Though often considered a 20th century phenomenon, arbitration—an out-of-court proceeding in which one or more neutral third parties hears evidence and then makes a binding decision—has a long and checkered past, starting with King Solomon’s famous approach to child custody. It was used in England back in the 13th century (and before the existence of the so-called common law—rules based upon court rulings), and George Washington even included an arbitration provision in his will.[i] Today, arbitration is the most commonly used method of alternative dispute resolution (ADR).
Binding or nonbinding. Arbitration can be binding (which means the participants must follow the arbitrator’s decision and courts will enforce it) or nonbinding (in which either party is free to reject the arbitrator’s decision and take the dispute to court, as if the arbitration had never taken place). Binding arbitration is more common.
Who can arbitrate disputes? Arbitration can be voluntary (the parties agree to do it) or mandatory (required by law). Most contract arbitrations occur because the parties included a clause requiring them to arbitrate any disputes “arising under or related to” the contract. If a provision like this isn’t included, the parties can still arbitrate if they both agree to it (although it’s tough to reach an agreement like this once a dispute has arisen).
Advantages and disadvantages. For simple contract disputes in which the matter can be heard in one day, arbitration is usually a good choice. However, if in doubt, consider the advantages and disadvantages, below:
- Advantages. Arbitration is usually faster, simpler, more efficient, and more flexible for scheduling, than litigation. Also, it avoids some of the hostility of courtroom disputes, perhaps because it’s a private proceeding versus the public drama of the courtroom. If the subject of the dispute is technical—for example, about a patent—the parties can select an arbitrator who has technical knowledge in that field.
- Disadvantages. Unlike a court ruling, a binding arbitration ruling can’t be appealed. It can be set aside only if a party can prove that the arbitrator was biased or that the ruling violated public policy. Unlike a court battle, there is no automatic right to discovery (the process by which the parties must disclose information about their cases). However, you can include a requirement for discovery in your arbitration provision or agree to it under arbitration rules. The costs of arbitration can be significant; in some cases, they may even exceed the costs of litigation (see below).
What does it cost? According to a survey by Public Citizen, a consumer watchdog group, the cost of initiating an arbitration is significantly higher than the cost of filing a lawsuit. On average, it costs about $9,000 to initiate a claim to arbitrate a contract claim worth $80,000 (versus about $250 to file that action in state court). Keep in mind that the people in the dispute pay the arbitrators, and arbitration fees can run to $10,000 or more. Add in administrative costs and your own attorney fees (if you hire one) and the process might even cost more than litigation.
Arbitration Checklist. A simple arbitration provision, such as the one shown in Example 1, may be suitable for basic contract disputes. But more complex contracts or those involving large sums of money may require the parties to consider some of the questions below. (Note: when you agree to arbitrate with an organization such as the American Arbitration Association, their rules permit the parties to work out some of these details later. Still, it’s generally easier to agree on these things before there’s a dispute.)
- Do you want an arbitrator knowledgeable in a specific field of law or business? If so, include that in your arbitration provision—for example, “Arbitration shall be conducted by an arbitrator experienced in the toy and licensing industry.”
- Do you want to understand why the arbitrator ruled a certain way? In this case, you should include a request for a written record of the decision.
- Do you want to prevent some issues from being arbitrated? If so, then you need to make exceptions—for example, “All claims and disputes arising under or relating to this Agreement are to be settled by binding arbitration, except for disputes relating to the validity of patents … “
- Are you worried that the potential award may be astronomical? If so, the parties may agree to limit the amount of the award—for example, by stating that the arbitrator cannot award more than $10,000 to any party.
- Do you want the arbitrator follow specific arbitration rules? If so, include the name of the organization, for example, the California Lawyers for the Arts or the American Arbitration Association.
- Should the winning party have its attorney fees paid by the loser? If so, include language regarding attorney fees—for example, “the prevailing party shall be entitled to its reasonable attorney fees and costs.” What are costs? The filing fees, charges for serving papers, court reporter charges for depositions (which can be very expensive), transcripts, costs of copying, and exhibits.
- Does it matter where you arbitrate or what state’s law applies to arbitration? If so, indicate those preferences in arbitration provision. Keep in mind that the location of the arbitration may seem unimportant now, but will prove a major issue if a dispute occurs and you have to book a flight to Anchorage for the arbitration hearing.
Sample arbitration clauses. Example 1 shows a simple no frills arbitration clause; Example 2 offers more conditions and obligations.
EXAMPLE 1: Arbitration. All claims and disputes arising under or relating to this Agreement are to be settled by binding arbitration in the state of [insert state in which parties agree to arbitrate] or another location mutually agreeable to the parties. An award of arbitration may be confirmed in a court of competent jurisdiction
EXAMPLE 2: Arbitration. All claims and disputes arising under or relating to this Agreement are to be settled by binding arbitration in the state of [insert state in which parties agree to arbitrate] or another location mutually agreeable to the parties. The arbitration shall be conducted on a confidential basis pursuant to the Commercial Arbitration Rules of the American Arbitration Association. Any decision or award as a result of any such arbitration proceeding shall be in writing and shall provide an explanation for all conclusions of law and fact and shall include the assessment of costs, expenses, and reasonable attorneys’ fees. Any such arbitration shall be conducted by an arbitrator experienced in [insert industry or legal experience required for arbitrator] and shall include a written record of the arbitration hearing. The parties reserve the right to object to any individual who shall be employed by or affiliated with a competing organization or entity. An award of arbitration may be confirmed in a court of competent jurisdiction.
Do you need to hire a lawyer for arbitration? If you have a significant amount of money or property in dispute, you should consider hiring a lawyer. The arbitrator’s decision will be binding, which means this is your only chance to win.
Arbitration variations. Arbitration is typically a straightforward matter. The parties submit evidence and arguments, and the arbitrator makes a binding decision. Over the years, however, a few variations have developed, including:
- Mediation/Arbitration (sometimes known as “Med/Arb”). In this arrangement, the parties first attempt to mediate their dispute and if they can’t resolve it with a mediator, they submit the matter to arbitration.
- Bracketed (High-Low) Arbitration. The parties agree in advance to high and low limits on the arbitrator’s authority. This method is best used when the only dispute is over how much money is owed.
- Pendulum Arbitration (also known as “Baseball Arbitration”): Each party gives the arbitrator a figure for which he or she would be willing to settle the case. The arbitrator must then choose one party’s figure or the other—no other award can be made.
- Night Baseball Arbitration: As in baseball arbitration, above, each side chooses a value for the case and exchanges it with the other side—but not with the arbitrator (“night baseball” refers to the fact that the arbitrator is ”kept in the dark.”) The arbitrator makes a decision about the value of the case, and then the parties must accept whichever of their own figures is closer to the arbitrator’s award.