement should be something of a team effort, with input from management, legal counsel and industry experts — as well as representatives of third party service providers that will be affected by the agreement. During this process, management should bear in mind that while the lawyers can provide general guidelines, they cannot provide the specifics. And it’s the specifics that will determine how well the agreement achieves the company’s objectives.

With that in mind, here are 10 tips toward drafting better agreements:

1. Grease the wheels. Typically in business disputes, neither party wants to destroy the relationship. So, pursuing the least abrasive approach can be advantageous for both parties. In their contract language, they may want to include a dispute resolution process that starts with an agreement to negotiate in good faith for a period of time, followed by a mediation session, followed by binding arbitration if the parties cannot resolve the dispute. To avoid delay, be sure to specify time frames for each procedure. The goal is to end the dispute as quickly, fairly and amicably as possible. Business parties may consider language something like this:

ARBITRATION. Whether or not mediation is requested by any party, any claim, dispute or controversy between us or arising from or relating to this agreement or the relationships which result from this agreement, including the validity of this arbitration clause or the entire agreement, including any that remain unresolved 120 days after an agreement for mediation, shall be resolved by binding arbitration by the National Arbitration Forum (or other neutral arbitration services provider), under the Code of Procedure then in effect.

2. Specify what’s covered. If the goal is to ensure that the arbitration agreement governs all disputes arising between the contracting parties, specify that clearly in the contract. Also, be sure to indicate that the arbitrator has the authority to decide whether the arbitration agreement is valid and enforceable. In this area, the U. S. Supreme Court has established something akin to a “magic words” formula for arbitration agreements. Agreements that indicate that all disputes will be decided by arbitration — including the validity of the arbitration provision itself — provide maximum authority for the arbitrator to decide all the issues of the case, thereby saving the parties a pit stop at the courthouse to wrangle over legal issues.

3. Take advantage of the Federal Arbitration Act (FAA). Different states have different laws governing arbitration. This can be confusing, especially for companies that are trying to draft an agreement that can be used in a number of different states. To avoid any doubts and confusion, consider invoking the FAA. The FAA affords parties the flexibility to structure their agreement as they deem appropriate, while at the same time providing assurance that the arbitration agreement will be enforced uniformly in different states. The FAA covers any dispute involving interstate commerce; and, according to a recent decision by the U.S. Supreme Court, the standard is expansive, covering disputes that are “affected” by interstate commerce.

4. Keep it close to home. Courts may turn a baleful eye to agreements that force the weaker party to needlessly travel a long distance to an inconvenient forum. Specify a location for the arbitration or mediation that is easy for both parties to reach. If there are several choices, select the one nearest to the weaker party.

5. Consider the other party’s costs. In drafting a contract affecting small businesses and individuals, do not be surprised if state law specifies that the financially stronger party cover some or all of the cost of the arbitration. The courts, especially in California, see this as a way of maintaining a level playing field.

6. Specify what law applies. Laws can vary from jurisdiction to jurisdiction, so if it’s important that the arbitrator or mediator apply the substantive law of a specific jurisdiction, state that clearly in the dispute resolution agreement. Note that if you want the FAA to govern the procedural aspects of the arbitration, draft the agreement so that it is clear that the arbitration will be “governed” by the FAA, but that the arbitrator will “apply the substantive law” of a particular state. If the language is muddy, you may find your arbitration proceedings subject to a state law that is not favorable to your dispute.

7. Follow the legal remedies. In most jurisdictions, legal remedies otherwise available in court must also be available through arbitration. This is especially true where contracting parties do not possess equal bargaining power.

8. Crimping punitive damages can be risky. Drafting parties are often tempted to limit an arbitrator’s ability to award punitive damages. But, before doing so, they should check out Pacificare Health Systems, Inc. v. Book, a recent case in which the U.S. Supreme Court cast doubt on setting such limits.

9. Select a reputable ADR administrator. The best way to assure that an ADR agreement will be enforced in court, if it comes to that, is to specify that the proceedings will be handled by a reputable ADR administrator with court-tested rules and fees. Doing so makes it unnecessary to draft lengthy provisions addressing discovery, selecting ADR neutrals, and a number of other issues. As one ADR expert put it: “Parties are decidedly better off engaging the services of a reputable ADR services provider to help them manage the arbitration proceeding than winging it on their own.” Also, when using an arbitration administrator, be sure to clarify whether the arbitrators will be legal professionals or laypeople. Even though you have a legal dispute, some arbitration providers will use arbitrators who have no legal background. It pays to ask.

10. Specify the award review process. The FAA and various state laws restrict the right of courts to review arbitration awards, although a number of courts have suggested that this is a default standard that can be altered. Parties who want a greater right to appeal an arbitration award can do this through explicit contract language or by simply incorporating, by reference, procedural rules (such as those of the National Arbitration Forum) that provide for review by a court to determine whether the arbitrator properly applied the law.

Curtis D. Brown is general counsel of the National Arbitration Forum, a leading neutral administrator of arbitration, mediation and other forms of alternative dispute resolution. A number of ADR materials, including resources for drafting arbitration clauses, are available at www.arbitration-forum.com.

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