We Agreed to What?! How the Selection of an Arbitration Clause Can Impact a Client's Legal Rights
Published in Business Law News, Issue 1, 2007. Copyright © 2007 by The State Bar of California. Reprinted with permission.
Arbitration clauses are everywhere and profoundly alter the rights of parties to agreements containing them. Often, however, it is not until an actual dispute arises that parties and their counsel first become aware of just how profound an effect these clauses can have.
In the momentum of a deal or settlement closing, the parties often fail to focus on the language of the arbitration clause. And, although the parties may agree to use a specific arbitration provider, little attention generally is given to the rules which will govern an arbitration. Unfortunately, the clauses "recommended" by arbitration providers, and included in many contracts, are extremely broad and often have unexpected, and undesired, consequences. One of the most significant and least anticipated of these consequences is to vest the arbitrator with the power to decide "arbitrability" - whether a claim is subject to arbitration - although this is one of the few issues still traditionally relegated to the courts' jurisdiction.
The impact of these unanticipated consequences is magnified by the strong presumption favoring arbitration. The United States Supreme Court in Buckeye Check Cashing, Inc. v. Cardegna recently explained that even where an agreement containing an arbitration clause is alleged to be illegal as a whole and therefore void ab initio, the arbitration clause is severable and an arbitrator, not a court, decides whether the agreement is in fact illegal. The only exceptions the Supreme Court allowed to this rule are where the arbitration clause itself is challenged, or where the formation of the contract is contested such that no contract exists (e.g. for fraud in the execution of the agreement). Otherwise, arbitration it is.
The Supreme Court's willingness to require arbitration even where an agreement is illegal illustrates the importance of clearly stating in each agreement what the parties are agreeing to arbitrate and who will decide what. Because arbitration clauses take a wide variety of forms, parties' rights can be affected either expressly or implicitly by the language chosen for the clause. The informed and careful selection of an arbitration clause and arbitration provider eliminates unintended and often unwelcome consequences.
The Effect of The Presumption Favoring Arbitration.
To help fulfill parties' intentions and overcome the judicial aversion to arbitration, the Federal Arbitration Act ("FAA" or "the Act") was enacted. Every arbitration agreement affecting interstate commerce is subject to the FAA. Therefore, only if a contract exclusively affects intrastate commerce will California's Arbitration Act apply.
Once a court determines that the making (formation) of an arbitration agreement is not in issue, it will direct the parties to proceed to arbitration in accordance with the terms of the agreement. The role of the courts in reviewing matters subject to arbitration, therefore, is usually limited to determining two issues: 1) whether a valid agreement or obligation to arbitrate exists; and 2) whether one party to the agreement has neglected or refused to arbitrate.
In construing an arbitration agreement, as with any other contract, the parties' intentions control, but those intentions are "generously construed as to issues of arbitrability." Any doubts concerning the scope of arbitrable issues generally should be resolved in favor of arbitration. As a general rule, questions of arbitrability must be addressed with "a healthy regard for the federal policy favoring arbitration." In fact, when contracts contain an arbitration provision, "a presumption of arbitrability" arises, such that any doubt about the "scope of arbitrable issues" is to be resolved in favor of arbitration.
When deciding whether the parties agreed to arbitrate a certain matter (including arbitrability), courts generally should apply the same ordinary state law principles that govern the formation of contracts. However, the FAA created a body of federal substantive law of arbitrability, which is applicable to any arbitration agreement within the coverage of the Act. And, because courts commonly decide issues of arbitrability, a substantial body of law has developed interpreting broad arbitration clauses. Even when applying general state-law principles of contract interpretation to the interpretation of an agreement within the scope of the FAA, courts give due regard to the federal policy favoring arbitration, and, typically, any ambiguities as to the scope of the arbitration clause itself are resolved in favor of arbitration.
Who Decides The "Gateway" Issue of Arbitrability?
Arbitration is a matter of contract and a party cannot be required to submit to arbitration any dispute that he or she has not agreed to submit. "Arbitrability" refers to whether parties agreed to submit a particular dispute to arbitration. For the most part, arbitrability involves two interrelated concepts: (1) whether the court or the arbitrator should decide the scope of the parties' agreement to arbitrate, and (2) whether the parties agreed to arbitrate their present dispute. As noted above, the FAA's policy favoring arbitration requires that any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration. However, where the agreement contains an ambiguity as to who decides the so-called "gateway issue" of arbitrability, the Act's presumption favoring arbitration is reversed so that the court will ordinarily decide this crucial threshold question:
Just as the arbitrability of the merits of a dispute depends upon whether the parties agreed to arbitrate that dispute, so the question "who has the primary power to decide arbitrability" turns upon what the parties agreed about that matter. Did the parties agree to submit the arbitrability question itself to arbitration?
Parties are free to assign to an arbitrator the question of whether a claim is arbitrable. But, "unless the parties clearly and unmistakably provide otherwise, the question of whether the parties agreed to arbitrate is to be decided by the court, not the arbitrator."
Unfortunately, this critical presumption favoring the court's authority to decide issues of arbitrability is often unintentionally extinguished: (1) by adopting a standard, broad arbitration clause "recommended" by an arbitration provider; and/or (2) by failing to carefully consider which arbitration provider is selected. Either way, a client may subsequently come to believe that he or she did not get what was bargained for, which is why careful attention should be paid to arbitration clauses.
Arbitration Clauses Commonly Eliminate the Presumption That Courts Will Decide Issues of Arbitrability.
In many arbitration clauses, parties commonly agree that all matters "arising out of or relating to" their agreement will be arbitrable. And, they do so at the suggestion of many arbitration providers. Even though they do not expressly so state, these broad "recommended" clauses have been interpreted to confer on the arbitrator the authority to decide his or her own jurisdiction and to divest the courts of all jurisdiction over questions of arbitrability. For instance, the American Arbitration Association suggests that parties use the following broad language for clauses in commercial contracts:
Any controversy or claim arising out of or relating to this contract, or the breach thereof, shall be settled by arbitration administered by the American Arbitration Association under its Commercial Arbitration Rules, and judgment on the award rendered by the arbitrator(s) may be entered in any court having jurisdiction thereof.
The International Institute for Conflict Prevention and Resolution (formerly the CPR Institute for Dispute Resolution) ("CPR") suggests the following standard language:
Any dispute arising out of or relating to this contract, including the breach, termination or validity thereof, shall be finally resolved by arbitration in accordance with the International Institute for Conflict Prevention and Resolution Rules . . . .
The International Chamber of Commerce ("ICC") suggests:
All disputes arising out of or in connection with the present contract shall be finally settled under the Rules of Arbitration of the International Chamber of Commerce. . .
Beware. Courts have recognized that this kind of language is "the paradigm of a broad clause" and "the broadest language the parties could reasonably use." Even without expressly stating "who decides" arbitrability, this broad language has been interpreted to mean that the parties intended to submit questions of arbitrability to the arbitrator, thus overcoming the presumption favoring judicial determination of this crucial issue. Indeed, many cases confirm that the breadth of an arbitration clause itself demonstrates a clear and unmistakable intent to have arbitrability decided by the arbitrator:
In construing arbitration clauses, courts have at times distinguished between ‘broad' clauses that purport to refer all disputes out of a contract to arbitration and ‘narrow' clauses that limit arbitration to specific types of disputes. If a court concludes that a clause is a broad one, then it will order arbitration and any subsequent construction of the contract and of the parties' rights and obligations under it are within the jurisdiction of the arbitrator.
Courts have explained that an objective reading of an arbitration clause that refers "[a]ny and all controversies" to arbitration leads to the conclusion that the parties intended to arbitrate issues of arbitrability. In other words, the referral to arbitration of "all disputes ... concerning or arising out of" an agreement evinces a "clear and unmistakable intent to submit questions of arbitrability to arbitration." This view is bolstered by the policy against dividing disputes into substantive and procedural aspects to be determined partly by arbitrators and partly by the courts. Some courts have held that such language does not clearly and unmistakably demonstrate the requisite intention of the parties to arbitrate arbitrability. However, the general trend appears to be to interpret broad arbitration clauses consistent with the general policy favoring arbitration and to relegate to the arbitrator all questions of arbitrability.
Therefore, by adopting commonly used or recommended language in an arbitration clause, clients may have unknowingly agreed to give up their right to have the courts decide the scope of their arbitration agreement and the extent of the arbitrator's jurisdiction. Doing so can significantly impact a client's rights because arbitrators' decisions are well insulated from review, and the courts have no ability to rectify any subsequent errors in law or contract interpretation. Making informed decisions about the language of an arbitration clause and carefully considering the rules of the selected arbitration provider can help clients avoid unwelcome surprises should future disputes ever develop.
Arbitration Clauses May Divest Courts of Jurisdiction to Decide Arbitrability
Arbitration clauses commonly state that the parties agree to be bound by the rules of the arbitration provider they select. Often, the parties specifically incorporate the rules of a particular arbitration provider into their agreement. Even if the agreement does not expressly incorporate the provider's rules, the rules themselves often state that merely by agreeing to arbitrate with the specified provider, the arbitration rules are deemed to be incorporated into the parties' agreement.
These simple acts can have unintended consequences. Unless care is taken to understand the effect of the referenced rules, and their potential effect in the future, the clients' legal rights can be altered. By routinely incorporating a certain provider's rules into an agreement, the parties may unknowingly agree to have the arbitrator determine the scope of his or her own authority. In fact, most arbitration rules contain specific provisions divesting the courts of jurisdiction to decide gateway issues of arbitrability.
The AAA's Commercial Arbitration Rules provide at R-7(a) that: "The arbitrator shall have the power to rule on his or her own jurisdiction, including any objections with respect to the existence, scope or validity of the arbitration agreement." The National Arbitration Forum Rules state at Rule 20(F): "An Arbitrator shall have the power to rule on all issues, claims, responses and objections regarding the existence, scope, and validity of the arbitration agreement, including all objections relating to jurisdiction, . . .."
The JAMS Rules similarly submit questions of the arbitrators' jurisdiction and arbitrability to the arbitrator. Rule 11(c) of the JAMS Comprehensive Arbitration Rules and Procedures provides:
Jurisdictional and arbitrability disputes, including disputes over the existence, validity, interpretation or scope of the agreement under which Arbitration is sought, and who are proper Parties to the Arbitration, shall be submitted to and ruled on by the Arbitrator. The Arbitrator has the authority to determine jurisdiction and arbitrability issues as a preliminary matter.
Likewise, the CPR Rules expressly provide that "The Tribunal shall have the power to hear and determine challenges to its jurisdiction, including any objections with respect to the existence, scope or validity of the arbitration agreement." The CPR states, as to Rule 8: "This should allow arbitrators to decide all issues, including arbitrability questions, without the necessity for court intervention." In its "Commentary on Individual Rules," the CPR explains that Rule 8 is meant to express principles consistent with the U.S. Supreme Court's decision in First Options of Chicago v. Kaplan, and thus, pursuant to Rule 8, it is up to the arbitrator(s) to decide whether the arbitration will proceed in the face of a jurisdictional challenge.
The courts have affirmed that language such as that quoted above eliminates the First Options presumption and vests the arbitrator with the authority to determine all challenges to his or her jurisdiction, as well as the scope of the arbitration agreement. In Lifescan, Inc. v. Premier Diabetic Services, Inc., a case arising out of a contract for the sale of medical devices and supplies, the Ninth Circuit concluded that by referring to the AAA's rules in their arbitration clause, the parties incorporated the AAA Rules into their agreement and those rules, "in turn, recognize the arbitrators' discretion to interpret the scope of their authority."
Despite the similarity of this language to AAA's rule, the two courts to address the JAMS rule have split on whether the incorporation of the JAMS Rule expresses a clear and unmistakable intent to submit the issue of arbitrability to arbitration.
The effect of incorporating an arbitration provider's rules into an agreement is not based solely on the FAA. State law contract principles also regularly apply the rule of incorporation by reference to enforce arbitration rules referred to in an arbitration clause. For instance, Delaware has a long history of enforcing parties' intentions of incorporating by reference documents referred to within an agreement.
As is clear from First Options, parties may, of course, expressly not agree to be bound by certain of the arbitration provider's rules. They also may expressly state that, notwithstanding their agreement to be bound by the provider's rules, they do not agree, nor intend, to divest the court of its jurisdiction to decide issues of arbitrability and jurisdiction and expressly do not agree to have such issues determined by the arbitrator. However, be sure to review the arbitration provider's rules to see if doing so jeopardizes the enforceability of the arbitration clause. For example, the National Arbitration Forum's Rule 48(E) provides that the Forum or the arbitrator may decline to arbitrate "where the agreement of the Parties has substantially modified a material portion of the Code."
Another option is just not to select a specific arbitration provider at the time the agreement is signed and to clearly state in the agreement: (1) the specific claims and types of disputes the parties intend to arbitrate and (2) that the parties intend the court to decide all issues of arbitrability, including the scope of the arbitrator's jurisdiction and/or the applicable statute of limitations. The parties can further agree to the method and deadline for selecting an arbitrator, thus insuring that no party's rights have been unintentionally waived or altered.
Arbitration Clauses May Bind Clients to Rules That Do Not Yet Exist
The selection of a specific ADR provider and often routine incorporation of an ADR provider's rules as part of an arbitration clause can subject your client to rules that did not even exist at the time the agreement was signed. For instance, Rule 1(a) of AAA's Commercial Arbitration Rules provides, in part:
These rules and any amendment of them shall apply in the form in effect at the time the administrative requirements are met for a demand for arbitration or submission agreement received by the AAA. The parties, by written agreement, may vary the procedures set forth in these rules.
The National Arbitration Forum's "Code of Procedure", Rule 1(C) provides: "Arbitrations will be conducted in accord with the applicable Code of Procedure in effect at the time the Claim is filed, unless the law or the agreement of the Parties provides otherwise." The ICC Rules of Arbitration state: "Where the parties have agreed to submit to arbitration under the Rules, they shall be deemed to have submitted ipso facto to the Rules in effect on the date of commencement of the arbitration proceedings, unless they have agreed to submit to the Rules in effect on the date of their arbitration agreement." CPR Rule 1.1 requires: "Unless the parties otherwise agree, these Rules, and any amendment adopted by CPR shall apply in the form in effect at the time the arbitration is commenced."
Thus, by incorporating an arbitration provider's rules into an agreement, or by agreeing to be bound by the rules, the parties may be agreeing to be bound by rules the arbitration provider may modify or create in the future. As a result, the parties may be subjected to future arbitrations governed by rules very different than existed, and that the parties intended to apply, at the time they executed the agreement. For instance, even if an arbitration provider's rules do not now vest the arbitrator with the power to decide issues of arbitrability, by the time future disputes develop, new rules may have divested the court of any authority over such disputes, even if the parties did not so intend when the agreement was signed. By expressly adopting an arbitration provider's rules, and failing to make any exception to them, or by failing to specify that a specific version will govern the parties' disputes, the parties will most likely be deemed to be bound by rules they did not even know of at the time the agreement was signed.
California's Court of Appeal recently spoke to the issue with respect to JAMS' arbitration rules in Evans v. Centerstone Development Co. The parties agreed to settle disputes arising from the operation of the real estate development company by resort to JAMS "Streamlined Rules." Among these was Rule 3 of the 2000 rules which stated that "JAMS may amend these Rules without notice. The Rules in effect on the date of the commencement of an Arbitration . . . will apply . . . unless the Parties have specified that another version of the Rules will apply." The court held that the arbitrator did not exceed his authority by applying the 2002 Rules, although the parties' agreement was executed when the 2000 Rules were in effect.
There is no reason for clients to agree to be bound by future, unknown arbitration rules, some of which may profoundly affect their rights. The Rules of most arbitration providers acknowledge that the parties may want to agree that prior, or specific, versions of their rules will govern arbitrations. Why not do so? That way, clients will receive precisely what they bargained for.
California's Presumption Favoring Arbitration
A number of recent cases confirm California's similarly strong presumption favoring arbitration. However, these California courts have also abided a number of contract and statutory principles that affect the interpretation of arbitration clauses, and the breadth of the FAA.
In California Correctional Peace Officers Assn. v. State of California, the Correctional Peace Officers Association sought to compel an arbitration to determine their rights under various agreements to have supervisory employees observe rank-and-file members' negotiations with the California Department of Personnel Administration, and vice versa. The Department took the position that such observations were precluded by the Government Code, and that because the relief sought in the arbitration is illegal, arbitration should not be compelled. The trial court bought the argument, but the Court of Appeal reversed, holding that "nothing in the statutes or the case law suggests that arbitrators cannot also interpret statutes. On the contrary, the body of case law governing arbitration has recognized repeatedly that arbitrators may be presented with issues of statutory interpretation and are entitled to resolve those issues--at least in the first instance." The Court went on to explain that, "the presence of a potentially dispositive statutory issue is not recognized as a defense to arbitration under Code of Civil Procedure section 1281.2."
In Kleveland v. Chicago Title Ins. Co., the Court of Appeal strictly interpreted the principle of incorporation by reference to deny a motion to compel to arbitration. In Kleveland, plaintiffs purchased a title insurance policy from Chicago Title on the basis of a preliminary title report they reviewed and approved which incorporated by reference an "ALTA [American Land Title Association] HOMEOWNER'S POLICY OF TITLE INSURANCE (11/98)," which contained an arbitration clause. However, the ALTA policy never issued. Instead, Chicago Title issued a California Land Title Association Standard Coverage Policy (CLTA) which contained a similar arbitration clause. When plaintiffs filed an action for breach of contract, the trial court denied defendant's motion to compel arbitration. The Court of Appeal affirmed, holding that the preliminary title report did not incorporate by reference the policy ultimately issued, and thus plaintiff could not be compelled to arbitrate under it. In addition to grounds based on title insurance law, the Court responded to Chicago Title's argument that it is unfair to deny arbitration when the arbitration clause in the policy it issued was virtually identical to the one referred to in the preliminary report:
While this argument has a sort of "no harm, no foul" appeal, it is unreasonable to rely on an arbitration clause in a nonexistent policy to deny plaintiffs the right to a jury trial. As the drafter of the preliminary report, Chicago Title was in the best position to avoid this problem: it could have simply included an arbitration clause in the report itself.
In another twist on contract interpretation, the California Supreme Court has recognized parties' rights to opt out of the FAA in favor of the California Arbitration Act (CAA). As is explained above, the Supremacy Clause imposes the FAA on parties whose contracts affect interstate commerce. However, the Supreme Court explained in Cronus Investments, Inc. v. Concierge Services that "the language of the arbitration clause in this case, calling for the application of the FAA ‘if it would be applicable,' should not be read to preclude the application of 1281.2(c), because it does not conflict with the applicable provisions of the FAA and does not undermine or frustrate the FAA's substantive policy favoring arbitration." While clearer language could have been used to identify disputes that were (and were not) subject to the FAA and the CAA, Cronus expresses a willingness to have courts make a factual determination whether the CAA or the FAA applies as a procedural matter, to be decided by the Court and not the arbitrator.
In Ferrer v. Preston, the Court of Appeal held that parties will not be compelled to arbitrate where a statute rests exclusive jurisdiction with the Labor Commissioner to decide an issue at the heart of the claim, there, whether someone was a talent agent within the meaning of The Talent Agencies Act.
Exercise Caution in Deciding what Claims to Arbitrate, and Who Will Arbitrate Them Because of the Extremely Limited Review Available in the Courts.
Parties to a deal often believe that even if an arbitrator gets it wrong, the courts will serve as a backstop to correct errors of law. But, aside from limited statutory grounds such as demonstrable bias, arbitrators' decisions are commonly reviewed only for a manifest disregard of the law. This is because of the presumption that where the parties have authorized the arbitrator to give meaning to the language of the agreement, a court should not reject an award on the ground that the arbitrator misread the contract. The Ninth Circuit Court of Appeals recently reiterated that a court's review of an arbitration panel's decision interpreting a contract is "extremely narrow." "If, on its face, the award represents a plausible interpretation of the contract, judicial inquiry ceases and the award must be enforced."
A simple error in reasoning by the arbitrator does not provide an opportunity to review the merits of the arbitrator's conclusion. "[A]s long as the arbitrator is even arguably construing or applying the contract and acting within the scope of his authority, that a court is convinced he committed serious error does not suffice to overturn his decision."
For one court, the mere reference to the contract as a basis for the decision was enough to reject the argument that the arbitrator manifestly disregarded the law. "A ‘misinterpretation of [a] contract[ ] will not, in itself, vitiate the award.' As long as the arbitrators did not disregard the language of the contract in their interpretation of it, their decision is not manifest disregard of the law. Here, the arbitrators explicitly stated that they reached their decision by construing the language of the contract. Therefore, the Court rules against Plaintiffs on this ground as well."
In Baize v. Eastridge Companies, the California Court of Appeal recently reiterated the narrow scope of review permitted, even where the arbitration agreement purports to limit the arbitrator's power to the application of California law. After surveying the cases, the court explained that:
The parties in this case contracted only for a binding arbitration in which the arbitrator applied California law. This is what they received. There is no suggestion in the record that the arbitrator purported to apply any law other than that of California. It is simply claimed that he did not do so correctly. Like the Pacific Gas & Electric and Marsch courts, we cannot endorse such an end run around the clear limitations set out in Moncharsh.
Based upon this reasoning, the Blaize Court refused to review the arbitrator's award for errors of law, and affirmed the arbitration award.
This limitation was reiterated in Cable Connection, Inc. v. DirecTV where the Court of Appeal recently held that the trial court may not review an arbitration award for errors of law even where the parties' arbitration clause specified that there was to be judicial review of errors of law. The Court explained that the parties could not, by agreement, confer jurisdiction on the trial court for a type of review not specified by the California Arbitration Act.
The FAA creates a strong presumption in favor of arbitration. Arbitration providers suggest, and parties commonly adopt, arbitration clauses that confer on the arbitrators the power to decide even those issues ordinarily decided by the courts. And, judicial review of arbitration awards is so limited that even blatant errors of law cannot be remedied by the courts. As a result, parties who are dissatisfied by an arbitral award are left with few, if any, options but to comply with the award.
Therefore, parties should carefully consider the breadth of the matters they agree to arbitrate, and carefully exclude from arbitration those matters for which they want to preserve their rights to trial and appeal in the courts. Careful consideration should be given to the language of the arbitration clause and equal consideration should be given to whether to specifically select an ADR provider or not. If an ADR provider is selected, the rules of the arbitration provider should be carefully reviewed and the parties should not only agree to use a specific version of the rules, they should agree to any rule modifications which might be appropriate. Most importantly, however, when drafting an agreement which includes an arbitration clause, be sure to fully investigate and explain the nature of the arbitration provisions to clients so that they know precisely what has been agreed to and what to expect in the future. Do not leave it up to the arbitrator to decide his or her own jurisdiction - it should be the clients who make that choice.
The articles on our Web site include some of the publications and papers authored by our attorneys, both before and after they joined our firm. The content of these articles should not be taken as legal advice or as an expression of the views of the firm, its attorneys or any of its clients. We hope the articles spur discussion in the legal community with insight into the experience of the authors. We expressly reserve the right in the future to become wiser or simply change our mind.