July 31, 2011

Hanging by a Thread: Finding Arbitrability without Clear Evidence of a Contract

Bruce M. Polichar

It is not unusual for business deals to fall apart just at the moment when everyone thought they were concluded. Well, not everyone--actually about half of those involved. The other half feels that it was just a potential deal that never came together. This scenario plays out in business every day, and just as frequently spawns legal disputes over whether enforceable contractual rights and obligations have been created or not. This article addresses a little-known body of law arising under the Federal Arbitration Act (as well as various state laws) that may find parties to a business negotiation binding themselves to arbitration as a dispute resolution forum even though their dealings never result in a fully binding contract on the larger substantive deal terms. I have structured the discussion of this potentially surprising situation by first relating an international arbitration that was recently presented to me for ruling, and then analyzing the federal and state law that brought the matter within my jurisdiction as an arbitrator. Suggestions for drafting arbitration provisions that address this situation appear at the end of the article.

The international commercial arbitration I referred to involved an American company, "Americo," against a European company, "Euroco." The notice of arbitration that commenced the proceeding quickly generated a vigorous response from Euroco contending that no arbitration could take place inasmuch as the parties had never entered into a contract and, thus, there was no agreement to arbitrate. As is often the case, an arbitrator was being asked to make a threshold determination as to whether the matter could proceed at all--whether the dispute was arbitrable--or, to put it another way, whether the arbitrator and the arbitral institution under whose rules the proceeding was initiated had jurisdiction to conduct an arbitration. My initial inclination in reviewing the arbitrability challenge was to take a step back from trying to determine the overall scope of the possible agreement of the parties in assessing the arbitrability issues without becoming immersed in the potential merits of the larger contract claims.

Factual Background

A brief overview of the exchange between Americo and Euroco presents a fact situation quite common in commercial disputes, particularly those where arbitrability is challenged. Americo and Euroco negotiated and exchanged various draft documents over many months in an attempt to reach a final and comprehensive agreement on their overall business arrangement. Americo argued that by reason of alleged oral agreements reached between the parties concerning the business Euroco was to conduct for Americo in certain European territories, as well as certain draft deal memos intended to confirm the parties' agreement (the deal memo), a legally binding written agreement was entered into establishing jurisdiction to arbitrate before the "XYZ" arbitral institution. A surface review suggested that the parties may not have fully reached an agreement on the substantive business terms of the underlying transaction. But the critical question for me was whether they had sufficiently agreed to confer jurisdiction on an arbitrator to resolve the dispute.

The version of the deal memo that Americo included in its notice of arbitration contains a provision that states, "In case of any dispute the parties agree to XYZ arbitration." The deal memo does not appear to have been signed by either of the parties. There appeared to have been various notes between the parties evidencing an exchange of comments and proposed modifications and revisions by each of the parties to the original draft of the deal memo. Their correspondence suggested that the parties concurred on numerous points, some potentially significant and material to the formation of a contract, and others seemingly much less important. There appeared to have been agreement on a number of negotiated points by the comment "Okay" offered by one or the other at various points in the course of the communications. In one e-mail exchange there is a comment from Americo's negotiator which reads, "13. In case of any disputes, we would like to use XYZ arbitration." Appended to that, and admittedly written by Euroco's negotiator is the comment, "Okay." Euroco acknowledged this "Okay" comment, but raised issues concerning its meaning, intent, and significance to this inquiry. On that same date Euroco's negotiator incorporated the XYZ arbitration clause into a revised draft of the deal memo and sent it back to Americo along with various other comments reflecting their ongoing negotiations. At some point, following this last written exchange, Euroco notified Americo that Euroco did not intend to proceed with the deal, with no reference being made to any unacceptable terms or other reason for withdrawing from the discussions of a business arrangement. Sometime thereafter, Americo initiated the arbitration.

Procedural Discussion

In its objection to the jurisdiction of the tribunal, Euroco argued that, under the XYZ's published Rules (XYZ Rules) and California law, a written contract between the parties agreeing to arbitration was a pre-requisite to the conduct of an arbitration, and no such written agreement had been consummated by the parties. The overall thrust of the challenge was that there was no contract upon which to base an agreement to arbitrate. I treated this as a motion to dismiss the arbitration proceeding.

Analysis

The ruling on the motion to dismiss focused solely on the question of arbitrability and jurisdiction of the tribunal to proceed under the XYZ Rules. The larger range of questions concerning a comprehensive agreement between the parties, its contents if any, or any questions regarding any breach of such an alleged agreement, was explicitly deemed outside the scope of the discussion and my ruling. The sole question addressed was: "Did the parties agree to arbitrate?" As noted below, this distinction is central to the applicable case law.

It is well-established that arbitration is a matter of private contract, and arbitrability and the jurisdiction of an arbitration tribunal require that the parties entered into a written agreement to arbitrate. The XYZ Rule in question states that "the Arbitrator shall exercise all powers granted to commercial Arbitrators under the laws of the State of California, USA, or the laws of the jurisdiction where the arbitration takes place . . . ." Under the XYZ Rules, all such arbitrations are conducted under California law unless the parties agree otherwise. With respect specifically to international arbitrations, the governing California law is found in Code of Civil Procedure (CCP) Section 1297 et seq. Section 1297.72 provides that:

An arbitration agreement shall be in writing. An agreement is in writing if it is contained in a document signed by the parties or in an exchange of letters, telex, telegrams, or other means of telecommunications which provide a record of this agreement, or in an exchange of statements of claim and defense in which the existence of an agreement is alleged by one party and not denied by another...

The XYZ Rule granting the arbitrator authority to rule on his/her jurisdiction was modeled on CCP Section 1297.161. The language of both provisions is almost identical. Section 1297.161 of the Code states:

The arbitral tribunal may rule on its own jurisdiction, including ruling on any objections with respect to the existence or validity of the arbitration agreement and for that purpose, an arbitration clause which forms part of a contract shall be treated as an agreement independent of the other terms of the contract, and a decision by the arbitral tribunal that the contract is null and void shall not entail ipso jure the invalidity of the arbitration clause.

The arbitrability clauses of most major international arbitral institutions use almost identical language in this regard. If the contract containing the arbitration agreement designates such rules of a named tribunal, then the court is to defer to them and leave arbitrability and all other issues to the arbitrator. (There is case law that makes this occasionally unclear; but it normally applies).

The Nicaragua Line of Cases

Americo cited Republic of Nicaragua v. Standard Fruit Co., 937 F.2d469 (9th Cir. 1991), cert. denied, 503 U.S. 919 (1992), for the general proposition that "even the most minimal indication of the parties' intent to arbitrate international disputes must be given effect." The case is instructive with respect to the complex issues presented in cases such as "Americo vs. Euroco." In any case in which the Federal Arbitration Act (FAA) applies, federal substantive law governs the question of arbitrability. This means the FAA applies to all cases involving interstate or international commerce. Nicaragua is a pivotal decision on this issue (having been cited favorably in over 100 subsequent state and federal decisions), and deserves careful analysis.

In Nicaragua, the newly-installed Sandinista government had begun negotiations with a group of affiliated American and Nicaraguan corporate entities comprising Standard Fruit Company (Standard) with respect to an expansive new arrangement for the growing and export of the nation's economically-critical banana crop. This followed an initial attempt by the rebels to nationalize the industry--an effort which they came to realize could be economically disastrous. While a written memorandum of agreement regarding certain aspects of the overall arrangement had been reached with some of the Standard-affiliated entities through an extended series of negotiations, additional implementing contracts were required to fully realize the overall understanding the contracting parties intended, and some of the Standard entities had not even signed the initial memo. However, the memo did contain a somewhat clumsy and incomplete arbitration provision which the parties intended to further refine and document in what ultimately became a failed series of further negotiations on the overall business arrangement between the parties. It read, very simply: "Any and all disputes arising under the arrangements contemplated hereunder . . . will be referred to mutually agreed mechanisms or procedures of international arbitration, such as the rules of the London Arbitration Association." (In all likelihood they contemplated the London Court of International Arbitration which had been a major center for international commercial arbitration for many years.)

The court noted that "Nicaragua admits that this is less than crystal clear, and in fact refers to an association that does not exist. . . . During the negotiations themselves, neither side could remember the name of the arbitration body in London."

In reversing the district court's denial of Nicaragua's motion to compel arbitration, the Ninth Circuit carefully reviewed the provisions and policies of the FAA and the various federal court cases interpreting them. To begin with, the court stated that the FAA reflects the strong Congressional policy favoring arbitration by making arbitration clauses "valid, irrevocable, and enforceable." The court in Nicaragua said that "the standard for demonstrating arbitrability is not a high one: in fact, a district court has little discretion to deny an arbitration motion. The court noted that "as with any other contract, the parties' intentions control, but those intentions are generously construed as to issues of arbitrability. . . . The only issue properly before the district court was whether the parties had entered into a contract evidencing a transaction involving commerce under the Act and committing both sides to arbitrate the issues of the contract's validity."

A Surgical Look at the Initial Evidence

We are all trained as lawyers, and certainly as quasi-judicial officers, to refrain from drawing conclusions until all of the evidence is in and carefully examined. However, that normally appropriate approach is exactly what the cases have historically warned against in assessing challenges to arbitrability based on claims of "no contract." Instead, an arbitrator must avoid delving into the merits of whether the parties had entered into a fully binding comprehensive agreement, and only seek out clear evidence of an agreement to arbitrate.

Nicaragua 's reversal of the district court turned significantly upon the fact that the lower court had looked to the existence of a contract as a whole to determine arbitrability. This was squarely contrary to the Supreme Court's landmark ruling in Prima Paint v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967). Prima Paint expressly held that courts may not consider challenges to a contract's validity or enforceability as defenses against arbitration. That case demands that arbitration clauses be treated as severable from the documents in which they appear unless there is clear intent to the contrary. An arbitration clause may thus be enforced even though the rest of the contract is later held invalid by the arbitrator.

Euroco had argued that, while it did respond to Americo's request that disputes be resolved under XYZ arbitration with an "Okay," it only meant that it was agreeable if all the rest of the terms of the arrangement were fully finalized. However, this reservation or explanation of the assent to arbitration was not included in any of the communications between the parties, and appears only to have been raised in defense of the effort by Americo to engage the arbitration process. A statement that a party did not intend to arbitrate, made only after a dispute over arbitrability has arisen, when the circumstances demonstrate otherwise, is ineffective to avoid the obligation to arbitrate.

Severability of the Arbitration Clause is Key

What was pivotal for my analysis in Americo vs. Euroco was the portion of Nicaragua and Prima Paint that requires the arbitrator to disregard the surrounding contract language as formulated in the communications exchanged by the parties, and consider only issues relating to the making and performance of the agreement to arbitrate. Nicaragua, referred to an earlier case to emphasize the logic of these rules:

White argues that if there is no contract to buy and sell motors there is no agreement to arbitrate. The conclusion does not follow its premise. The agreement to arbitrate and the agreement to buy and sell motors are separate. Sauer's promise to arbitrate was given in exchange for White's promise to arbitrate and each promise was sufficient consideration for the other.

Thus, the court in Nicaragua concluded that in the absence of anything in the ambiguous arbitration clause that was included in the incomplete agreement between the parties showing that it was not intended to be severable, "we must strictly enforce any agreement to arbitrate, regardless of where it is found." The arbitrator or a court can only determine whether a written arbitration agreement exists, and if it does, enforce it in accordance with its terms. As noted above, various types of writings evidencing the agreement to arbitrate are appropriate to evaluate the existence of the agreement. Similarly, the doctrine of severability of an arbitration clause is firmly based on both state and federal statutory and case law, as well as most tribunal rules.

Policy and the Agreement to Arbitrate

It is well established that where the contract contains an arbitration clause, there is a presumption of arbitrability. The Nicaragua court discussed what, in fact, constitutes an agreement to arbitrate. It begins by emphasizing the emphatic federal policy in favor of arbitral dispute resolution (which) applies with special force in the field of international commerce. The Federal Arbitration Act's presumption in favor of arbitration carries "special force" when international commerce is involved.

And, Nicaragua notes:

According to the Supreme Court, when international companies commit themselves to arbitrate a dispute, they are in effect attempting to guarantee a forum for any disputes. Such agreements merit great deference, since they operate as both choice-of-forum and choice-of-law provisions, and offer stability and predictability regardless of the vagaries of local law. The elimination of all such uncertainties by agreeing on a forum acceptable to both parties is an indispensible element in international trade, commerce, and contracting. An agreement to arbitrate before a specified tribunal is, in effect, a specialized kind of forum-selection clause that posits not only the situs of suit but also the procedure to be used for resolving the dispute. The fact that the United States has enacted the International Convention on the Recognition and Enforcement of Foreign Arbitral Awards as part of the Federal Arbitration Act, 9 U.S.C. Sec. 201-208, is further evidence of this federal policy.

Even where there are problematic issues about the clarity of an agreement to arbitrate, Nicaragua says that "the clear weight of authority holds that the most minimal indication of the parties' intent to arbitrate must be given full effect, especially in international disputes," and "the scope of the clause must also be interpreted liberally. As a matter of federal law, any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration." If the agreement in question can be interpreted to allow arbitration, the clear federal policy of liberal application of the FAA to resolve any doubts in favor of arbitration. Nicaragua continues to be relied on by courts and is an important source on these issues almost 20 years after its issuance.

A State Law Perspective

As regards consideration of arbitrability in Americo v. Euroco, the propositions articulated in the Nicaragua line of cases are, of course, consistent with a large body of state court opinion as well. In light of the comprehensive statutory scheme regulating private arbitration, state courts will generally indulge every intendment to give effect to such proceedings. This is generally consistent with arbitration in most jurisdictions, particularly where the Uniform Arbitration Act has been used as a foundation for state arbitration statutes.

Thus, even though the proposal to submit the dispute to XYZ arbitration and the responsive "Okay" were exchanged between Americo and Euroco in the course of negotiating a preliminary agreement regarding the proposed business arrangement, such a preliminary agreement appears to be binding under both California and federal law regardless of whether a subsequent contract is finalized. The standard for demonstrating arbitrability under most state law is also not high, and such agreements are usually rigorously enforced. Parties may identify the arbitrable claims indirectly by choosing a body of private arbitration rules, such as the XYZ Rules, that specifies the scope of arbitrable claims. They may also exclude certain matters from arbitrability either explicitly or by refusing to allow certain substantive provisions into their agreement.

In light of such strong and clear judicial statements of policy regarding arbitration agreements in international commerce, the facts in the Americo vs. Euroco arbitration clearly supported a finding that Americo and Euroco, whatever other issues they may have been left open, reached a written agreement that disputes surrounding their dealings would be resolved through arbitration, and under the XYZ Rules. In the end, an analysis of the parties' communications made clear that they had agreed upon a forum and a body of rules for the resolution of any future disputes. Under applicable law, the arbitrator's jurisdiction included the authority to rule on the issue of arbitrability itself, even though the overall posture of the parties' comprehensive agreement--if any--was hanging by a mere thread based upon the uncertainties that remained in the communications.

Considerations in Drafting

The situations that we have discussed start early on when business people are working out potential terms of an agreement. The consequences of casual communications about arbitration are not usually the focus of early-stage deal making, and the consequences of those communications are usually not apparent to the people trying to hammer out the basics of the deal. When the deal falls apart and litigators or arbitrators get involved, the parameters for dealing with the dispute may are already be fixed in place. It is important, then, that business people, as well as their corporate and outside counsel, are aware of how arbitrability issues may affect them, and recognize the importance of communicating clearly about how they want to handle disputes if they arise in the future. As noted in the recently-published Protocols of the College of Commercial Arbitrators:

Business users, guided by knowledgeable and experienced counsel, are in the best position to determine how and when arbitration will be brought to bear on business disputes, and what kind of arbitration process to prescribe. If business parties really want arbitration to be a truly expeditious and efficient alternative to court, they have to assume control of the process and not delegate the responsibility to outside counsel-in other words, principals and not agents, should act as principals. This must include not only choices made after disputes arise, but also active choice-making at the time of contracting. Ideally, it begins even earlier with strategic discussions regarding the management of conflict in which arbitration is considered among the variety of tools and approaches.

There are three principal issues involved in the creation of a contractual arbitration provision: (1) whether arbitration is desired at all, and when to address that choice; (2) the so-called "delegation" questions defining the arbitrator's authority to rule on arbitrability and jurisdiction; and, (3) the scope of arbitral issues.

Consider Arbitration Early in the Process

In most business dealings, negotiators will tend to focus on major commercial terms in the early stages of discussions and in the preparation of deal memoranda or draft agreements. Choice of forum issues tend to arise as afterthoughts or become important points only when a deal has failed to conclude or was concluded but has later gone sour, and the parties are seeking remedies. As we have seen, casual treatment of the question of where and under what rules disagreements are addressed may produce surprises that one or more parties may not be happy experiencing when a dispute subsequently arises. In-house corporate counsel (or other contract negotiators), need to determine early on in a business negotiation the issue of forum selection in the event the contracting process aborts, and to lay the groundwork accordingly. Likewise, it behooves outside advisors to counsel their clients on the importance of thinking through the arbitration issues even as they begin to consider new business dealings. This starts with the not-always simple issue of whether or not to adopt arbitration as the designated forum for dispute resolution.

Just as a specific choice of law provision will address the rule structure for future disputes, the designation of a particular forum or arbitral institution for dispute resolution may also serve to define a set of rules which, in themselves, affect issues such as authority to rule on arbitrability and the scope of the arbitration provision's coverage. It would therefore be prudent to look carefully at both a specific designation of governing law as well as the language of the arbitration provision to assure that the choices are complementary to the desired result, i.e., whether the choice of law is favorable to the selection of a particular arbitration institution and its rules. As noted earlier, there may be potential issues to consider on procedural as well as substantive matters concerning the interplay of state and federal law. The extent to which an arbitration clause can anticipate and can be negotiated so as to determine how those issues will be decided in future proceedings is open to some question as the law in this area is not stable.

These choices may arise as part of the early contract-negotiation process without being initially apparent, and counsel should identify and make clients aware of them as they begin the process of exchanging proposals and early-stage forms of agreement. Inasmuch as a focused approach to these issues is going to arise as soon as any form of agreement--interim or more formal--is exchanged, the nature of the communications among the parties deserves close attention. As seen from Americo v. Euroco, the arbitration issue may often arise very casually, but often has substantial impact on the outcome of the dispute. To the extent that participants in the deal-making process have reservations about pinning themselves down to various choices of forum and law, they may want to consider explicitly stating in their written exchanges that all terms, including dispute resolution provisions, remain conditioned upon finalization of a full and formal written agreement.

Another potential trap for the unwary is the equally-common situation in which the parties negotiate a legally binding deal memo, and reference the possibility of moving to a more detailed formal agreement at a later date. Even though the deal memo might not contain any reference to arbitration, it is often the case that the parties will reference a particular long form agreement as the intended model for further documentation. In many industries parties are likely to reference an "industry model" long form agreement. These broadly used contract forms frequently contain arbitration protocols. If the parties negotiating the deal are not sure about whether to adopt arbitration in the early stages they would be well-advised to note that the arbitration provisions of the potential long form will also not come into force and effect unless and until the long form is in fact fully adopted and executed by the parties.

Delegate Issues as within the Arbitrator's Authority

While courts often suggest that the question of whether a matter is clearly within the purview of the arbitrator is unequivocally a threshold issue for a court, I would submit that a survey of the cases makes this anything but clear and predictable. If a decision has been made to submit future potential future disputes to arbitration, one would be well-advised to adopt the language used by most of the major arbitral institutions, which tends to track the language of CPP 1297.161 noted above. I am not aware of any reported case in which a specific, explicit delegation of authority of the arbitrator to rule on his or her jurisdiction has been rejected by a court. Bear in mind, however, that the matter of delegation of arbitral authority, and the delineation of the scope or range of issues that fall within the authority of the arbitrator to rule, are often expressed in one comprehensive arbitration clause. In drafting these provisions it is important to analyze each of these arbitrability issues with a clear focus and careful choice of language. We have seen that the attempt to use broad and general language may not be sufficient to assure the desired scope of authority.

Define the Scope of the Arbitrator's Authority

A broadly-worded arbitration clause is not a guarantee that it will be honored and applied by a court, even with comprehensive, inclusive language employed. Thus, issues of who--court or arbitrator--should decide arbitrability, the inclusion or exclusion of any issue, including the formation, ratification/finalization, validity, enforceability, or other application of the overall terms of the agreement, are subjects that might be wise to explicitly incorporate in the arbitration clause itself. One must be cognizant of the current case law and Congressional exploration of certain subjects as possible exclusions from the arbitral forum, namely the issue of unconscionability and, potentially, contracts involving employment and consumer dispute-resolution mechanisms. If the drafter's desire is to achieve the most comprehensive, inclusive arbitrability coverage, he or she should consider adding to the customary broad language of the arbitration clause language, such as, "any and all matters arising under, related to, growing out of, or otherwise pertinent to the subject matter of this agreement, including, but not limited to, all issues of any nature concerning the formation, ratification, validity, enforcement or breach of this agreement; save only those matters which, by law raise challenges specifically to this arbitration provision, and/or whose substantive subject matter has been removed from arbitral jurisdiction by statute."

However, if the parties negotiating a commercial contract are only prepared to have disputes submitted to arbitration once the contract has been fully completed and executed, they would be well-advised to state that specifically in their negotiation communications from the very beginning. A failure to do so may well result in the application of arbitral jurisdiction under the principles that I have explored in this article. Similarly, negotiation communications might also address the question of where arbitrability is to be determined in the absence of a fully-detailed arbitration clause that would normally be the place to fix a venue, either explicitly or by reference to a body of arbitration rules of a chosen institution.

Conclusion

Whether arbitration is or is not a desired forum for resolution of potential disputes in the future of a business agreement is a question requiring careful analysis. The conclusions that business negotiators come to on this issue may vary by the specific circumstances of each business dealing; and one doesn't always guess right in hindsight. Arbitration has its pluses and minuses in each situation and business context. Given the nuances of the law in applying arbitration to a future dispute, it is extremely important that this be given thoughtful consideration in the formulation of contracts at every stage of the negotiation process.

Bruce M. Polichar

Bruce Polichar is a full-time ADR neutral based in Los Angeles. He can be reached at polichar@sbcglobal.net. This article is derived from a version appearing in International Dispute Resolution News, Fall 2010 edition, a publication of the International Litigation Committee, International Arbitration Committee, and International Mediation Committee of the Section of International Law, American Bar Association.