Mandatory arbitration clauses--powerful when used appropriately.

Many businesses have included mandatory arbitration clauses in the standard contracts that they use, both with their employees and with their customers. There have been a number of recent legal developments that significantly affect both the scope of issues that can be subject to mandatory arbitration agreements, and the limitations such agreements can impose on the parties' substantive and procedural rights.

Businesses generally find that arbitration clauses can result in substantial savings on litigation costs by substituting a streamlined, cost-effective arbitration process for the normal litigation process. Arbitration can be more efficient than litigation because the scope of discovery can generally be limited, and the arbitrator, because he or she is working for the parties, can more closely manage the case and bring it to a swifter resolution than is likely in the cluttered dockets of the courts.

In addition to obtaining the procedural benefits of arbitration, some businesses have attempted to craft their arbitration clauses to modify the parties' rights, generally by shortening the time within which a claim must be filed, and by limiting the remedies that can be sought. For example, some businesses have included provisions in arbitration agreements that prohibit the parties from bringing class actions and from obtaining punitive damages.

In light of recent changes in the law, businesses should review their arbitration agreements, both to make sure that they take full advantage of the ability to arbitrate various types of disputes, and to ensure that they do not go so far in limiting the parties' rights that they risk being held invalid and unenforceable if challenged in court.

A Recent Expansion of The Scope

Until recently, the courts prohibited employers from forcing employees to agree in advance to arbitrate certain federal civil rights claims. But on September 30, 2003, the Ninth Circuit Court of Appeals overruled the prior case law, and held that (a) federal civil rights claims can be the subject of mandatory arbitration agreements, and (b) an employer can require all of its employees to sign such an agreement as a condition of employment. Businesses that drafted their employee arbitration agreements prior to the date of this decision may wish to review those agreements to ensure that they provide for the arbitration of civil rights claims as allowed by the new court decision.

Limitations

The courts place limitations on the substance of arbitration clauses contained in consumer and other customer contracts. Generally speaking, provisions in an arbitration clause can be held to be unenforceable if a court determines that they are both procedurally and substantively unconscionable.

To determine whether a clause is procedurally unconscionable, courts will look at:

* whether the contract is a contract of adhesion--that is, a contract where the customer has no meaningful ability to renegotiate the challenged contract term,

* whether the customer has a meaningful choice of a reasonably available alternative that can be obtained free of the terms claimed to be unconscionable, and

* whether the terms claimed to be unconscionable were hidden from the customer--for example, by burying them in a prolix printed form.

To determine whether an arbitration agreement is substantively unconscionable, the courts look to see whether the challenged provision unduly favors the interests of the entity that imposed the arbitration agreement over the interests of the other contracting parties. In making this determination, courts do more than merely look at the language to see if it is equally applicable to each party to the agreement. Even language that appears to apply equally to both parties will be held to be unconscionable if the provisions favor the interests of one of the parties over the other. For example, a contract provision prohibiting either party from bringing a class action was held to be unconscionable when it was contained in a contract between a large telephone company and an individual consumer. The court reasoned that the large telephone company would have no reason to bring a class action against its customers, whereas the customers were much more likely to want to bring a class action against the telephone company.

Likewise, arbitration clauses requiring a consumer to pay for a share of the arbitrator's fees have been held to be unconscionable where it appeared that these clauses could significantly increase customers' costs of having their claims resolved. Even confidentiality agreements in consumer contracts have been held unconscionable on the grounds that they prevent consumers from pooling information and obtaining precedent that could be useful for them in challenging the company's practices. Likewise, contract provisions designed to prevent consumers from obtaining punitive or other extra-contractual damages have also been held invalid.

If a court determines that an arbitration provision is invalid, there is a substantial chance that the court will simply strike the invalid provision from the agreement. The court is not required to rewrite the provision to provide the company with the greatest extent of protection allowed by law. For this reason, it is important for businesses to draft their arbitration agreements carefully.

Drafting Enforceable Clauses

There are a number of things that a business can do to maximize the chances that its consumer arbitration clauses will be upheld by the court. First, as has previously been explained, courts will not uphold an adhesion contract that is procedurally unconscionable. The chances of having a contract held to be procedurally unconscionable are significantly minimized by providing customers with an opportunity to renegotiate the objectionable terms. For example, customers could be offered a lower price if they agree to the arbitration provision. By making the same products and services available at a higher price if the customer turns down the arbitration clause, the customer is being given an opportunity to obtain the same products and services without agreeing to arbitration, thereby weakening the argument that the contract was a contract of adhesion. A customer who voluntarily chose to enter into an arbitration clause in order to obtain a discount will have a harder time convincing a court that he or she was forced to agree to arbitration.

It is also important to provide customers with reasonable notice of the provisions of the arbitration clause. Instead of burying the arbitration clause deep within the fine print of the contract, the clause should be prominently disclosed to the customer. By clearly informing the customer of the rights that it is giving up by agreeing to arbitration and by giving the customer a meaningful alternative to agreeing to arbitrate its disputes, the chances of being able to successfully enforce the arbitration clause are substantially increased.

In order to avoid a finding of substantive unconscionability, it is important to make sure that the contract is not extremely one-sided. Courts view the primary purpose of arbitration agreements to be to obtain a private forum for the resolution of disputes. In dealing with adhesion contracts, they look down on any practice that significantly alters the substantive rights of the parties.

Business-to-Business Transactions

The limitations on arbitration clauses discussed above apply to contracts with consumers. But an arbitration clause that significantly affects the substantive rights of the parties is much more likely to be held enforceable if it is contained in a contract entered into by two businesses, each of which has adequate bargaining power. In the business-to-business context, one should carefully consider the terms and scope of the arbitration clause, and tailor a clause that best meets the parties' needs for each significant transaction.

In drafting such clauses, the parties should focus on the procedural aspects of the arbitration process, as well as upon any limitations they wish to impose on the remedies that may be obtained in the arbitration.

A good arbitration clause will specifically address important procedural issues, such as the scope of discovery that will be allowed in the arbitration and the time frame in which the arbitration should be concluded.

It is also important to clearly define the scope of the issues that the parties are agreeing to arbitrate. It is surprisingly common for conflicts to arise regarding the scope of such issues. For example, do the parties wish to agree to arbitrate any dispute that may arise between them, or do they wish to limit the arbitration clause to disputes relating to the agreement? Do they wish to limit the arbitration to contract interpretation, or do they also wish the arbitrator to address contract performance? These are all issues that should be considered and addressed in the arbitration clause itself. If this language is vague or ambiguous, in the event a dispute arises it is likely that significant sums of money will be wasted fighting over the proper scope and interpretation of the arbitration clause.

Robert Leventhal and Howard Cohen are members of Foley & Lardner's Litigation Department.