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  • Writer's picturePaul Swegle

Arbitration - The Pool Noodle of Justice

As a tool of commercial justice, arbitration substitutes for litigation about as well as tofu substitutes for a good steak.

 

Having been involved in hundreds of disputes, I can say with confidence the only times you should hope a commercial dispute will be arbitrated is when your case is weak or you have something to hide.

 

But if your company honors its commitments and operates conscientiously, consider crossing out arbitration clauses in your commercial agreements.

 

Consumer-Facing Issues. Consumer-facing agreements are generally beyond the scope of this article, but preempting costly class-action litigation for problems like data breaches and unexpected product shortcomings is a common reason for combining arbitration clauses with class-action waivers in consumer-facing agreements, licenses, and terms of service.

 

On the other hand, if hundreds or thousands of customers might try to harm your company through fraud or other misconduct, handling those claims under an arbitration clause could be highly ineffective compared to litigation.

 

After several instances of customer fraud at one company with 1.5 million online customers, I removed our arbitration clause so we could more easily track down, sue, and pursue the bank accounts of miscreants. That program eventually became profitable enough to handily pay for weekly beer-Fridays due to our attorneys’ fees clause, liquidated damages clause for reversed transactions, and our ability to seek treble damages.

 

I Don’t Think You Want My Opinion. About a decade ago I reluctantly agreed to give an interview to an arbitration and mediation firm, after warning them emphatically that my opinions wouldn’t support their marketing objectives. I don’t believe the following excerpt ever saw the light of day.

 

Interviewer: How often do you have cases that involve mediation or arbitration?

 

Swegle: Not often. As a rule, I tend to avoid both mediation and arbitration. Sometimes I am forced to arbitrate because of a clause in an agreement, but it is rarely my first choice. That’s not to say that arbitration is always bad. My favorite arbitration victory involved a $240M award against a company that tried to back out of a contract by claiming market forces prevented it from performing. Economic force majeure is not a valid legal theory for evading contractual commitments, and fortunately the arbitrator agreed.

 

But in general, I find that arbitration is almost as formal and expensive as litigation, but with far less predictable outcomes and usually no right of appeal. As a lawyer, I am naturally distrustful of processes and decision-makers not subject to formal review.

 

The greater ease of keeping arbitrated disputes out of the public eye can sometimes be an important consideration, but rarely does it carry more weight than other strategic or tactical concerns. And in any dispute where the other party faces potentially damaging publicity for its misdeeds, the prospect of a public airing of that dirty laundry can actually help drive a faster and better resolution.

 

Similarly, I tend not to use mediation because I feel like I have a better shot at resolving disputes before litigation through my own negotiating techniques and strategies.

 

In mediation, clear victory is an unlikely outcome. The most likely outcome is compromise. If the law and facts are on my side and I have adequate resources, I’d much rather take my chances in litigation, or at least go through certain motions leading up to litigation that might force a settlement. More often than not, that has been the path to outcomes that feel more like real victories, not handing my case over to a neutral who’s likely to push both parties to meet in the middle, regardless of the facts or law.

 

That said, mediation could be the better choice where the facts or law are less clear or less favorable. In less predictable cases, mediation could be a faster, less expensive and safer route to resolution. Generally, though, I guide my clients and companies to conduct themselves such that the facts and the law are generally on our side.  Then if disputes arise, I tend to take advantage of that high ground.

 

While other very knowledgeable and experienced lawyers have reasons for preferring arbitration, here are ten reasons why I tend to avoid arbitration clauses in commercial agreements.

 

1.    Arbitration Cannot be Compelled. If you sue someone in court and they don’t answer your complaint, you file a motion for default and get an enforceable default judgment. With a court’s default order in hand, you can help yourself to their bank accounts. 

 

Most arbitration clauses have no such mechanism to force anyone to participate actively in arbitration or to obtain an award if they fail to appear and participate.

 

I currently have a case where a company that owes one of my companies money has simply refused to respond to the arbitration process we properly initiated. The only way to deal with that behavior is to file a lawsuit and see how the court deals with the situation. So we first paid arbitration filing fees and attorneys’ fees, and now we are paying similar litigation costs.

 

“Mandatory” in the phrase “mandatory arbitration” simply means you can only seek justice via arbitration. Participation itself is not mandatory. Arbitration is a private process with no government force or coercion behind it.

 

2.    Coin-Operated Justice. Even if a party says they will participate in arbitration, they can usually stall the process indefinitely by not paying their half of the up-front arbitration fees. Arbitration does not begin until all upfront fees are paid.

 

This pattern played itself out in one of my cases, delaying commencement of the matter for more than six months. Obviously, tax-funded public courts do not have this coin-operated aspect.

 

3.   Expenses are Comparable. Despite what arbitration advocates might try to argue, the legal costs and expenses of arbitration are essentially equal to those in litigation. Right up front, each party usually has to write a check for thousands of dollars to the arbitrator(s). That is one expense you do not have in court – at least not in the U.S.

 

And discovery costs now seem roughly equal to those in litigation. Early on in the development of modern arbitration, there were rules strictly limiting discovery, but those seem to be largely out the window.

 

My recent arbitrations have involved extensive discovery and costly depositions, including court reporter expenses. There’s also nothing shorter or more expedited about arbitration proceedings compared to proceedings in most well-run court systems.

 

And lawyers certainly don’t reduce their hourly rates for arbitration versus litigation.

 

4.   Fewer Procedural Protections. Court rules provide clear guardrails for procedural timelines and requirements in litigation. If a party does not comply with discovery requests, a motion to compel can give teeth to the process, including the risk of sanctions and penalties for non-compliance.

 

Arbitration has no such teeth. At best, the arbitrator can cajole.

 

5.   Fewer Tactical Tools. In litigation, defendants can sometimes get an action dismissed by filing a “motion to dismiss for failure to state a claim upon which relief can be granted.” 

 

Such a motion effectively says “nothing they said in their complaint entitles them to any relief under the law, even assuming it’s all true.”

 

And apart from a motion to dismiss, litigants on either side can file a motion for summary judgment and prevail by showing that the other party is unlikely to prevail, even when looking at the facts in a light most favorable to them. A court will grant summary judgment if the moving party shows that there is no genuine dispute as to any material fact and they are entitled to judgment as a matter of law.

 

There are no such offramps or quick victories in arbitration. I have been stuck in arbitrations several times where either judicial dismissal for failure to state a claim or success on motion for summary judgment would have been a foregone conclusion.

 

In one such case, a mentally ill person argued that his purchase from my company of an exchange-traded fund, or ETF, that was focused on silver companies entitled him to have actual bars of silver delivered to his door. No kidding, totally true.

 

Despite ultimately succeeding, the company’s arbitration costs in that matter exceeded $150,000. Had that matter been litigated in court, victory via motion to dismiss would have cost less than $25,000.

 

In another case at that same company, another delusional online brokerage customer claimed that a market stock pricing error caused elsewhere in the financial system and lasting two or three minutes entitled her to millions of dollars. She said that, because her stock falsely displayed value of more than $5 million instead of its actual worth of about $50, she was entitled to the peak value shown.


Despite the obvious facial absurdity of her claims, the case was fully arbitrated at a cost of around $200,000 – a miscarriage of justice.

 

6.    Lower Professionalism/Accountability. Although I know some great people who are arbitrators and mediators, and although many arbitrators and mediators are former judges, I have perceived a lower level of professionalism and accountability in arbitration versus in courts of law.

 

After all, to whom are arbitrators accountable? Nobody.

 

Even arbitrators that belong to dispute resolution firms or organizations operate quite independently, outside of any apparent supervisory structure with real checks and balances.

 

Arbitrators are also not subject to enforceable standards of judicial conduct the way that judges are, aside from what are likely toothless industry rules and standards.

 

And, in most cases, arbitration awards are confidential and non-appealable, so an arbitrator’s work is highly unlikely to be subject to any official review, let alone any reputation-harming public scrutiny or ridicule.

 

7.   Arbitration Awards Often “Split the Baby.” Possibly the worst aspect of arbitration is the tendency of arbitration awards and decisions to be completely arbitrary.

 

The most arbitrary decision I have experienced was inflicted on one of my companies just a few years ago. The arbitrator, a distinguished and reputable former judge, found in favor of our company on the law and the facts and then awarded zero dollars.

 

This happened in a case that ideally should have taken place in federal court or the Delaware Court of Chancery, since it involved complex and egregious violations of fiduciary duties, theft of intellectual property, theft of other company assets and resources, and theft of a corporate business opportunity.

 

The malefactors had made more than $1,000,000 from their misdeeds. That amount would have been the measure of damages in any court of law – but not in arbitration.

 

The arbitrator made no effort to explain his anomalous and devastating decision. Achieving that Pyrrhic victory cost more than $300,000 in legal expenses and more than a year of distraction for the company.

 

The arbitration clause that caused this disastrous situation was contained in an LLC operating agreement – something that would never happen in a corporate context, fortunately.

 

The reasons for such arbitrariness are elusive, but many arbitrators and mediators seem to embrace a “splitting the baby” philosophy.

 

In other words, unlike in litigation where the law is applied to the facts and injured persons are made whole when, how, and to the extent called for under the law, arbitrators seem to want to just help each party dust themselves off and move forward - to help maintain societal harmony. Neither party, even bad actors, should be harmed in the process. It’s not about “justice,” it’s more about simply “resolving” the dispute.

 

If you talk to arbitrators and mediators about their cases or reputation, they often say something along the lines of, “I figure the best decisions are ones where neither party is perfectly happy. Each party got some of what it wanted, but not everything.” 

 

No, sorry - if a deadbeat company owes my company $1 million, I want the correct result under the law and nothing less. My goal in litigation is not to pursue societal harmony, and I do not care how happy the other company is about the result.  

 

8.   Non-Appealable. While every court decision is subject to appeal, virtually no arbitration awards are subject to appeal. So, in arbitration, you have a single point of failure and no recourse. None. Non-lawyers find that impossible to believe when the result is aberrant and unjust.

 

In what aspect of business has anyone ever recommended or extolled a single point of failure?

 

And as mentioned above, how can the total absence of accountability not impair the quality of arbitration decisions relative to appealable court decisions?

 

Lastly, something unknowable, but still worth asking.

 

Does the utter lack of accountability for arbitration decisions and the complete lack of transparency in how arbitration decisions are reached make arbitration vulnerable to corruption?

 

Aside from self-professed values and ethical standards, what’s to stop one party from handing a financially struggling arbitrator a big wad of cash to throw the case in their favor?

 

Corruption would certainly be a logical explanation for how a company can win on all of the facts and law but obtain no financial compensation where bank records demonstrate financial damages.

 

But we will never, ever know about corruption in arbitration given the strictures of confidentiality, the lack of appeal rights, and the absence of the types of mechanisms that exist for exposing, investigating and prosecuting judicial corruption. For what it's worth, arbitration corruption is a known problem in certain countries, as detailed in articles like the one at this link - https://www.sciencedirect.com/science/article/pii/S2949791423000325

 

9.   Not Self-Enforcing. One of the ironies of arbitration, a process for avoiding court, is that most arbitration orders are unenforceable without going to court.

 

Unless the arbitration clause says otherwise (very rare), you cannot simply take an arbitration order to the losing party’s bank and compel the bank to give you their cash.

 

Rather, you have to file an action in court, ask the court to “confirm” the arbitration award, and then take that court order to the bank to compel payment.

 

This obviously increases costs, delays, and uncertainties and reduces the effectiveness of arbitration.

 

10.  Confidentiality. Arbitration proceedings are generally completely confidential. Confidentiality is one of those things that sound great, but arbitration confidentiality often favors bad actors by allowing them to hide their misconduct from the disinfecting light of day.

 

When you sue someone in court for bad behavior, it’s perfectly appropriate to describe their bad behavior in public court filings.

 

So when you tell a bad actor you plan to sue them, they often quickly realize that their bad conduct will be made public. This provides a strong incentive to settle potentially embarrassing matters before litigation is filed.

 

Bad actors hiding behind arbitration confidentiality clauses have no such concerns.

 

Summary. There certainly are contexts where arbitration clauses make sense - certain consumer-facing agreements, for example.

 

But in many commercial contexts, arbitration clauses are a recipe for highly ineffective justice with no offsetting cost or efficiency advantages.

 

And given the ease of evading arbitration and given how unpredictable arbitration awards can be, threatening to initiate arbitration usually feels a lot like menacing someone with a pink pool noodle.

 

Bad actors certainly have reasons for hiding behind arbitration clauses. But good actors should take a more skeptical and thoughtful approach to arbitration language in contracts.

 

Paul Swegle, editor of the StartupGC Blog, serves as in-house chief legal officer/general counsel to numerous tech companies and has advised countless others. He has completed $13+ billion of financings and M&A deals, including growing and selling startups to public companies ING, Capital One, Nortek, and Abbott. Paul teaches entrepreneurship law at Gonzaga Law and Seattle University School of Law and speaks regularly at other top law schools and MBA schools where his popular business law books are widely used in courses focused on entrepreneurship and business law.












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