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By Ronan J. McHugh and Glenn Kennett
Thelen LLP
Introduction
At its best, arbitration offers a mechanism for the expeditious resolution of disputes in distinct contrast to litigation. 1/ While arbitration often achieves this goal, too frequently arbitration involves unintended and costly arbitrability disputes concerning the validity and scope of the arbitration agreement. The upshot is that clients who have chosen arbitration as their dispute mechanism often find themselves spending time and incurring significant costs simply to establish the process that they thought had been agreed.
It is beyond stating the obvious that clients do not want, and should not have to, incur these costs and time as part and parcel of choosing arbitration. Yet, conversations, or thought processes, concerning the specific language of arbitration clauses that could save thousands of dollars in legal fees spent in arbitrability disputes too often do not occur in the heady marriage of the deal when no one wants to talk divorce or dispute. Such disregard, however, often is the source of the arbitrability disputes that disrupt, sometimes fatally, the assumed arbitration mechanism.
Recently, we have been involved in a number of cases involving arbitrability disputes. While it may be too optimistic to think it possible to eliminate all of these disputes, it is possible, with some thought and consideration, to significantly close the door on a large number of these disputes. Doing so would save time, cost and generate more positive views of arbitration. This note reviews two recent arbitrability disputes that we have been involved in, looking at why and how they arose, and proposes two simple solutions that may, at least, lessen the cost and pain of these disputes, even if it does not prevent them completely.
Enforcement of Arbitration Agreements Under the Federal Arbitration Act
It is remarkable in one sense that there remain so many arbitrability disputes. The Federal Arbitration Act, enacted more than 80 years ago, and the associated case law that has developed around it require in explicit language both federal and state courts to stay litigation in favor of arbitration or compel arbitration when there is a valid arbitration agreement that covers the dispute at issue. See, 9 USC §§3 and 4. While in some hard cases there really is a devil in the detail, all too often arbitrability is raised as a litigation forum tactic when there is no genuine dispute concerning arbitrability. Even so, merely raising the issue costs money and, at best, causes delay to the party relying on the agreed arbitration clause.
Arbitrability disputes often occur at the outset of a formal dispute, when the plaintiff files a complaint in court even though the parties' contract contains an arbitration agreement. There are innumerable reasons why this happens. These reasons cover a likely range from the plaintiff not being aware of the arbitration agreement, the claim not being a contract claim, the hope that the other side will waive the arbitration agreement and agree to litigate, to obtain publicity, because the plaintiff is a non-party to the arbitration agreement, through to the position that the arbitration agreement is invalid or does not apply to the dispute. When occurring via a court filing, arbitrability disputes become potentially a "two bites at the apple" issue. Even if the party prosecuting the court action loses and arbitration is required, it still gets to re-argue the matter before the arbitrators - causing further cost and delay. Arbitrability disputes are, however, not confined to the initial stages of a proceeding. They can occur later, during an arbitration or even after an award. 2/ These disputes often arise when parties see advantages to be gained in seeking to arbitrate more or fewer issues with more or fewer parties. When this scenario occurs, these disputes can be even more pernicious than arbitrability disputes arising at the outset of a case and potentially more devastating for the arbitration, with the ultimate potential being that the arbitration award is rendered non-enforceable and the entire process wasted. 3/
Regardless of when they arise, at the very least arbitrability disputes delay the resolution of the dispute. Moreover, depending on their outcome, they can fundamentally alter the nature of the dispute, change the dispute forum and undermine the entire chosen arbitration mechanism. Perhaps these potential outcomes explain why arbitration disputes can be so costly. The cost of dealing with an arbitrability issue can run into thousands of dollars in legal fees and management time. As it appears that the Federal Arbitration Act and supporting cases are not alone sufficient in deterring these disputes, now it is perhaps time that parties reviewed their arbitration agreements to try and prevent at least some, if not most, of these disputes.
Case Study 1: An Arbitrability Dispute Arising at the Outset of Proceedings
We recently were involved in a case in which an arbitrability dispute arose from the filing of a complaint in the U.S. District Court for the Eastern District of Virginia in the face of an arbitration agreement. The case involved renovations and new construction of buildings on a multi-million dollar construction project in Virginia. The general conditions of the contract (AIA A201, 1997 version) set out the standard tiered dispute resolution procedure. First, the architect was to render a decision on the claim, followed by mediation and followed by arbitration under American Arbitration Association Construction Industry Rules. In the course of the project, the general contractor, our client, began submitting numerous claims requesting changes to the contract amount. The architect issued what the owner argued were final decisions denying the claims, and the parties participated in an unsuccessful mediation. The contractor filed a demand for arbitration. In response, the owner filed a declaratory judgment action in federal court seeking an adjudication that the claims had been waived or else were not subject to the agreement to arbitrate. The contractor filed a motion to dismiss, arguing that all questions raised by the owner were subjects to be decided by an arbitrator, not a court. The issue took two months of fairly intensive legal briefing and a day of oral argument before it was resolved.
The owner asserted that the demand for arbitration (as to certain final decisions of the architect), coming more than 30 days from the date of issuance of the alleged final decisions, was not timely and was, therefore, waived. It also argued that various claims sought the recovery of damages not allowed by contract (i.e., a waiver on consequential damages pursuant to AIA A201 Article 4.3.10) that, as a consequence, the owner asserted meant that such claims were non-arbitrable. In essence, the owner's complaint sought to have a court rule, at the outset, whether certain claims were subject to arbitration. In support of its position, the owner relied on the Maryland case, Diesselhorst v. Munsey Building, No. 04-3302, 2005 U.S. Dist. LEXIS 1947 (D.Md. Feb. 9, 2005), which held that the incorporation of the AAA rules did not demonstrate the parties' intent to have an arbitrator rule on issues of arbitrability but required the court to do so.
In response, the contractor argued that it was not for a court to determine the issue of whether certain claims had been waived due to an alleged untimely demand for arbitration. The U.S. Supreme Court in Howsam v. Dean Witter Reynolds, Inc., 537 U.S. 79 (2002) held that gateway procedural matters such as whether a claimant met the timing requirements for submission of a claim are more appropriately decided by the arbitrator, not a court. In so holding, the Supreme Court differentiated between substantive questions of arbitrability (i.e., such as whether a party is bound by an agreement to arbitrate or whether a corporate successor is bound by an agreement to arbitrate made by its predecessor corporation), which are for a court, and more limited procedural concerns, which are for an arbitrator to determine.
The contractor also argued that the contract's incorporation of the AAA Construction Industry Arbitration Rules dictated the outcome as to which forum should rule on the issues raised by the owner. In this regard, Rule 8 specifically provides 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." Thus, even if the matters to be decided were not procedural gateway concerns addressed by Howsam, the arbitration rules incorporated into the arbitration agreement - which the parties agreed would govern the resolution of disputes - expressly provided that the arbitrator would determine the scope of claims that it would entertain.
The court agreed with the contractor and dismissed the case. While persuaded by the Howsam rule, the court homed-in on the fact that the parties had agreed to a specific means of resolving arbitrability issues. The court held that the specific incorporation of the AAA rules and the provision within those rules empowering the arbitrator to determine his own jurisdiction were a compelling indication that the parties' intended to have issues of arbitrability decided by the arbitrator. The court found the Diesselhorst decision unpersuasive. The result is consistent with the increasingly recognized rule that arbitral tribunals have authority to decide arbitrability issues. Most institutional rules provide arbitrators with such authority, and courts increasingly acknowledge this authority. 4/ Nevertheless, a process that requires a party to first fight the point in court and then again in arbitration - a double arbitrability dispute - is hardly the most comforting and efficacious dispute resolution format.
Case Study 2: An Arbitrability Dispute During the Arbitration
Arbitrability disputes also may arise during any arbitration. This occurred in our second case study, and the arbitrator exercised his power to determine the issue under AAA Commercial Arbitration Rule 7. 5/
In late 2006, we were asked by a client to assist in an AAA Commercial Rules arbitration involving power generation equipment. We were told by the client's in-house counsel, who had been handling the case since spring 2005, that the amount in dispute had just been increased from $3 million to $30 million on claims for breach of warranty, breach of contract and misrepresentation and that the arbitration hearings were due to begin in a week. We sought an immediate adjournment from the sole arbitrator, and we were granted 60 days until mid-December 2006. In our preliminary review of the documents, we noticed two things. First, midway through the discovery stage, opposing counsel had begun changing the caption of the case, adding the name of a third party who was not a party to the arbitration agreement or arbitration demand. Second, and more significantly, the claimant's arbitration memorandum, filed the day before the initially scheduled arbitration hearings, for the first time sought to advance claims arising out of an entirely different contract between the parties that had not been the subject of the Demand for Arbitration or raised previously in the arbitral proceedings and that increased the quantum claimed to $30 million. As a consequence of these facts, we spent approximately half of the 60-day adjournment in an arbitrability dispute that had the potential to involve court proceedings to unravel the entire arbitration and remove the arbitrator.
Insofar as our client was concerned, the arbitration related to one agreement made with one party, the owner, and a dispute involving only the $3 million claim. That agreement was an EPC-type contract executed solely by our client and the owner in early 2004 for the supply of six electricity generating turbines. In contrast, claimant argued that it was entitled to raise in the arbitration claims concerning other contracts for 24 turbines of a different type because the arbitration clause in the 2004 contract provided that to the extent possible all disputes between the parties to the contract would be consolidated and dealt with in a single arbitration. The clause, in fact, provided that no arbitration would include by consolidation, joinder or otherwise any other person unless that person was required for complete relief to be accorded. Claimant argued that this term applied not simply to multiple claims under the contract but that it also covered multiple claims under any other agreement between the parties. Further, the claimant sought to add 14 additional parties to the arbitration, none of whom were parties to the 2004 contract. Most of these parties were third-party limited liability corporations established for tax purposes to own, operate and maintain the turbines and to receive the revenue from the electricity generated. Moreover, most of these LLCs were third-parties to entirely separate contracts and under which no demand for arbitration had been made. The claimant asserted that there was an agreement between the owner and these potential claimant entities by which the claims were to be owned and would be pursued by these 14 additional parties.
Other than the arbitration clause, the 2004 contract contained other language that bore on the issue of whether additional parties and claims might be properly included in the arbitration. The agreement's arbitration clause provided that the arbitrator did not have any jurisdiction or authority to alter the provisions of the contract, and thus both sides relied on certain language in the 2004 contract to support of their positions. The contract stated that it was binding upon the parties, their successors and assigns, but that it could not be assigned by either party, by operation of law or otherwise, without the prior written consent of the other party. No written assignments had been made. The contract also contained a clause providing that, except as otherwise expressly provided, the contract and all rights thereunder were intended for the sole benefit of the parties thereto and that it did not imply or create any rights on the part of or obligations to any other person. The warranty clause was the only clause that provided any third party rights. The warranty applied not only to the owner but also to each "Project Owner," and any Project Owner could utilize all rights provided by the provisions of the warranty clause. The "Project Owners" were two LLCs established by the owner, each of whom owned three of the six turbines supplied under the 2004 contract. The owner with whom the 2004 contract had been made thus had no ownership interest at all in the turbines except via the LLCs, some of which had not been in existence at the time the contract was made.
After extensive briefing that kept the issue outstanding until early December 2006, the arbitrator ruled on the issue 10 days before the hearings were to commence. He held that he would allow into the arbitration the claims associated with the 24 turbines supplied under the separate contract but only as a matter of procedure and pleading. Otherwise, he bifurcated these claims from the claims under the 2004 contract and held that only the contract claims relating to the six turbines would be heard in the hearings scheduled for mid-December.
Thus, the arbitrator decided he had jurisdiction over the other contract claims, even though no arbitration demand had been filed concerning them, but deferred when such claims would be heard. Further, he ordered that no parties other than the claimant and the two project owners with warranty rights under the 2004 contract would be made parties to the arbitration. In making these decisions, the arbitrator's order also expressly stated that objections to and issues concerning these jurisdictional issues had not been decided and were reserved and deferred to the hearing. This language seems to have been an attempt by the arbitrator to circumvent litigation based on any potential argument that the arbitrator had exceeded his jurisdiction. It was likely that this decision could have been challenged in court, but this never occurred as the substantive dispute was resolved when the parties settled all of their disputes. However, the case illustrates the difficulties that can arise in determining who has an arbitrable claim and what those claims may involve when significant numbers of entities and contracts are intertwined.
Two Ways to Potentially Resolve the Arbitrability Problem
Aside from the cost and delay, needless arbitrability disputes give arbitration a bad name as an effective dispute resolution alternative to litigation and are one reason why arbitration is seen as unnecessarily expensive. 6/ However, just as treating arbitration like privatized litigation pursuant to the Federal Rules of Civil Procedure abuses the arbitral concept, so too does neglecting to properly consider the arbitration clause when the parties make their contract.
Unthinkingly choosing a standard form arbitration clause, be it AIA or some other, or simply extracting the clause from a prior deal is not always appropriate. The outcome in Case Study 1 illustrated this fact, with an extensive dispute arising until the court found that the parties had intended, under an incorporation by reference approach, for arbitrability to be decided by the arbitrators. The decision, however, merely means that the parties have to fight arbitrability again before arbitrator, likely incurring substantially similar, if not greater, costs. The result, while supporting the arbitration clause, is hardly a victory for arbitration as a process. To cut arbitrability disputes, thought must be given to the dispute clause within the matrix of the overall contract and the parties' relationships. Too many times this is not done.
One simple means of reducing arbitrability disputes is to provide in the arbitration clause that any party who brings an arbitrability challenge and loses will pay the other party's legal fees and costs arising from that challenge. The court's decision in Case Study 1 shows that courts will enforce the arbitration agreement's terms so there is no reason to think such a clause in a commercial agreement would be unenforceable. While numerous contracts, particularly international ones, contain legal fee-shifting provisions in arbitration clauses, these usually are tied only to the outcome of the entire case, not specifically also to disputes over arbitrability. And, even when such ultimate fee shifting clauses are present, oftentimes the costs of a pre-arbitration court proceeding are not sought from the arbitrators or the court. In these circumstances, a fee-shifting provision covering arbitrability challenges would more than likely weed out a good number of lawsuits speculatively filed in the face of arbitration agreements. Accordingly, this change alone would save time and money in many situations where arbitrability disputes currently arise. The only possible instance where such a provision likely would not work is with a dispute resolution provision that provides an option for one party to arbitrate or litigate. 7/
In addition, arbitration clauses that consider the entire matrix of the deal can better prevent arbitrability disputes. Case Study 2 involved a complex and convoluted contractual and corporate structure with numerous entities existing on the owner's side and also a number of agreements with the contractor, some with the owner, some with its entities. In addition to the 2004 contract, there were service and maintenance agreements between the parties, as there often are on a EPC deal, involving the supply of equipment expected to operate for years. In these circumstances, who the parties might be to any claims and what claims might be brought under which agreements are important issues. Indeed, there seems to be a rising tide of arbitrability disputes involving non-parties to the original arbitration agreement under which courts' focus on the entities' proximate relationship as the basis for their decisions. 8/ Within any complex structure of multiple agreements and entities, if the arbitration clause is left ambiguous as to who and what is arbitrable, the prospect of an arbitrability dispute increases. In Case Study 2, the dispute resolution provision was not a few lines providing for arbitration. It covered an entire page in the agreement. While it clearly had been given some thought, it likely could have prevented the arbitrability dispute if it had clearly limited consolidation of claims and parties to claims involving the 2004 contract and specifically defined those who could utilize the arbitration mechanism under the contract.
Conclusion
Arbitrability disputes can undermine the intent of an arbitration agreement and be vehicles for parties who wish to pursue high-cost litigation strategies. Such disputes risk placing the substantive dispute before a forum that was never intended to hear the dispute and having the case resolved in an undesired manner. Furthermore, simply giving either courts or arbitrators power to decide the issue does not resolve the point. When a party initially litigated, a court's finding that the matter is for an arbitrator simply means it has to be re-examined again. When an arbitrability dispute arises during the arbitration, it often can place arbitrators in impossible situations and unsettle the entire process.
A fee-shifting provision in an arbitration agreement relating specifically to arbitrability challenges will be enforced by courts and arbitrators. Such a provision will likely reduce - by making a party think twice before filing in court or challenging in arbitration - arbitrability disputes. In addition, more careful consideration of the arbitration clause by focusing on and clarifying who can arbitrate over what will further eliminate arbitrability issues. If considered, these measures may allow those of us who promote and use arbitration to say that it took no more than 100 years from the date of the FAA to truly make arbitration agreements effective and binding and to create an efficient and effective arbitration dispute resolution process that really saves money and time.
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For more information about the issues covered in this report, please contact Ronan J. McHugh in our Washington, D.C. office at 202-508-4125 or at rmchugh@thelen.com, or Glenn Kennett in our Washington, D.C. office at 202-508-4337 or at gkennett@thelen.com, or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.
ENDNOTES
| 1/ | See, e.g., Arbitration v. Litigation: An Unintended Experiment, Jeffrey R. Cruz, www.constructionweblinks.com, December 18, 2006.
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| 2/ | But, many institutional arbitral rules now establish time limits on when arbitrability disputes can be raised without the issue being waived. See, e.g., AAA Commercial Rules Rule 7(c) providing that objections to arbitrability must be made no later than the answering statement.
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| 3/ | 9 USC §10(a) (4); New York Convention, Article V(1)(c).
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| 4/ | See, International Chamber of Commerce Rule 6(2), London Court of International Arbitration Rule 23, AAA Commercial Rule 7. See also, Oriental Republic of Uruguay v. Chemical Overseas Holdings, Inc., No. 05 Civ. 6151, 2006 WL 164967, at *6 (S.D.N.Y. Jan. 24, 2006) [holding an arbitration clause adopting the ICC Rules evidenced the parties intent to arbitrate questions of arbitrability]; Contec Corp. v. Remote Solution Co., 398 F.3d 205 (2nd Cir. 2005) [holding likewise under an arbitration clause adopting the AAA rules].
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| 5/ | Rule 7(a) provides: "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."
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| 6/ | See, e.g., Cause for Alarm, ABA Journal, November 2006.
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| 7/ | While such clauses give one party an element of control, there is little sense in having such a clause if you intend to arbitrate. This is because if the opponent is the claimant, it nearly always will be first file suit in court so that the clause becomes in essence one that promotes arbitrability disputes as the price for the option.
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| 8/ | See, e.g., Twin Oaks at Southwood v. Summit Constructors, Inc., 941 So. 2d 1263 (Fla. Dist. Ct. App. 2006). For a review of the law on arbitrating with non-parties, see also M. Farley, Arbitrating with People Who Are Not Parties to the Agreement, The Review of Securities and Commodities Regulation (Vol. 39, No. 22, Dec. 20, 2006, at p. 245). |
©2007 Thelen LLP
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