Clause and Effect: Parties agreeing to standard arbitration clauses may unwittingly alter their rights

Copyright ©2006 Reprinted with permission from the Los Angeles County Bar Association

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Arbitration clauses are ubiquitous 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 closing a deal or settlement, the parties often fail to focus on the language of the arbitration clause. Although the parties may agree to use a specific arbitration provider, little attention generally is given to the rules that will govern the 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 jurisdiction of the courts.

The impact of these unanticipated consequences is magnified by the strong presumption favoring arbitration. The U.S. Supreme Court in Buckeye Check Cashing, Inc. v. Cardegna[1] recently explained that even when 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 when the arbitration clause itself is challenged or if the very existence of the contract is contested due to a defect, such as fraud, in its formation or execution.

The Supreme Court’s willingness to require arbitration even if 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, the rights of parties 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 unwelcome results.

The purpose of the Federal Arbitration Act is to help fulfill the intentions of the parties and overcome judicial aversion to arbitration. Every arbitration agreement affecting interstate commerce is subject to the FAA.[2] The California Arbitration Act will only apply to contracts that exclusively affect California intrastate commerce.[3]

Once a court determines that the 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. [4] Thus the role of the courts in reviewing matters subject to arbitration usually is 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.[5]

In construing an arbitration agreement, as with any other contract, the controlling factor is the intentions of the parties. Nevertheless, those intentions are “generously construed as to issues of arbitrability.”[6] Any doubts concerning the scope of arbitrable issues typically are resolved in favor of arbitration.[7] As a general rule, questions of arbitrability must be addressed with “a healthy regard for the federal policy favoring arbitration.”[8] In fact, when contracts contain an arbitration provision, a presumption of arbitrability arises, and questions about the scope of arbitrable issues are decided in accordance with that presumption.[9]

When deciding whether the parties agreed to arbitrate a certain matter, including arbitrability, courts generally should apply the same state law principles that govern the formation of contracts.[10] However, the FAA has led to the judicial creation of a body of federal arbitrability law, which is applicable to any arbitration agreement covered by the act.[11] Since courts commonly decide issues of arbitrability, this body of law is substantial. Even when applying general state law principles of contract interpretation to an agreement within the scope of the FAA, courts give due regard to the federal policy favoring arbitration and, typically, resolve any ambiguities in an arbitration clause to broadly embrace rather than limit the applicability of arbitration.[12]

The Gateway Issue

A party to a contract cannot be required to submit to arbitration any dispute for which the party has not agreed to do so.[13] The concept of 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[14] should decide the scope of the parties’ agreement to arbitrate, and 2) whether the parties agreed to arbitrate their present dispute. The FAA’s policy favoring arbitration requires that any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration.[15] However, if an agreement contains any ambiguity as to who decides the “gateway issue” of arbitrability, the act’s presumption favoring arbitration is reversed. Once that occurs, the court ordinarily will decide a 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 of who has the primary power to decide arbitrability turns upon what the parties agreed to about that matter. Did the parties agree to submit the arbitrability question itself to arbitration?[16]

Parties are free to assign to an arbitrator the question of whether a claim is arbitrable.[17] 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.”[18]

Unfortunately, this critical presumption favoring the court’s authority to decide issues of arbitrability is often unintentionally extinguished by 1) adopting a standard, broad arbitration clause recommended by an arbitration provider, and 2) 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.

In many arbitration clauses, parties commonly agree that all matters “arising out of or relating to” their agreement will be arbitrable. They do so at the suggestion of many arbitration providers. Even though the arbitration providers do not expressly say so, their 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 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 (CPR) (formerly the CPR Institute for Dispute Resolution) 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....[19]

The International Chamber of Commerce offers this sample clause:

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....

Practitioners should beware of these provider suggested clauses. Courts have recognized that the kind of language contained in these recommendations is “the paradigm of a broad clause” and “the broadest language the parties could reasonably use.”[20] While the clauses do not expressly state who will decide the issue of arbitrability, their language has been interpreted to mean that the parties intended to submit questions of arbitrability to the arbitrator. By doing so, the clauses defeat 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.[21]

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.[22] Thus 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.”[23] 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.[24] Some courts have held that the language of these broad clauses does not clearly and unmistakably demonstrate the requisite intention of the parties to arbitrate arbitrability.[25] 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 agreed unknowingly 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 affect a client’s rights because the decisions of arbitrators are well insulated from review, and courts have no ability to rectify any arbitral 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 develop.

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.[26]

By routinely incorporating an arbitration 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.

Rule R-7(a) of the AAA’s Commercial Arbitration Rules 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.

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 arbitrator’s 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, Rule 8.1 of the CPR rules[27] expressly provides 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 that Rule 8 “should allow arbitrators to decide all issues, including arbitrability questions, without the necessity for court intervention.”[28] 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.[29] Thus, pursuant to Rule 8, the arbitrator has the authority to decide whether the arbitration will proceed in the face of a jurisdictional challenge.

Courts have affirmed that language like that in the providers’ clauses 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.,[30] a case arising out of a contract for the sale of medical devices and supplies, the Ninth Circuit concluded that the parties incorporated the AAA’s rules into their agreement by referring to them in their arbitration clause. Those rules “in turn, recognize the arbitrators’ discretion to interpret the scope of their authority.”[31]

Despite the similarity of the language in the JAMS rule to the AAA rule, the two courts that have addressed 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 [32]

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 the intention of parties to incorporate into the agreement any documents to which the agreement refers.[33]

Pursuant to the rules of the National Association of Securities Dealers, arbitrability issues also can encompass the timeliness of arbitration demands—and this can directly affect applicable statutes of limitations. NASD Code Section 10304 provides that no dispute “shall be eligible for submission...where six (6) years have elapsed from the occurrence or event giving rise to the...dispute.” Section 10324 further provides that “arbitrators shall be empowered to interpret and determine the applicability of all provisions under this Code.” In Howsam v. Dean Witter Reynolds, Inc.,[34] the U.S. Supreme Court, citing to these two provisions, resolved a lower court split by holding that the NASD’s time limit rule does not fall within the class of gateway arbitrability disputes that are within the court’s jurisdiction.[35]

So despite any statute of limitations rule that would otherwise govern the parties’ dispute, if the parties have agreed to NASD arbitration, their claims may be untimely under the NASD rules. In a recent case, Pellegrino v. Auerbach,[36] the trial court deferred to the arbitrator to determine which statutes of limitations governed the claims and whether the statutes expired before the claims were filed with the NASD.

As is clear from First Options, parties may expressly agree not to be bound by specified rules among 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, counsel should 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 NAF 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 simply to refrain from selecting a specific arbitration provider at the time the agreement is signed. The parties should clearly state in the agreement 1) the specific claims and types of disputes the parties intend to arbitrate, and 2) their intention that the court decide all issues of arbitrability, including the scope of the arbitrator’s jurisdiction and the applicable statute of limitations. Further, the parties can agree to the method and deadline for selecting an arbitrator, thus ensuring that no party’s rights have been unintentionally waived or altered.

The selection of a specific ADR provider and routine incorporation of an ADR provider’s rules as part of an arbitration clause can subject a client to rules that did not even exist at the time the agreement was signed. For instance, Rule 1(a) of the 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.

Rule 1(C) of the National Arbitration Forum’s Code of Procedure 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 those that existed at the time of the execution of the agreement. In addition, the rules may be unlike any the parties intended to apply at the time of the agreement’s formation. For instance, even if an arbitration provider’s rules do not 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 an arbitrability dispute, contrary to the intention of the parties. 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 of the rules will govern the parties’ disputes, the parties will most likely be deemed to be bound by rules they did not even know about when they signed their agreement.

The California Court of Appeal recently addressed this issue with respect to the JAMS arbitration rules in Evans v. Centerstone Development Company.[37] The parties in Evans agreed to settle disputes arising from the operation of a real estate development company according to the Streamlined Rules of JAMS. Among these was Rule 3—a part 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.”[38] 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, specific versions of their rules will govern arbitrations. If clients are allowed to do so, they will achieve precisely what they bargained for.

Parties to a deal often believe that even if an arbitrator gets it wrong, the courts will serve as a last resort to correct errors of law. But aside from limited statutory grounds such as demonstrable bias, the decisions of arbitrators are usually reviewed only for a manifest disregard of the law. Courts are limited by the presumption that parties who authorize an arbitrator to give meaning to the language of the agreement should not have their awards rejected by a court on the ground that the arbitrator misread the contract[39] 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.”[40] The court noted, “If, on its face, the award represents a plausible interpretation of the contract, judicial inquiry ceases and the award must be enforced.”[41]

A simple error in reasoning by the arbitrator does not provide an opportunity to review the merits of the arbitrator’s conclusion.[42] Indeed, “as 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.”[43]

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.”[44]

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.

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 issues ordinarily decided by courts. 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.

Careful consideration should be given to the language of the arbitration clause and to whether to choose an ADR provider to govern future disputes. If an ADR provider is selected, counsel should carefully review the rules of the arbitration provider. The parties should not only agree to use a specific version of the rules—they should also agree to any rule modifications that might be appropriate. Most importantly, however, when drafting an agreement with an arbitration clause, counsel must 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 agree to let the arbitrator decide the extent of his or her jurisdiction. The client should make that choice.