What is an Arbitration Clause: From Theory to Practice

How do contract disputes get resolved if things go sideways? The choice to include an arbitration clause gives you the option to quickly and privately resolve.

This guide examines comprehensive arbitration rules under the Federal Arbitration Act, the strategic benefits of including the clause, and best practices for drafting provisions.

Let’s get started.

What is an arbitration clause?

An arbitration clause in a contractual agreement requires parties to resolve disputes through binding arbitration rather than traditional court litigation. 

But, not all arbitration clauses work the same way. The American Arbitration Association offers standardized commercial arbitration rules, types, and frameworks.

Breaking down types

Optional vs Mandatory Arbitration

With mandatory arbitration clauses, you don’t get a choice. Optional clauses let parties decide after a dispute emerges whether they’d rather arbitrate or litigate.

Binding vs. Non-binding Arbitration:

The arbitrator’s decision is final and enforceable in binding arbitration. In non-binding arbitration, the decision is a recommendation, and parties can still pursue litigation if they are not satisfied.

Also read here for Sample Arbitration Clauses

What is alternative dispute resolution?

Alternative dispute resolution encompasses all the ways parties can resolve conflicts without traditional courtroom litigation—arbitration, mediation, negotiation. These processes use neutral third parties in private settings, typically costing less and moving faster than court proceedings. 

ADR gives parties flexibility to customize procedures to their needs while keeping sensitive information confidential. 

How does arbitration differ from litigation?

But cost isn’t everything. Consider what else changes:

• Privacy matters: Unlike arbitration, litigation plays out in public.
• Who decides: You’re not guaranteed who judges your case with litigation. Alternatively, you can select one or more arbitrators with deep expertise in your field.
• Discovery differences: Here’s where arbitration diverges from litigation. You won’t spend months in discovery, deposing everyone who ever touched the contract. Limited discovery speeds things up, but it can hurt if you need extensive evidence to prove your case.

The significance of arbitration clauses 

Well-drafted arbitration clauses deliver predictable benefits:

• Speed and cost control: You typically spend less time, energy, and resources when arbitrating.
• Confidentiality protection: Arbitration is a private process that keeps competitive information, settlement terms, and client relationships from public record.
• Expertise on demand: Arbitration allows you to select someone with specialized industry knowledge.
• Finality brings closure: With limited avenues for appeal, the arbitration award is usually final.

Risks that keep lawyers up at night

Here are pitfalls that legal teams could encounter with arbitration:

• Discovery limitations: The discovery process is limited. You may not have everything you need to build the strongest case.
• No meaningful appeals: Spurious campaigns have shown how plaintiffs’ firms can abuse the arbitration clause, filing identical claims to pressure settlements.
• Arbitrator bias concerns: Arbitrators appointed may be picked from a limited pool and may have a financial interest in matters.
• Class action complications: Forced arbitrations often include class action waivers that prevent parties from participating in opposing systemic issues.

Arbitration clauses that work

Governing law around arbitration

Specify the rules of an established institution, such as the American Arbitration Association (AAA), JAMS, or the International Chamber of Commerce (ICC). Each provides clear frameworks.

• Arbitrator selection: One arbitrator moves faster and costs less while a panel can bring diverse perspectives. Clearly state whether the dispute will be heard by a single arbitrator or a panel.
• Seat and venue: Define the geography and the jurisdiction thereof whose procedural laws will govern the arbitral proceedings.
• Language and costs: Specify the language of the arbitration proceedings and how parties split costs. Will one party pay? Do both contracting parties split?

Sample clause

“Any dispute arising out of this contract shall be finally resolved by arbitration under the LCIA Rules. The seat of arbitration shall be London, England. The governing law shall be English law.”

Scope decisions that count

The scope makes provision for the boundaries, inclusions, and exclusions.

• What does it cover: The clause must make provision for future disputes or specific types.
• Common exceptions: Consider carve-outs for specific types of claims. For example, in intellectual property disputes, parties may seek provisional remedies like injunctions, or small claims court actions.

Procedural details

• Discovery boundaries: Set clear boundaries on depositions, document requests, and timelines.
• Confidentiality isn’t automatic: Include specific language around the confidentiality of the proceedings and the award.

Enforceability of arbitration clauses

The Federal Arbitration Act (FAA) in the United States governs the enforceability of the arbitration clause. State laws and industry-specific regulations also play a role, as does international law. Example, the New York Convention, for cross-border contracts.

Common barriers to enforcement

• Unconscionability: One-sided clauses can be deemed unenforceable. To avoid this, conspicuously place the clause within the contract and draft it with mutual obligations.
• Mutual assent failures: Both parties must agree. If only one party can compel arbitration while the other can’t, it may fail.
• Fraud or duress: If a party is fraudulently induced to sign an agreement containing an arbitration clause, the clause becomes unenforceable.
• Waiver through conduct: A party litigating for an extended time may forfeit its right to arbitration.

Industry-specific considerations

While the core principles remain the same, different sectors approach arbitration differently. Here’s a brief look at how different sectors approach them.

Managing arbitration clauses in your contract portfolio

Here’s where theory meets practice. Managing hundreds or thousands of contracts means you need to prioritize systems over good faith agreements. 

Drafting practices that scale

• Clear language: Use plain English, define terms, and specify every procedural detail that matters.
• Bilateral provisions: Make sure both parties are equally bound to avoid one-sided provisions.
• Multi-party reality: Explicitly address how multi-party disputes will be handled.

Also read, How to Write a Contract

Obligation tracking challenge

Managing a large volume of contracts requires a centralized, automated tracking. Here’s how a CLM solution helps:

• Centralized visibility: A single source of truth allows legal teams to know which contracts contain the arbitration clause, what type, and what they cover. This makes it easy to find them with AI-powered search.
• Automated obligation tracking: A key breakthrough in contract management is automating metadata extraction. With HyperStart, companies can track critical contract obligations and get automated reminders for renewal dates.
• Risk assessment: An automated system allows for contract risk assessment, helping legal teams proactively identify and manage key clauses.

HyperStart helps legal teams review contracts and track key clauses with streamlined, AI-powered CLM solutions. Our platform provides a centralized workflow library for consistent drafting, version control, automated metadata extraction, and obligation tracking.

The bottom line for legal teams

When drafted and managed correctly, the arbitration clause can lead to significant cost savings, faster resolutions, and trusting relationships. The key to success lies in standardizing these clauses according to the language you prefer, tracking them in a centralized repository, and using technology to ensure compliance and mitigate risk.

When evaluating contract management software for your organization, consider a partner who can run and scale with you in the long haul.