Thinking the Unthinkable: The Four Essential Elements of a Smart Arbitration Clause - ABA YLD 101 Practice Series

By Paul Quigley

In most contract negotiations, the parties' attention is principally on the subject matter of the deal, and resolving any substantive contentious matters. After working hard to hammer out the elements of a mutually beneficial contract, the parties and their lawyers are disinclined to focus their full imaginations on what happens if it all falls apart. A prenup is practical, but so unromantic.

Increasingly, arbitration is selected by commercial actors as the preferred means for dispute resolution. This short article is intended for lawyers drafting arbitration clauses, which are frequently used in modern commercial contracts. For drafters faced with 11th hour deadlines, it identifies four "Essential Elements" that help ensure that the final arbitration clause works as the parties intended. It also identifies a fifth Essential Element for drafting international arbitration clauses.

Why Reinvent the Wheel?
With many drafting tasks, the modern lawyer is often wobbling atop the shoulders of giants. Internal law firm databases or internet searches provide legions of model clauses or provisions. Many of these provisions are "time tested," or at least have been used successfully before. The author assumes that anyone charged with drafting an arbitration clause in a commercial contract will enjoy this starting point. (The author also presumes that the choice of substantive law governing the contract is dealt with separately.) What is the benefit of understanding the operation of arbitration clauses when there are so many successful model arbitration clauses out there that one can borrow?

A starting point of too much information can be dangerous, as the cutting and pasting drafter may not fully appreciate why the clause is the way it is. As negotiations proceed, the model clause that was cut and pasted in from a prior contract will almost inevitably be tweaked to the parties' preferences. Also, a drafter may think of edits to an arbitration clause that bridge differences between the parties' positions. But even minor changes may compromise the functionality of the entire arbitration clause. Therefore, it is crucial for the drafter to understand how that model operates, so the drafter can tweak it without breaking it.

A set of four Essential Elements should be borne in mind by drafters throughout the negotiation process, so that the clause may be successfully adjusted. First, the clause must be written and satisfy any other legal requirements as to its form. U.S. law requires clauses be written, and even requires "magic language." Second, the clause must unequivocally provide that arbitration be used to resolve disputes, and define the scope of the disputes covered. Third, the clause should choose a procedure to govern the arbitration, including the number of arbitrators to be appointed. Fourth, the clause should select a place of arbitration. Additional elements should be considered when drafting international arbitration clauses. When these Essential Elements are present, an arbitration clause will be clear in its scope and in the procedures it establishes. It should result in binding and enforceable arbitral awards. As such, any later dispute will be resolved without any need for court involvement, and in accordance with the parties' expectations.

The Four Essential Elements

Essential Element 1: Write it down, and Satisfy any other Minimum Requirements.
At a minimum, all arbitration clauses must satisfy the mandatory requirements of applicable laws if they are to be judicially enforceable. U.S. law contains very few requirements regarding the form of arbitral clauses. Section 2 of the Federal Arbitration Act just provides that arbitration clauses must be: "written" and "in ... a contract." 9 U.S.C. § 102. There are some decisions that suggest that consent to entry of judgment is essential for courts to enter judgment confirming an award, so including a line that provides that consent is advisable. See I/S Stavborg v. National Metal Converters, Inc., 500 F.2d 424 (2d Cir. 1974).

Essential Element 2: Choose Arbitration.
Agreement to arbitrate is the foundation of arbitration. Hence, to bind parties to resolving a dispute by arbitration, an arbitration clause should clearly state that disputes shall be resolved by arbitration. Clear imperative language should be used. Also, the clause should define the scope of the arbitration clause. Unless the parties wish otherwise, a broad phrase should be used to encompass all disputes related to a contract. If a narrower phrase is used, an arbitral tribunal may not have jurisdiction to consider quasi-contractual or tort claims related to the contract. (Of course, some tort claims may, by their nature, always fall outside the scope of the clause.) At any rate, a phrase recognized by the U.S. Supreme Court as sufficiently broad to encompass quasi-contractual or tort claims is "all disputes arising out of, connected with, or relating in any way to this agreement." Prima Paint Corp. v. Flood & Colkin Mfg. Co., 388 U.S. 395, 398 (1967). If the parties wish to use a narrower clause, the drafter should make a clear distinction to define the scope of the clause in order to avoid litigation about that scope.

Essential Element 3: Choose a Functional, Fair Procedure.
Commercial arbitration can be either institutional (where the arbitral tribunal is administered by an arbitral institution such as the American Arbitration Association (AAA)), or ad hoc (where the tribunal operates without supervision or support from an arbitral institution, but in accordance with procedures established by or referred to in the arbitration clause). In the U.S., there is no difference at law between an arbitral award issued by an ad hoc tribunal and one that operates under the aegis of an institution such as the AAA. There may be differences in the costs associated with each option, and there are appreciable differences in costs among the arbitral institutions. If the drafter wishes to incorporate the arbitration rules of an arbitral institution, the website of that institution will be a good place to start. Each of the institutions that administer arbitrations has recommended clauses for choosing that institution's rules. These clauses may be found on the websites of the institutions, or in the prefaces to arbitration rules. It is not necessary to follow these clauses to the letter: the choice of arbitral institution just needs to be clear and uncompromised. Some institutions, such as the International Center for Dispute Resolution, also offer free, practical, guides to drafting a clause that incorporates their rules. A clause providing for ad hoc arbitration needs more attention, and should at the very least state the size of the Tribunal, provide a procedure for appointing the tribunal, and set forth or select rules of procedure for the Tribunal.

Essential Element 4: Choose the Right Place of Arbitration.
The venue (or "seat") of arbitration is significant for two principal reasons. First, the arbitral tribunal will likely apply the law of the venue to determine procedural issues governing the arbitration, so the law of the forum will control issues such as privilege. Second, the mandatory rules of the venue that govern arbitration will define what the tribunal can and cannot validly do. (Each U.S. state has an arbitration statute, and the states with the most significant commercial centers tend to have liberal statutes with few mandatory rules to interfere with Tribunals. Check the appropriate state's statute.) The venue is particularly important for international contracts, as set forth below.

The Fifth Element: The New York Convention
If drafting a clause for a contract involving any non-U.S. parties, providing for performance outside the U.S., or involving assets outside the U.S., the drafter should ensure the arbitration clause and the manner of its execution are in accordance with the United Nation Convention on the Recognition and Enforcement of Foreign Arbitral Awards, also known as the "New York Convention" (incorporated into U.S. law as 9 U.S.C. § 201 et seq.). Simply put, this means that the clause should be in writing, comply with any laws of the place of arbitration, and be properly executed by a person with sufficient authority to bind each party. If properly drafted, the arbitration clause and any future arbitration award will be enforceable in any New York Convention signatory country, including the U.S. The New York Convention is a powerful tool for ensuring that arbitral awards are enforced, so if enforcement is a client concern, it should be borne in mind by the drafter. The drafter should also explicitly select a language for the arbitration, and not presume that the language of the contract (or the country that is the seat of the arbitration) will govern the arbitration. If contemplating arbitration outside the U.S., the drafter should investigate whether courts in the foreign jurisdiction are supportive of arbitration. The drafter should avoid jurisdictions with onerous mandatory rules that could result in awards being vacated (unless strategic considerations dictate otherwise). The drafter should also ensure that the selected forum is a New York Convention signatory state, so any award can be enforced in any other New York Convention signatory states.

Additional Advice
If the parties to a contract are selecting arbitration for the confidentiality they presume it affords, the drafter should examine whether the arbitration rules selected actually provide that proceedings are confidential. Many do not. A savvy drafter will also be aware of the potential importance of interim measures in the event of a dispute. Many arbitration rules now provide for appointment of "emergency arbitrators", "referees" or "special arbitrators" who can deal with requests for interim measures while an arbitral tribunal is still being constituted. These clauses tend to be "opt in" or "opt out." The parties should make a conscious choice about which they want. The parties may also wish to set forth minimum criteria for the qualifications of arbitrators. They may also wish to provide rules regarding payment of the costs of arbitration, including legal fees.

When adding bells and whistles to the arbitration clause, the drafter should bear in mind the law of unintended consequences. Mandatory provisions that compel or encourage parties to meet or mediate before initiating proceedings should be inserted with caution, as they could complicate later proceedings. (At the very least, such provisions should express clearly whether the mediation is a strict condition precedent to initiating arbitration, or is merely suggested.) Similarly, an arbitration clause should not overreach by establishing a very complicated situation-specific procedure for a future arbitral panel to follow. Nor should it be over-specific regarding the qualification of arbitrators. Disputes will often come from unexpected directions, and a Tribunal that is hamstrung by its own terms of reference may not be able to issue an enforceable award that encompasses the entire dispute. Finally, the procedures established should also be facially fair to all parties, or a court may later find that the entire procedure violated due process or other rights, and vacate or refuse to enforce the resulting arbitral award.


Resources
The below pieces offer more detailed guidance to the drafter of an arbitration clause. They are practical and, at the time of publication, free online.

John M. Townsend, Drafting Arbitration Clauses: Avoiding the 7 Deadly Sins, 58 Disp. Resol. J. 1 (Feb.-Apr. 2003), http://www.adr.org/si.asp?id=3620.

R. Doak Bishop, A Practical Guide for Drafting International Arbitration Clauses, A Practical Guide for Drafting International Arbitration Clauses, 1 Int'l Energy L. & Tax'n Rev. 16 (2000), http://www.kslaw.com/library/pdf/bishop9.pdf.

International Center for Dispute Resolution, Guide to Drafting International Dispute Resolution Clauses, http://www.adr.org/si.asp?id=4945.

Resources

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About the Author

Paul Quigley is an associate at the New York office of Simpson Thacher & Bartlett LLP. His practice focuses on international commercial arbitration and litigation. The author thanks Guillaume Lemenez of the ICDR for his helpful suggestions regarding this article.

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