Arbitration Risks—Outcome Risk
Introduction
Our last segment of our B-2-B arbitration series (here) wrapped up discussion of the structural characteristics of arbitration agreements. Now that we’ve covered the nature and purpose of arbitration, and the structure of arbitration agreements, let’s consider some of the risks an agreement to arbitration can pose to a small or medium-sized business.
For simplicity’s sake we’ll focus on five types of risk associated with agreeing to arbitrate disputes:
- “Outcome risk;”
- “Fail-Safe risk;”
- “Bleak House risk;”
- “Counterparty risk;” and
- “Integrity risk.”
These are not necessarily the only types of risk one assumes in arbitration, but they are among the more significant ones. There are ways to help hedge against these risks and perhaps even lessen the frequency and severity of their manifestation, but for present purposes, let’s briefly discuss each, starting with outcome risk.
What is Outcome Risk?
Outcome risk is the risk that the outcome of an arbitration award on the merits will be difficult to predict, and will not necessarily reflect what the parties intended.
Businesses memorialize deals in formal contracts for good reason. All else equal, they usually want a clear record of the parties’: (a) mutual promises; (b) expectations about performance; (c) allocation of risks between or among them; and (d) understandings about what happens if things go south.
Courts do not purport to be perfect, but at least in jurisdictions that feature business-friendly contract law (New York, for example), they generally can be counted on to enforce as written the clear language of a business contract negotiated at arm’s length. And when parties to a contract take care to express themselves clearly, they usually do so because they are counting on courts to enforce the contract that way in the event of litigation.
Whether or not the same result will obtain in arbitration is far less certain and, depends on the particular arbitrator or panel of arbitrators appointed to resolve the dispute, the parties’ contract (including their arbitration agreement) and a number of other things. Businesses without meaningful experience in arbitration far too frequently assume that arbitration is simply a different way of resolving disputes, and that it is thus reasonable to expect that, all else equal, arbitration panels and courts will ordinarily reach the same outcomes based on the same facts, and that, accordingly, arbitral outcomes are, for the most part, as predictable as judicial outcomes. While commonsense and logic would appear to support the validity of that assumption, practice frequently proves it untrue, or at least unrealistic.
Arbitral outcomes are predictably unpredictable. Contract language parties reasonably assume to mean one thing may be interpreted by arbitrators to mean something different. Arbitrators may render compromise awards that reflect a “compromise” to which neither party would likely have agreed. Parties with highly questionable claims or defenses may emerge victorious even though the other party has what most courts would likely consider to be strong claims or defenses.
Outcome unpredictability can have a number of profound consequences on the contractual and business relationship between the parties. It may, for example, increase the odds that a dispute between the parties will arise.
It is not uncommon for one party to an arms-length deal to become dissatisfied with how the economics of deal turned out for it. Counterparties acting in bad faith or in an otherwise untrustworthy (or at least unseemly) fashion, will all too often look for some excuse or justification—no matter how contrived or misguided—in an effort to avoid their obligations or attempt to renegotiate the terms of the deal.
Outcome unpredictability is generally a boon to recalcitrant and untrustworthy counterparts searching for low cost ways of avoiding or renegotiating contracts. If the outcome of a dispute is unpredictable, then the value of an iffy claim or defense to our opportunist counterparty will increase, while the relative value of an otherwise objectively strong claim or defense to the contract-defending party will decrease. That vests in our opportunist counterparty an inordinate amount of bargaining power that the law of contracts was designed to deny it. If, on the other hand, both parties can depend on the decision maker enforcing the contract according to its terms, then the opportunistic counterparty would have little or no incentive to raise frivolous claims and defenses.
A closely related consequence of, outcome unpredictability is that it tends to undermine the whole point of entering into a well-structured and clearly drafted business contract. One of the reasons parties often invest effort into making contractual provisions as clear as possible is to avoid the sort of gamesmanship discussed above, but if you agree to arbitrate you may risk defeating the purposes and objectives of careful contract drafting, and may unintentionally be providing your counterparty with a means to escape or renegotiate its obligations at your or your client’s expense. Why invest all that time, money and effort in careful contract drafting unless you can be reasonably sure that the contract will be enforced as written?
Outcome unpredictability is anathema to the law of contracts—as we said, courts in business friendly jurisdictions, generally interpret and apply contracts in relatively predictable ways—and yet it is a risk one undertakes by agreeing to arbitrate disputes. It has a number of other consequences apart from those we touched on above, but the bottom line is that it can be very costly, and usually needs to be managed carefully if one decides to agree to arbitrate.
Compounding outcome risk is arbitration law. Arbitration is supposed to be an alternative to litigation that will help relieve congested court dockets. That is why arbitration is a favorite son of the law. See Roughneck Concrete Drilling and Sawing Co. v. Plumbers’ Pension Fund, 640 F.3d 761, 765 (7th Cir. 2011) (“bias in favor of arbitration. . . seems largely motivated by a desire to limit judicial workloads”).
The Federal Arbitration Act is supposed to promote arbitration by making it a viable and cost effective alternative to litigation. Perhaps arbitration might be more attractive to some parties if there were more judicial oversight, but that would not only deprive courts of the benefits of reduced docket stress, but would probably add considerably to it. It would also make arbitration more time consuming and expensive, making it less desirable to many as an alternative to litigation. (See, e.g., Loree Reins. & Arb. Law Forum post here.)
When a court resolves a contract dispute, its final decision can be appealed to an appellate court, where a panel of judges will review questions of law de novo—that is, independently—and factual questions for clear error. Thus, even if a trial court misinterprets the contract, that error may be corrected on appeal.
But when it comes to the merits of the dispute, arbitration is a one-shot deal, generally without the opportunity for second chances. There is no right to appellate review of an arbitration award, and courts cannot and will not review—let alone correct—an arbitrator’s mistakes of law or fact. (See, e.g., Loree Reins. & Arb. Law Forum post here.)
The recourse of a losing party in a Federal Arbitration Act (“FAA”) governed arbitration is usually limited to an order vacating modifying or correcting an award under FAA Sections 10 or 11. These narrow grounds for relief act as a “fail safe” or “safety net,” which is designed to ensure that the award upon which the court is asked to enter judgment is a legitimate product of the parties’ agreement to arbitrate, and that the challenging party has not been deprived of the modest requirements of fundamental fairness FAA Sections 10(a)(1) through 10(a)(3) imply into every arbitration agreement. See Wise v. Wachovia Securities, LLC, 450 F. 3d 265, 269 (7th Cir. 2006) (a party challenging an “arbitration award. . . does so not on the ground that the arbitrators made a mistake but that they violated the agreement to arbitrate, as by corruption, evident partiality, exceeding their powers, etc.—conduct to which the parties did not consent when they included an arbitration clause in their contract”).
While challenges to arbitration awards are fairly common, successful ones are not. Petitions or motions to vacate, modify or correct awards are adjudicated summarily and, for the most part, the arbitrator’s outcome will be deemed to exceed his or her powers only when it is not even arguably based on an interpretation of the contract, that is, where the award lacks any contractual basis. (See, e.g., Loree Reins. & Arb. Law Forum post here.) Some courts may allow vacatur where the award manifestly disregards some well-established and clearly applicable legal rule or principle argued to the arbitrator, but relief under this standard is exceedingly rare. In any event, courts have imposed several requirements that usually have to be met to successfully challenge an award, and for the most part, any doubts about vacatur, modification or correction are resolved in favor of rejecting the challenge and confirming the award (that is, entering judgment on it).
In the next segment of this post we’ll discuss “fail-safe risk,” which is the risk that courts will give award challenges shorter shrift than may otherwise be appropriate, even in close cases.
Links to Previous Segments of this Multi-Part Small Business B-2-B Arbitration Post:
