Imagine that you and a close friend are starting a business. Money is tight as the majority of your funds have been invested into the business itself.
The two of you seek out a lawyer in order to draft a partnership agreement. While you and your friend have never fought before, you fear that some disputes may arise as the business grows. As mentioned, money is tight, and you worry that any disputes which need to be handled pursuant to the partnership agreement could be costly to you and the success of the business itself. While arbitration or mediation seems cheaper than litigation itself, you realize you will have to pay an attorney to represent you in the arbitration/mediation as well as pay other fees. Discussed below is a new form of dispute resolution that is cost-effective and advantageous to individuals looking to start a new business.
What is Arbitration?
Arbitration is the process by which a neutral decision maker (the “arbitrator”), settles a dispute between two parties. The arbitrator is a neutral decision-maker who listens to both sides of the dispute and makes a final decision that is generally binding upon the parties. The Federal Arbitration Act (“FAA”), which applies to both state and federal courts, governs most arbitration awards. (see Southland Corp. v. Keating, 465 U.S. 1, 14–15 (1984)). In Massachusetts, for a commercial dispute to be governed by the Massachusetts Uniform Arbitration Act for Commercial Disputes (“MUAA”), the arbitration clause itself must clearly state that the dispute is governed by state law. (see Rest. Consulting Servs., Inc. v. Mountzuris, 253 F. Supp. 2d 45, 51 (D. Mass. 2003)). Even if there is a choice of law provision, if the arbitration clause itself is silent as to the choice of law, the FAA governs. Regardless of the relevant controlling law, arbitration still has many downfalls.
Are Arbitration Clauses Effective?
Critics point to several flaws when discussing the effectiveness of arbitration clauses. First and foremost, the core purpose of arbitration is to pick a winner. An arbitrator will hear both sides of a dispute and choose which side has made the better argument. The result, in many cases, is that the issue being arbitrated is put to rest in the short term. However, the factors that caused the issue are not often solved, which can lead to more issues down the line, especially if the parties continue to have a working relationship following arbitration.
Building off this, Arbitrators are only human and, therefore, prone to mistakes.
This is troublesome because arbitration is often binding. Unlike the judicial system, which offers appeals and processes for parties who feel the judge(s)’ or jury’s decision was wrong, an arbitration decision is often final. With no mechanisms in place to aid aggrieved parties, the “loser” in arbitration is forced by the FAA or other relevant statutes to honor the arbitrator’s decision, even if it is based upon mistake or error. The lack of a proper appeal system and the chance for human error weakens the effectiveness of arbitration.
Lastly, many parties often include arbitration clauses in their contracts because they believe that arbitration will be an effective alternative to litigation.
However, arbitration can be a costly and cumbersome endeavor. Most arbitration associations, similar to federal and state courts, have filing fees that must be paid prior to cases being heard. Then, once arbitration begins, the arbitrator must be paid on an hourly basis. According to recent ABA data, the hourly rate for arbitrators can cost anywhere from $300 to $1,150. Arbitration fees and rates, coupled with attorney’s fees in preparation of arbitration, can become costly for parties looking to settle a dispute. Given the aforementioned drawbacks, parties to contracts should consider employing a tiered dispute resolution (TDR) clause as opposed to a standard arbitration or mediation clause.
What is Tiered Dispute Resolution (TDR)?
The language of the TDR clause should indicate that parties will engage in the relevant dispute resolutions in the order which they are discussed below.
First, executives from each side to the dispute should meet and attempt to negotiate a resolution to the dispute.
The relevant executive for each side, be it a controlling partner, or the manager of an LLC, will be included by title in the contract. The clause will indicate that the sides are to meet a certain number of times, or a certain amount of time, before moving on to the next tier. For example, the clause may indicate that the first dispute resolution step is for the president of company A to meet with the president of company B for at least 3 hours. The clause may then indicate that neither side to the agreement can pursue the next step (mediation), until two weeks after the mandatory 3 hours of meeting(s).
This will allow both sides to mull over what they discussed and hopefully reach an agreement that avoids the latter tiers.
Assuming the executives are unable to negotiate a resolution, the TDR clause would require the parties to mediate the dispute. The TDR clause will stipulate how many negotiation sessions are required before either side can initiate the next tier, which is arbitration. While the goal of the TDR clause is for parties to resolve the issue early on and avoid arbitration, it is inevitable that some disputes will not be resolved through negotiation and mediation, therefore leading to the third tier being initiated. The third tier is a standard arbitration. However, parties to a contract may want to agree to have their dispute heard before a panel of arbitrators as opposed to a single arbitrator.
While the downfalls of arbitration are clear, a TDR clause differs from a standard arbitration clause in two ways. First, is in its goal to reach an amicable resolution through negotiation and mediation before reaching arbitration. Second, the arbitration decision is not binding and offers a party a right to appeal as a fourth tier should they find the arbitrator’s decision was wrong or prone to error. The TDR system is not without its own flaws. Given the variety of dispute resolution options, it may take longer for disputes to be resolved than a standard arbitration clause would. Also, costs associated with the clause may be higher than a standard arbitration, especially if parties reach the appeals tier of the clause.
Conclusion
With these issues in mind, it is best for attorneys to discuss all of the potential dispute resolution clauses that could be included in a contract and choose the one that fits their clients’ costs and needs most appropriately. At Pakrooh Law, we take all of our client’s needs into consideration and strive to draft a contract that will meet all of your needs whilst protecting your interests.
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