Townsend
Townsend
ARBITRATION CLAUSES:
Avoiding the 7 Deadly Sins
By John M. Townsend
John M. Townsend is a partner in the Washington, D.C., office of Hughes Hubbard & Reed LLP
and is the chair of the firm’s Arbitration and ADR Group. He is a member of the Board of
Directors and the Executive Committee of the American Arbitration
Association. He also chairs the AAA’s Law Committee.
1 FEBRUARY/APRIL 2003
When advising a client about dispute
resolution options and deciding on the
“Sometimes the involved in international commerce, as
long as the country where the arbitra-
type of clause to use, the drafter, at a drafter ... cannot tion takes place and the country where
minimum, should ask the following the award is to be enforced are parties
questions: be reconciled to ... to the same convention.5 No similar
• What type of dispute resolution treaty to which the United States is a
process is best suited to the client letting go of the party makes judgments enforceable
across national lines. Foreign judg-
and the transaction?
familiar security ments are enforced in the United
Arbitration is not the only option.
States and U.S. judgments are enforced
There are many alternative dispute blanket of litigation.” abroad only as a matter of comity.
resolution processes and there is
The key is to pay sufficient atten-
always litigation. In particular circum-
tion to the underlying transaction so
stances it may be preferable to litigate in court, provided
that the arbitration clause can be tailored to the client’s
that the parties can agree on which court to designate and
particular requirements and to possible disputes that may
whether that court will have jurisdiction. Litigation, how-
reasonably be anticipated. The drafter should consider in
ever, may not be an option in an international agreement.
what country the client is most likely to need to enforce
• If arbitration is selected, does the client understand
an eventual award (such as where assets of the adversary
that the arbitration clause will commit the client to a
are located) and determine whether that country is a par-
binding process that involves certain trade-offs?
ticipant to a treaty on the enforcement of arbitral awards.
Arbitration has advantages, prominent among them The arbitration should be sited in a country that is a party
privacy, as well as the possibility of crafting a process that to the same treaty.
will be speedier and more economical than litigation. It
also provides the opportunity for the parties to choose a Omission
fair and neutral forum—and to participate in the selection A drafter who omits a crucial (or even a useful) ele-
of the decision maker and the rules that will be applied. ment from an arbitration clause commits the sin of omis-
On the trade-off side, the client should understand that it sion. This can result in a clause that expresses an agree-
is giving up some rights provided by law to litigants. ment to arbitrate, but fails to provide guidance as to how
These may include the right to a jury trial, the right to an or where to do so. Here is an extreme example:
appeal and, under certain institutional arbitration rules
(such as the arbitration rules of the International Centre Any disputes arising out of this Agreement will be finally
for Dispute Resolution (an arm of the American resolved by binding arbitration.
Arbitration Association) and those of the CPR Institute This clause is probably enforceable because it clearly
for Dispute Resolution), the right to claim punitive dam- requires the parties to arbitrate disputes. However, it
ages, unless the contract provides otherwise. does not achieve the goal of an arbitration clause, which
The drafter should be especially cautious about giving in is to stay out of court. Unless the parties can agree on the
to the temptation to advise the client to agree to arbitrate details concerning their arbitration, they will have to go
some types of disputes and go to court for others. This may to court to have an arbitrator or arbitral institution select-
be inevitable in some countries that do not allow certain ed for them.6
types of disputes to be arbitrated (e.g., patent disputes) — Section 5 of the FAA provides a partial remedy for the
but dividing jurisdiction should be the subject of an incomplete arbitration clause. It provides:
advanced course in drafting. Do not try it at home.
If in the agreement provision be made for a method of
• Have the parties considered providing for steps preced- naming or appointing an arbitrator or arbitrators or an
ing arbitration, especially if the relationship between umpire, such method shall be followed; but if no
the parties is an ongoing one? method be provided therein, or if a method be provid-
It may be that, in light of their prior relationship, the ed and any party thereto shall fail to avail himself of
parties should agree to mediate or negotiate before head- such method, or if for any other reason there shall be a
ing into arbitration. They can always arbitrate if less lapse in the naming of an arbitrator or arbitrators or
adversarial techniques are unsuccessful. A “step clause” umpire, or in filling a vacancy, then upon the applica-
can be drafted with as many steps preceding arbitration as tion of either party to the controversy the court shall
the parties desire. designate and appoint an arbitrator or arbitrators or
• Have the parties considered where they may want to umpire, as the case may require, who shall act under
enforce an award or a judgment based on an award? the said agreement with the same force and effect as if
This is particularly critical in an international contract. he or they had been specifically named therein; and
The New York Convention and the Panama Convention unless otherwise provided in the agreement the arbi-
make arbitration awards enforceable in most countries tration shall be by a single arbitrator.7
FAA Section 5 only gets the parties an arbitrator, how- The Arbitration shall be conducted by three arbitrators, each
ever. In the arbitration, the parties will still have to of whom shall be fluent in Hungarian and shall have twenty
resolve disputes about when, where and how to conduct or more years of experience in the design of buggy whips,
the arbitration. It is far better to provide in the arbitra- and one of whom, who shall act as chairman, shall be an
tion clause for the minimum fundamentals needed to get expert on the law of the Hapsburg Empire.
an arbitration under way without the intervention of a This may seem like a comic exaggeration, but if you
court. Ten essential provisions are: substitute computer chips for buggy whips, with appro-
• the agreement to arbitrate, priate adjustment of the language and law in question,
• what disputes will be arbitrated (broad or narrow you will find this example chillingly similar to many that
clause), make their way to arbitration.
• the rules that will govern the arbitration, Basically, it is a big mistake to over-draft an arbitration
• the institution, if any, that will administer the arbi- clause. When the arbitration clause is excessively detailed,
tration, those layers of detail can make it difficult or impossible to
arbitrate a dispute when one arises. The standard clauses
• the place of arbitration,
recommended by the major arbitral institutions are used
• in an international agreement, the language of the by many knowledgeable people because they have been
arbitration, tested by the courts and they do the job.
• the applicable law, if not provided elsewhere in the
agreement, Unrealistic Expectations
• the procedural law that will apply to the arbitration, A companion sin to over-specificity is the sin of unreal-
• the number of arbitrators and how they will be cho- istic expectations. We have all encountered arbitration
sen, and clauses along the following lines:
• an agreement that judgment may be entered on the The claimant will name its arbitrator when it commences
award.8 the proceeding. The respondent will then name its arbitrator
There are many other subjects that can and should be within seven (7) days, and the two so named will name the
dealt with in the arbitration clause, some of which will be third arbitrator, who will act as chair, within seven (7) days
touched on later, but these are the ones that must be of the selection of the second arbitrator. Hearings will com-
addressed if the drafter wants to avoid the sin of omis- mence within fifteen (15) days of the selection of the third
sion. arbitrator, and will conclude no more than three (3) days
later. The arbitrators will issue their award within seven
Over-Specificity (7) days of the conclusion of the hearings.
The opposite of the sin of omission is the sin of over- There are circumstances that may justify, indeed even
specificity. Rather than providing insufficient detail, the require, tight time limits. It may be reasonable to provide
drafter provides too much. Drafters occasionally take the for accelerated resolution of an urgent matter, such as the
job of crafting an arbitration clause as a challenge to show need for provisional relief of a dispute involving the use
how many terms they can invent. This can produce a clause of a trademark or one that would delay a major construc-
that is extremely difficult to put into practice. For example: tion project. But most commercial arbitration proceeds at
a more stately pace. While clients and their attorneys
understandably become impatient with that pace, they
should be aware that too tight a timeframe for an arbitra-
tion can cripple the process before it gets started. The
risk is, as usual, collateral litigation. American courts have
been less rigid than their European counterparts in find-
ing that a failure to meet a deadline in an arbitration
agreement deprives an arbitrator of jurisdiction to pro-
ceed with the arbitration.9 However, drafters should not
invite a challenge on that basis by imposing unrealistic
deadlines on the parties, the case administrator, or the
arbitrator.
Litigation Envy
Sometimes the drafter of an arbitration clause cannot
be reconciled to the thought of letting go of the familiar
security blanket of litigation. What sometimes results is a
clause that calls for the arbitration to follow court rules.
This is the sin of litigation envy. Take the following
3 FEBRUARY/APRIL 2003
clause, which the author once had to rules required the arbitrators to be
deal with as the chair of an ad hoc arbitra-
“The temptation impartial or independent of Hooters.
tion panel: to overreach in • The employee was required to file with
The arbitration will be conducted in her claim a list of all fact witnesses, speci-
accordance with the Federal Rules of Civil drafting the fying the facts known to each, but
Procedure applicable in the United States Hooters was not required to file any
District Court for the Southern District arbitration clause notice of its defenses.
of New York, and the arbitrators shall
follow the Federal Rules of Evidence. should be strongly • Hooters was permitted to move for
summary disposition, but the employee
Trying to conduct the arbitration resisted. ” was not.
under rules designed for an entirely dif-
ferent kind of proceeding produced pre- • Hooters could amend its position, but
dictable and needlessly expensive wheel-spinning. The the employee could not.
arbitrators had to decide whether and how to apply the • Hooters could record the hearing, but the employee
local rules of the Southern District, whether a pre-trial could not.
order was required, whether the parties were obligated to • Hooters could modify the arbitration rules at will
make the mandatory disclosures required by the Federal
and without notice to the employee.
Rules, and other controversies about discovery of the sort
that people resort to arbitration to escape. • Hooters, but not the employee, had the option to
Whether administered or non-administered arbitration cancel the agreement to arbitrate.
is desired, there are many good sets of procedural rules One eminent witness stated before the trial court,
available that can be incorporated in an arbitration clause.10 “This is without a doubt the most unfair arbitration pro-
Any one of them is preferable to requiring an arbitration to vision I have ever encountered.”14 The 4th Circuit con-
be conducted according to the rules governing litigation. cluded that the appropriate remedy for such a one-sided
Drafters also manifest litigation envy when they are clause was not to enforce it. The court stated:
reluctant to trust the result and provide for expanded
The parties agreed to submit their claims to arbitra-
review of the arbitration award. Here is an example:
tion—a system whereby disputes are fairly resolved by
The award of the arbitrators may be reviewed for errors of an impartial third party. Hooters by contract took on
fact and law by the United States District Court for the the obligation of establishing such a system. By creat-
District in which the arbitration is held. ing a sham system unworthy of the name of arbitra-
There is considerable disagreement in the arbitration tion, Hooters completely failed in performing its con-
community as to whether it should be possible to expand tractual duty ... [and] also violate[d] the contractual
judicial review of an award. Currently there is a split in obligation of good faith .... Hooters’ ... performance
the federal circuit courts concerning whether to an under the contract was so egregious that the result was
enforce an arbitration agreement that expands the hardly recognizable as arbitration at all.15
grounds upon which Section 10 of the FAA would permit The temptation to overreach in drafting the arbitration
a court to review an award.11 Accordingly, one should clause should be strongly resisted. It is not only wrong,
approach the subject of expanding court review of awards but it is also counterproductive.
with great care.12
Doing it Right
Overreaching If one knows what to avoid in drafting the arbitration
Sometimes the drafter of an arbitration clause cannot clause, how does the drafter go about drafting it correct-
resist the temptation to tilt the arbitration process in ly? Here is a do-it-yourself kit for drafting a simple arbi-
favor of his or her client. This is the sin of overreaching. tration clause.
Where this sometimes comes up in a painfully obvious The beginning drafter is well advised to begin with a
way is in contracts of adhesion. A notorious example is standard clause by one of the many respected arbitral
the clause the Hooters chain of restaurants used in
institutions. The Web sites of the principal arbitral insti-
employment agreements. Some of the overreaching ele-
tutions provide recommended provisions for both admin-
ments in that agreement were listed by the 4th Circuit:13
istered and non-administered arbitration that have been
• The employee and Hooters each were to select an tested by the courts and that work. The arbitration clause
arbitrator, and the two so selected were to pick the used here for illustration starts with the clause from the
third arbitrator, but all three had to be chosen from Commercial Arbitration Rules of the American Arbitra-
a list created by Hooters, which had exclusive and tion Association (AAA) (numbered items 1-4). The steps
unrestricted control over who was on the list. below correspond to these numbers in the “basic clause”
• Nothing in the arbitration clause or the Hooters’ pictured on the next page.
Step 1: Define what is arbitrable. Step 9: Provide for mediation first. Because mediation
Step 2: Commit the parties to arbitration. offers the possibility of reaching a mutually agreed-upon
Step 3: Pick a set of rules (and, in this case, an arbitra- settlement, it may be useful to include a “mediation first”
tion institution to administer the case). clause. This dispute resolution clause is adapted from the
Step 4: Provide for entry of judgment. This is essential AAA standard clause:
to enforcement in the United States.16 (a) If a dispute arises out of or relates to this contract, or the
breach thereof, and if said dispute cannot be settled through
Recommended Clauses negotiation, the parties agree first to try in good faith to set-
After Step 4 you basically have the AAA standard tle the dispute by mediation under the Commercial
clause, which is enforceable and can stand on its own. Mediation Rules of the American Arbitration Association,
There are, however, some additional details that it is wise before resorting to arbitration.
to add. These details are added by going through the fol-
(b) Any dispute arising out of or relating to this contract, or the
lowing steps (see the corresponding numbers in the basic
breach thereof, that cannot be resolved by mediation within 30
clause on this page).
days shall be finally resolved by arbitration administered by the
Step 5: Specify the language in which the arbitration
American Arbitration Association under its Commercial
will be conducted. Obviously, this is most important in an
Arbitration Rules, and judgment upon the award rendered by
international arbitration.
the arbitrators may be entered in any court having jurisdic-
Step 6: Specify the location of the arbitration.
tion. The arbitration will be conducted in the English language
Step 7: Specify the procedural law that will govern the
in the City of New York, New York, in accordance with the
arbitration. This is important in domestic clauses when
United States Arbitration Act. There shall be three arbitra-
one wants the FAA to trump state arbitration law.17
tors, named in accordance with such rules.
Step 8: Specify the number of arbitrators. The parties
usually will require only one arbitrator in small domestic Step 10: Provide for a reasoned award. The drafter may
disputes, but in large cases and international disputes, want to specify whether the arbitrators should provide rea-
they often will want a panel of three. The parties can sons for their award in the written decision, which is not
choose the method of arbitrator selection stated in step 8 required unless the parties request it. This can be accom-
in the sidebar, or provide for each party to select one plished by adding a sentence at the end of clause (b) above.
arbitrator and the third arbitrator (the chair) to be The award of the arbitrators shall be accompanied by a
appointed by the two party-appointed arbitrators. Other statement of the reasons upon which the award is based.
variations are also possible. Step 11: Address the substantive law. If the substantive
law that will govern is not dealt with elsewhere in the
Optional Additions document (or in a document incorporated by reference),
After all eight steps are taken, the clause will normally the drafter could include a governing law provision in
contain all that is needed. However, there are some paragraph (b) above by adding the following:
optional provisions that could be considered.
The arbitrators shall decide the dispute in accordance with
the substantive law of the state of New York.
[1] Any dispute arising out of or relating to this This wording has the effect of requiring the arbitrators
contract, or the breach thereof, to apply the law. Care should be taken not to add a sub-
stantive law clause if one already exists, since to do so
[2] shall be finally resolved by arbitration could produce an ambiguous clause.
The Basic Clause
[3] administered by the American Arbitration Asso- Step 12. Address the need for interim relief. In any dis-
ciation under its Commercial Arbitration Rules, pute there is a possibility that one party will need to obtain
emergency relief before the arbitrators are appointed. To
[4] and judgment upon the award rendered by the authorize the appointment of an emergency arbitrator, the
arbitrators may be entered in any court having juris- parties may specifically provide in their arbitration agree-
diction. ment that the AAA’s Optional Rules for Emergency Relief
[5] The arbitration will be conducted in the English will apply. (These rules are part of the AAA Commercial
language Dispute Resolution Procedures but they do not apply
unless the parties’ agreement so states.18)
[6] in the city of New York, New York,
The parties also agree that the AAA Optional Rules for
[7] in accordance with the United States Arbitration Emergency Measures of Protection shall apply to the pro-
Act. ceedings.
[8] There shall be three arbitrators, named in accor- The parties could provide, instead, for interim relief by
dance with such rules. a court, as is explicitly permitted under the AAA Com-
mercial Rules (Rule R-36(c)).
5 FEBRUARY/APRIL 2003
Other Issues jurisdictions, and it has gained widespread acceptance.
The parties can also address other issues in the arbitra- • whether there is a need for a waiver of sovereign
tion clause, including: immunity.23
• whether claims by or against parents or affiliates are • whether special confidentiality protection is needed.
covered or not covered by the arbitration agreement;19 Most institutional arbitration rules require the institu-
• issues arising from the presence of multiple parties, tion and the arbitrators to maintain confidentiality, but
such as whether or not related arbitration proceedings not the parties. The principal countervailing concern is to
may be consolidated, or whether provisions (other than preserve the ability of the parties to comply with legal
those stated in the selected arbitration rules) should apply obligations, such as securities law disclosures.
to selecting the arbitrator. • whether to authorize arbitrators to award attorney’s
The usual solution in commercial disputes is for the fees.
administering institution to select all the arbitrators when Some institutional arbitration rules, such as the
there are more than two parties. ICDR International Rules, allow the arbitrators to award
• whether there should be limits on the authority of the attorney’s fees to a prevailing party. Others, such as the
arbitrators to award punitive or similar damages, although AAA Commercial Arbitration Rules, do not. Almost all
some courts have refused to enforce such limits.20 arbitration rules permit the parties to provide otherwise in
The drafter should not try to limit the arbitrators’ their arbitration agreement.
authority to award statutory remedies because the result The list of optional provisions could be extended
may be either to invalidate the arbitration clause or leave almost indefinitely. To avoid drafting an over-specific
an adversary free to pursue a parallel court proceeding for arbitration clause, which can get the drafter’s client into
such remedies.21 trouble, the safest course is to start with a standard,
• whether to address the scope of discovery. proven clause that the courts have regularly enforced.
Institutional arbitration rules usually address the Then, add to it only necessary, consistent provisions that
need for information exchange, so the drafter should are tailored to the particular transaction. Do not overload
know what the selected rules provide. Many international the clause with excessive detail, unrealistic deadlines, bias
lawyers choose to provide for discovery under the toward either party, or matter already dealt with satisfac-
International Bar Association (IBA) Rules on the Taking torily in the arbitration rules that will apply. The result
of Evidence in International Commercial Arbitration.22
should be a serviceable, if not necessarily perfect, arbitra-
These rules articulate a middle ground between the type
tion clause, free, at least, from the seven deadly sins that
of “discovery” practiced in common law and in civil law
drafters are often tempted to commit. ■
ENDNOTES
1
International Chamber of Commerce Arbitration § 9.02 (1990 (4th Cir. 1999).
2d ed. Oceana Publications). 14
Id. at 939.
2
9 U.S.C. § 2. 15
Id. at 940.
3
In New York, for example, Article 75 of the N.Y. Civil 16
See 9 U.S.C. § 9.
Practice Law & Rules. 17
The perils of not doing so are illustrated (and largely cre-
4
Published following 9 U.S.C. § 201. ated) by Volt Information Sciences, Inc. v. Stanford University, 489
5
Lists of signatories to both conventions may be found fol- U.S. 468 (1989).
lowing 9 U.S.C.A. §§ 201 and 301. 18
See www.adr.org.
6
E.g. Warnes, S.A. v. Harvic International, Ltd., 1993 U.S. 19
See J. Townsend, “Nonsignatories and Arbitration:
Dist. LEXIS 8457 (S.D.N.Y. 1993).
Agency, Alter Ego, and Other Identity Issues,” ADR Currents,
7
9 U.S.C. § 5.
vol. 3, no. 3 (Sept. 1998), pp. 19-23.
8
This is required for enforcement under the Federal 20
Dunlap v. Friedmans, No. 30035 (Sup. Ct W. Va. June 13,
Arbitration Act. See 9 U.S.C. § 9.
9 2002) (arbitration clause prohibiting award of punitive damages
E.g., In re Arbitration No. AAA13-161-0511-85 under Grain
unconscionable and unenforceable).
Arbitration Rules, 867 F.2d 130, 134 (2d Cir. 1989).
10
Many of the organizations listed in the sidebar on page 35
21
Investment Partners v. Glamour Shots, No. 01-60651 (July
promulgate arbitration rules, which can be downloaded from 15, 2002 5th Cir.) (prohibition on punitive damages does not
the organization’s Web site. preclude arbitrator from awarding treble damages).
11
Compare Lapine Technology Corp. v. Kyocera Corp., 130 F.3d
22
The IBA rules may be found at www.ibanet.org. See S.
884 (9th Cir. 1997), with UHC Management Co. v. Computer Elsing & J. Townsend, “Bridging the Common Law-Civil Law
Sciences Corp., 148 F.3d 992 (8th Cir. 1998). Divide in Arbitration,” Arbitration International, vol. 18, no. 1 (Feb.
12
A useful discussion of the subject and a model appeal pro- 2002).
cedure appear on the CPR Web site, www.cpradr.org. 23
28 U.S.C. § 1605(a)(6) (agreement to arbitrate waives sov-
13
Hooters of America, Inc. v. Phillips, 173 F.3d 933, 938-939 ereign immunity of foreign state).
7 FEBRUARY/APRIL 2003