Clause and Effect

Reprinted and/or posted with the permission of Daily Journal Corp. (2009).

Arbitration clauses can profoundly alter the rights of contracting parties.  Yet they are often little more than an afterthought - boilerplate contract provisions governing disputes that no one believes will ever arise.  Many attorneys simply adopt and incorporate the standard arbitration clause recommended by the dispute resolution provider of their choice.  Such clauses usually state that arbitrations will be conducted in accordance with the provider's rules that are in existence when the arbitration occurs, whatever those rules might be.  In other words, as the 4th District of the California Court of Appeal recently observed in Gilbert Street Developers, LLC v. La Quinta Homes, LLC, 2009 DJDAR 8496, your client is buying "a pig in a poke."

Arbitration is a matter of contract. A party cannot be required to arbitrate any dispute not within the scope of a contractual agreement.  Agreeing to arbitrate future disputes pursuant to rules that may be different than those in force at the time of the contract's signing subjects parties to unknown risks and may bind them in ways they did not anticipate and to which they would not have agreed.  Moreover, such rules can, and often do, divest parties of the right to have a court, not an arbitrator, decide what disputes are to be arbitrated.

Unless the parties "clearly and unmistakably provide otherwise," whether or not a particular dispute is arbitrable is a determination reserved to the courts.  First Options of Chicago, Inc. v. Kaplan, (1995) 514 U.S. 938.  But many arbitration providers implement rules that divest the courts of jurisdiction to decide the threshold issue of arbitrability and instead permit the arbitrator to decide the scope of his or her own jurisdiction.  By adopting arbitration clauses that call for arbitrations to be conducted according to the rules an arbitration provider may enact in the future (or by not investigating the provider's current rules), attorneys often unwittingly strip their clients of this crucial right.

At issue in Gilbert was the arbitration clause in a 1998 contract between Tone Yee Investments and La Quinta Homes to develop certain property on Gilbert Street.  The contract provided that, in the event a dispute arose, it was to be resolved through arbitration and "conducted in accordance with the Rules of the American Arbitration Association existing at the date thereof."  There was, however, an exception in the arbitration clause for matters that were expressly within the discretion of the parties.  Additionally, the contract included a "buy-out" provision which, if invoked, required a party to purchase the other's interest or have its interest purchased instead. In 2000, the American Arbitration Association amended former Rule 8(a), now Rule 7(a), to provide that American Arbitration Association arbitrators have the power to decide their own jurisdiction, including the power to determine objections to the existence, scope or validity of an arbitration agreement.

In 2008, a dispute arose over an offer to purchase the parties' jointly owned property.  The Yee parties wanted to sell, but La Quinta did not.  The Yee parties invoked the buy-out provision and commenced arbitration. La Quinta did not participate in the arbitration, arguing that the dispute fell within the discretionary exception to the arbitration clause. La Quinta also objected to the arbitrators deciding their own jurisdiction.  The arbitration proceeded and the Yee parties prevailed.  Pursuant to the buy-out provision, La Quinta was divested of its ownership interest in the Gilbert Street property.

The arbitrators held that they had the authority to decide their own jurisdiction because, even though there was no such express provision in the 1998 American Arbitration Association rules, the idea was nevertheless "implicit" in the rules.  They also relied on Rule 1, now Rule 1(a), which stated in 1998: "These rules and any amendment of them shall apply in the form obtained at the time the demand for arbitration or submission agreement is received by the AAA."

The trial court subsequently rejected the Yee parties' petition for an order confirming the arbitration award, holding that the arbitrators did not have the power to decide their own jurisdiction.  The court noted that the 1998 rules were silent on that issue and concluded "the possibility of a change in the Rules is not sufficient to show a clear and unmistakable intent by the parties that the arbitrator would decide issues of arbitrability at the time the agreement was entered."  The trial court also held that the buy-out provision was discretionary and not subject to the arbitration agreement.

In affirming the trial court's decision, the Court of Appeal reiterated the First Options directive that, in determining who decides arbitrability, ordinary principles of contract interpretation do not apply.  The court stressed that First Options established an important exception to contract interpretation principles - an exception that is applicable to questions of arbitrability.  In such instances, the law reverses the presumption in favor of arbitration.  First Options requires the parties to clearly and unmistakably state their intent to vest jurisdiction over the arbitrability question with an arbitrator. Silence or ambiguity is not enough.

The court distinguished the holdings of Dream Theater Inc. v. Dream Theater, 124 Cal.App.4th 547 (2004), and Rodriguez v. American Technologies Inc. 136 Cal.App.4th 1110 (2006), both of which held that incorporation of the American Arbitration Association rules by reference was sufficient to "clearly and unmistakably" provide that arbitrators could decide their own jurisdiction.  The court observed that, in those two cases, the rule relied on actually existed at the time the contracts were signed, so that, before signing the contract, the parties could look up the rules to which they were agreeing.

That being said, the court concluded that Dream Theater and Rodriguez represent "the outer limits" of the use of incorporation by reference to confer upon arbitrators the power to decide their own jurisdiction. The court further concluded that "a contract which contains the mere possibility that [American Arbitration Association] rules might one day in the future provide that arbitrators would have the power to decide their own jurisdiction does not ‘clearly and unmistakably' provide that arbitrators will determine their own jurisdiction."

The court also observed that incorporating the possibility of a future rule by reference does not meet even the basic requirements for a valid incorporation by reference under state contract law, which requires what is being incorporated to actually exist at the time of the incorporation.  The court characterized the incorporation of an arbitration rule that does not exist at the time of contracting as similar to an old medieval con game in which an unsuspecting buyer purchases what is supposed to be a pig in a bag only to discover that it is an inedible cat or rat - hence the expression "pig in a poke."  In this case, the court stated "the bag was empty at the time of the transaction and might or might not be later filled with a pig. Or a cat or rat or, for that matter, nothing."

But the court's discussion does not end there.  The court goes on to consider the current split in the federal appellate courts over whether contracts providing for arbitration of securities disputes incorporate a rule of the National Association of Securities Dealers allowing arbitrators to decide their own jurisdiction.  The court finds more persuasive the majority rationale (the 3rd, 6th, 7th, 10th and 11th Circuits), which holds that, under the First Options' analysis, the mere incorporation of the National Association of Securities Dealers rules into a contract is insufficient to show a clear and unmistakable agreement to have arbitrators decide their own jurisdiction.

Notwithstanding the Gilbert court's analysis and the federal court split over the National Association of Securities Dealers rules, many other state and federal courts have held, as in Dream Theater and Rodriguez, that the reference to, or incorporation into a contract of, an arbitration provider's rules is sufficient to divest a court of jurisdiction to decide arbitrability. The 11th Circuit did so in Terminex Co. LP v. Palmer Ranch Ltd. Partnership, 432 F.3d 1327 (11th Cir. 2005), holding that the parties' reference to the American Arbitration Association rules in their arbitration clause served to incorporate the rules into the agreement and those rules recognized the arbitrators' jurisdiction to interpret the scope of their authority and the validity of the arbitration clause.  Moreover, even if the arbitration clause does not incorporate the provider's rules into the parties' contract, arbitration providers make this conclusion inevitable by promulgating rules that provide that, by agreeing to arbitrate with a specified provider, its arbitration rules are deemed to be incorporated into the parties' written agreement.

While the Gilbert decision (which is refreshingly blunt, amusing and wry) appears to vitiate the ability of arbitration providers to incorporate entirely new rules into prior arbitration agreements, it also illustrates why attorneys should draft arbitration clauses as carefully as they draft any other contract provision. Your clients typically do not know one arbitration provider from another.  Your clients are relying on you to protect their rights if the deal falls through.  So, before you drop into a contract the "standard" arbitration provision that you have used in the past, stop and think about it.

Why specify an arbitration provider whose rules will become part of your clients' contract?  Why divest your clients of their right to have a court determine arbitrability disputes? Why not instead spell out the process by which arbitrators will be selected, the specific claims and types of disputes to be arbitrated, the rules of procedure and evidence that will govern the arbitration and who will determine issues of arbitrability?  It might take some time and some thought, but presumably, so did the other contract provisions. Why bind your clients to future arbitrations governed by uncertain rules that could be unilaterally changed without their knowledge or agreement?  Why have them buy a pig in a poke?

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