Do you really want an arbitration clause?
Arbitration is often pitched as a no-brainer. Almost invariably, the pitch goes like this:
“You definitely want an arbitration clause. Arbitration is quick, it’s efficient, it’s confidential, and it keeps costs much lower.”
In the real world, arbitration doesn’t always make sense.
Here’s a breakdown of certain considerations that should be kept in mind when deciding on whether an agreement to arbitrate disputes is desirable:
A party’s role in the transaction
A party’s role in a transaction is an important factor in determining whether an arbitration clause is advisable. In large part, this is because arbitration can be very costly.
Unlike state and federal court judges, whose salaries are paid by taxpayers, arbitrators are generally paid by the disputing parties. This can mean hundreds of thousands of dollars on a single dispute.
With this in mind, when I am representing an investor in connection with a U.S.- based investment, I rarely recommend that the investor accept an arbitration clause (absent additional considerations).
The logic is simple: the high costs of arbitration can serve as a barrier to a party’s pursuit of its legal rights and remedies if and when doing so becomes necessary.
Investors don’t usually have many reasons to be sued in connection with a particular transaction. Usually, their main obligation is to bring the money, and this is often self-enforcing through the issuance (or non issuance) of equity.
On the other hand, investors often do have plenty of reasons to sue the issuer and its principals. Some reasons may include: seeking an equitable accounting or audit, seeking removal of an officer for a defined “cause”, derivative enforcement of corporate rights, breach of contract, fraud, breach of a fiduciary duty, a declaration of rights under an agreement, etc.
U.S. courts are very much accessible, and investors may unfortunately need that access under multiple potential scenarios.
Applying the same logic but in reverse, an agreement to arbitrate might make much more sense for the issuer and its principals because a requirement to arbitrate disputes may deter claims by a dissatisfied investor. Depending on the amount being raised and other factors, the fund raising party may prefer to be protected by a costly barrier like mandatory arbitration. And investors often do bring claims, with or without merit.
Disputes within a U.S. Jurisdiction:
Another factor to consider is whether or not a dispute can reasonably be limited to some U.S.-based jurisdiction.
U.S. courts will usually respect and enforce a properly drafted forum selection clause. For matters involving international components, therefore, a well drafted forum selection clause can help to ensure that your dispute ends up in a U.S. jurisdiction— as opposed to, for instance, Peru or wherever your transaction or business partner is based.
Sometimes, however, a forum selection clause is not enough. For instance, if your Peruvian dispute involves assets that are located in Peru, then even the best forum selection clause will not necessarily protect you from your local partner taking a dispute to a Peruvian court. You could unwittingly find yourself fighting over frozen Peruvian assets in Peru’s courts regardless of your agreement’s forum selection clause. This can also occur if your forum selection clause is not well drafted and in line with case law requirements. Your fate, so to speak, will be in the hands of judges that may be partial to their own nationals or otherwise improperly influenced (i.e., bribes…).
If it is apparent that potential disputes involving international components cannot reasonably be kept within a U.S. based jurisdiction, then arbitration becomes a more attractive option. This is particularly the case if the relevant country is a signatory to an applicable arbitration award recognition treaty such as the New York Convention of 1958 or the Panama Convention.
Whereas the investor making the US based investment may be well advised to fight back against an agreement to arbitrate disputes, an investor making an investment abroad may be well advised to insist on an arbitration clause.
Although confidentiality is not guaranteed by arbitration, it is definitely an important factor.
Arbitration is far more confidential than state or federal court litigation. It is also less likely to immediately become attractive to the press.
In large part, this is because court dockets are public and there are press outlets that constantly look through court dockets for newsworthy disputes.
Based on this consideration, some large employers prefer arbitration in order to avoid constant press about employee claims. Similarly, celebrities and influencers would often want an arbitration clause in their various agreements for privacy considerations. Banks and investment advisors often require arbitration largely for this reason as well.
Amounts potentially in dispute and other factors.
As previously indicated, arbitration can be very costly. This is often the source of frustration to investors that were advised to accept an arbitration clause, only to later find that pursuing a dispute may cost as much as the amount of their claim.
However, there’s a point at which the difference between the costs of arbitration, on the one hand, and state or federal court litigation, on the other, is negligible in relation to the amount in dispute. In such a scenario, when a transaction is large enough, various other factors would play a role in the decision of whether or not to enter into an agreement to arbitrate potential disputes.
For instance, the operation may be highly complex, and the parties may therefore prefer the ability to choose “specialized” arbitrators with particular knowledge in a field. A developer of a sky rise and the building contractor, for example, may both prefer to each select a reputable construction lawyer as their party appointed arbitrator so that any dispute is decided by experienced experts.
Another example may be a desire for a neutral forum. For example, in a transaction involving a French enterprise and a Mexican partner, the parties may choose to arbitrate disputes in New York simply to avoid either French or Mexican courts.
An arbitration clause should not be included into an agreement without careful consideration.
Sometimes, arbitration is absolutely desirable, especially when dealing with matters that are highly complex or confidential, or that involve multiple countries and potential jurisdictions.
But other times, an agreement to arbitrate disputes can result in an investor discovering that the bringing of a claim may be just as costly as the amount of the claim itself.
Contracts are filled with highly significant clauses, forum selection being only one example. It is important to have an experienced attorney guide you through the drafting and negotiation of your business agreements. Contact our firm today for a consultation regarding your transaction or dispute.