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Small Business B-2-B Arbitration Part II.A: The Nature and Purpose of Arbitration

July 12th, 2013 Arbitration Agreements, Arbitration Practice and Procedure, Authority of Arbitrators, Awards, General, Making Decisions about Arbitration, Mediation, Negotiation, Practice and Procedure, Small Business B-2-B Arbitration Comments Off on Small Business B-2-B Arbitration Part II.A: The Nature and Purpose of Arbitration By Philip J. Loree Jr.

The long- and short-term success of a business is generally measured by the economic benefits it produces for its investors.  Most business decisions require a business to accept risks of varying severity and frequency if the business is going to realize a meaningful return on investment.  All else being equal, to increase the likelihood that those decisions will yield profits, the business must accurately assess all material risks, their corresponding benefits and the interplay between the two.

The same holds true for the decision whether to make an arbitration agreement part of a business transaction, and if so, on what terms.  But in the author’s experience otherwise savvy and intelligent small-business-persons frequently view an arbitration agreement as a throw-in term that isn’t likely to affect materially the risk-benefit calculus of the transaction as a whole.  These business persons are therefore likely to agree to arbitrate with a more economically powerful counterpart without giving the matter much thought, let alone the careful thought they devote to the price and performance terms of the deal.  This approach, as a number of business people have learned the hard way over the years, can result in a very frustrating and potentially debilitating one-two punch:  dashed reasonable expectations coupled with very little, if any, meaningful judicial review.

The decision whether to agree to arbitrate disputes arising out of a transaction, and if so, under what terms, can be as important as the decisions a business must make about the price and performance terms of a transaction.  To appreciate why that is so, one must have a least a general understanding about the basics of arbitration.  This Part II.A , and the follow-up posts of Part II., will focus on arbitration’s basics.

Let’s begin by defining arbitration and its nature and purpose.

Arbitration and its Nature and Purpose

Arbitration is a means by which parties to a business transaction can delegate to one or more private decision makers the authority to resolve a dispute, usually by way of a final and binding award on the merits issued after the parties have had an opportunity to present their evidence and arguments in support of their positions. While parties can agree to “non-binding” arbitration, we are concerned here solely with “binding” arbitration, which is not optional, and which contemplates the arbitrators issuing one or more final awards that a court having jurisdiction can enter judgment upon—that is, “confirm”— making the award as enforceable as any other judgment of the court.

Arbitration is more akin to court litigation than other forms of alternative dispute resolution (“ADR”)—for example, mediation or negotiation—because it is an adversarial-system-based ADR method under which each party advocates its position on the merits of the dispute to one or more impartial decision makers—or to one impartial decision maker and two party-appointed arbitrators who are not necessarily expected to be impartial. Negotiation is designed to reach a compromise resolution of a dispute, whereas mediation is a method by which an impartial person (the mediator) proactively assists the parties in reaching a negotiated resolution.

Arbitration is supposed to be an alternative to litigation, the principal benefit of which is to allow parties to control their own dispute-resolution destiny by designing a private, informal and confidential method of dispute resolution that is, at least in theory, more efficient, less time consuming and less expensive than court adjudication, and features the added benefit of party input in selecting the decision makers, including, if the parties so desire, ones having special expertise in particular subject matters.  Arbitration law — particularly the Federal Arbitration Act, 9 U.S.C. §§ 1, et seq. (the “FAA”)—is designed to promote arbitration as an attractive alternative to court litigation, not because legislators and judges think it is inherently better than court adjudication, but because it relieves docket congestion in the court system, and allocates resources better by shifting to private parties most of the time and money costs associated with resolving their disputes.

Arbitration law effectively offers would-be litigants a bargain—which may seem somewhat Faustian to some unfortunate parties who, for whatever reason, did not understand what they bargained away when they agreed to arbitrate:  the courts will lend their coercive, enforcement powers to arbitration agreements and awards based on them in exchange for the parties opting out of judicial dispute resolution.  But the parties who opt for private dispute resolution have to accept, among other things, that courts will not become embroiled in resolving disputes concerning the ambiguities in the scope of an arbitration agreement—instead resolving doubts in favor of arbitration—and that judicial review of arbitration awards will be limited to the narrow grounds set forth in the Section 10(a) of the FAA, grounds that do not include appellate review of arbitration awards.   For if courts were to take a more active role in the arbitration process, that would defeat arbitration’s purposes—it would not relieve stress on the court system (and might even increase it) and it would deprive the parties of, among other things, their ability to opt for a more efficient and speedy way of resolving their disputes.

Arbitration simply describes a concept or construct:  private parties can agree to opt out of the court system, and resolve their private disputes privately and informally and on their merits by submitting them to private decision makers of their choosing under procedures agreed by the parties or imposed by the arbitrators.  How the parties and their privately appointed decision makers go about deciding disputes is largely up to them.

Arbitration is not an institutional system of dispute resolution or even a group of such systems. Institutional systems feature norms, rules and principles that the institution strives to apply consistently to similarly-situated disputes, and these decisional rules and standards are readily available.  Courts are institutional systems of dispute resolution, and the U.S. state and federal court system is a group of institutional systems, some of which are interrelated and all of which are bound to follow the rules and principles embodied in or derived from the U.S. Constitution, applicable federal statutes, and where applicable, state constitutions and statutes. Each of these systems has its own decision-making hierarchy, as well as a hierarchy of rules, principles and interpretive sources.  And perhaps most importantly, each of these public-sector dispute resolution systems values and strives to yield uniform and predictable outcomes.

Arbitrators are not simply private judges or private surrogates for them.  Like judges, they are decision makers, but, as a general rule, the similarities end there.  Judges in trial courts of general jurisdiction (“trial court judges”) or appellate courts (“appellate court judges”) are almost always lawyers by trade with experience in the public or private sector, and frequently both. For example, New York State requires the Justices of its Supreme Court (New York’s system of trial and intermediate appellate courts of general jurisdiction), and the judges of its Court of Appeals (New York’s highest court), to “be admitted to practice law [in New York State for].  .  .  at least ten years.”  New York State Const., Art. VI, § 20.  And while federal judges are not constitutionally or statutorily required to be attorneys, they are usually recommended for Presidential appointment by members of Congress and vetted by the U.S. Department of Justice, both of whom have their own eligibility criteria, which typically includes not only being a licensed attorney but one deemed professionally competent by the American Bar Association.   Arbitrators, however, are not required to be attorneys, and while many are, they are—particularly in specialized industries—often non-lawyer industry professionals chosen for their unique expertise in the subject matter to be arbitrated.

Federal or state trial and appellate judges typically have practiced law and quite frequently have special expertise in particular areas of practice, but as judges they have to be generalists. They must resolve both criminal and civil cases, any of which may involve any number of different subject- matter types or a specialized area of the law.  And while there are many trial and appellate courts across the country with impressive expertise in a wide range of commercial disputes (New York’s U.S. District Court for the Southern District of New York and the U.S. Court of Appeals for the Second Circuit are good examples) not all judges of those courts necessarily possess the same level of expertise in commercial matters, judges are usually assigned to cases based on a random assignment process—not based on their expertise or experience—and litigants have no say in the assignment process.

Arbitration is designed to allow the parties to choose specialized decision makers that are not simply surrogates for generalist  judges.  One of the key tenets of arbitration is that parties get to have a say in who their arbitrators will be, which they frequently do by agreeing in advance who the arbitrators will be, or by specifying arbitrator qualifications and a method of arbitrator selection.  That in turn allows them to increase the odds that the arbitrators who hear their disputes will have particular expertise and experience in the subject matter, and will hopefully be likely to resolve any disputes in a way consistent with party expectations.

There are some other significant differences between arbitrators and judges.  For example, judges are public servants who are not paid by the case or by the hour, and who generally are not compensated as well as many of the attorneys that regularly appear before them.  Arbitrators, by contrast, are typically paid by the hour, frequently at rates that are as high as, or higher than, those charged by the lawyers.  Arbitrators are often (particularly in industry arbitration) persons who know—or at least know of—the parties and their lawyers, and may work in the same industry as one or both of the parties.

It is for these reasons that the impartiality standards applicable to arbitrators are less demanding than those applicable to federal and state judges.  As Associate Justice Byron R. White famously wrote, that is so because “[i]t is often because [arbitrators] are men of affairs, not apart from but of the marketplace, that they are effective in their adjudicatory function.” Commonwealth Coatings Corp. v. Continental Cas. Co., 393 U.S. 145, 150 (1968) (White, J., concurring).  In a similar vein, Circuit Court of Appeals Judge Richard A. Posner explained:

There is a tradeoff between impartiality and expertise. The expert adjudicator is more likely than a judge or juror not only to be precommitted to a particular substantive position but to know or have heard of the parties (or if the parties are organizations, their key people). ‘Expertise in an industry is accompanied by exposure, in ways large and small, to those engaged in it.  .  .  .  ‘

Merit Ins. Co. v. Leatherby Ins. Co.,  714 F.2d 673, 679 (1983) (Posner, J.) (quoting Andros Compania Maritima, S.A. v. Marc Rich & Co., 579 F.2d 691, 701 (2d Cir. 1978) (Kaufman, J.)).

While parties have significant input into who their arbitrators will be, the manner in which an arbitration will proceed, and what the outcome will be, are generally not easy to predict. Arbitrations that arise out of substantially similar arbitration agreements and involve materially identical facts can nevertheless proceed in very different ways and yield very different outcomes, both of which are usually capable of judicial confirmation.

Predictability and uniformity of outcomes are not expected in private-sector dispute resolution and, apart from enforcing arbitration agreements—which at least  in theory could be drafted to require some degree of predictability and uniformity—arbitration law is not designed to promote outcome predictability and uniformity.  If anything it promotes unpredictability and eschews uniformity by authorizing courts to play only a limited role in reviewing arbitration awards and interpreting arbitration agreements.

This is a tie-back to our earlier point that arbitration is not an institution, but merely a way of resolving disputes privately, informally and confidentially. Even if confirmed, arbitration awards do not have any precedential value (although they may have issue- and claim-preclusive effect on a party in subsequent judicial proceedings).  And unlike judges, arbitrators are not required to state the reasons for their award unless the parties agree they must.  By contrast, the public-sector, institutional system of dispute resolution—the court system—is designed to promote predictability and uniformity, which is why court decisions have precedential value (the degree of which depends on the court’s official and unofficial hierarchy within the system), and why those decisions are supposed to be reasoned and based on particular procedural and decisional rules and principles.

Arbitration is predictably unpredictable because it is not institutionalized, is guided mainly by the parties’ agreement and by the decision makers to whom they delegate decision-making authority, and is subject to only limited judicial oversight.  Arbitrators are generally not bound to strictly apply the law, and, at least absent express party agreement, they can and frequently do interpret contracts in ways that most courts would not.  By the same token, they have greater leeway to rely on industry-related norms and customs, are usually more familiar with them than generalist judges are, and are often more likely to accord them greater weight.  Loosely-defined notions of fairness may also play a significant part, and because arbitrators are generally not required to strictly follow the law, they frequently have more leeway than courts to decide cases based on subjective notions of fairness or equity, and to reach decisions which more closely resemble compromises than adjudications on the merits.

Those who opt for judicial resolution can reasonably expect a just outcome based on the law, which, as respects contract interpretation, has for the most part been established for decades.  And while arbitrators can, and not infrequently do, decide cases according to controlling law applied in the way a court would, those who opt for arbitral resolution can reasonably expect no more than rough justice that is at least colorably based on the parties’ agreement, including their agreement to arbitrate.

While arbitration is predictably unpredictable, at least some of that uncertainty can be managed by careful and precise arbitration agreement wording, a topic to be covered in a later installment of this series.  One of the benefits of arbitration is that it can be tailored to particular types of a disputes, but that’s a benefit of which small businesses far too frequently do not take advantage.  By contrast, their dispute-resolution-savvy big business counterparts tend not to make that mistake.

Just as the choice between arbitration and litigation is not a choice between two institutionalized systems of dispute resolution, so too is an informed choice of arbitration agreement not merely a matter of selecting from a menu of standard or boilerplate arbitration agreements.  There are, however, certain structural characteristics that most arbitration agreements share, and it is to these that we shall turn in Part II.B.

Links to Previous Segments of this Multi-Part Small Business B-2-B Arbitration Post:

Part I

Links to Future Segments:

Part II.B.1

Part II.B.2(A)

Part II.B.2(B)

Part II.B.2(C)


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