The Arbitration Dilemma

The Arbitration Dilemma

By Kathleen D. Cerniglia, Esq.

KCerniglia@gpfoxlaw.com

October 4, 2012

I.  INTRODUCTION

Over the last several decades the use of arbitration in place of state or federal court litigation has become prominent in this country, not only by virtue of form contracts that strong-arm unknowing potential plaintiffs into agreeing to arbitration provisions, but also by way of contracts negotiated at arm’s length.   However, there are plenty of reasons for one to pause and think carefully before agreeing to an arbitration clause. 

This is because (1) more and more defendants in arbitration have stopped paying their arbitration fees to shift them to the plaintiffs, without consequence, unless they have meritorious cross-complaints; (2) more and more arbitration administrators—who have little to no legal training—are making substantive preliminary decisions that only a judge would rule on if the same issues were in court; (3) more and more attorney-arbitrators conceal biases as they jockey to be selected, especially as arbitrators continue to push their hourly rates higher and higher; and finally, (4) more and more underfunded and overcrowded courts are reluctant to vacate even the most out-of-line arbitration awards—even those tainted with undisclosed biases.  This article briefly touches on these issues.

II. BAD FAITH SHIFT OF FEES BY ARBITRATING DEFENDANTS

When parties contractually agree to resolve potential disputes through arbitration, that contract should logically incorporate an agreement as to who will pay for those arbitration services, and a consequence for failing to do so, such as a default judgment entered in court.  After all, it is axiomatic law that a contracting party may not embrace the benefits of an agreement while simultaneously avoiding its burdens.  (See, e.g., Metalclad Corp. v. Ventana Environmental Organizational Partnership (2003) 109 Cal.App.4th 1705, 1714; NORCAL Mutual Ins. Co. v. Newton (2000) 84 Cal.App.4th 64, 82.)  This principle is founded on the doctrine of equitable estoppel, which “precludes a party from asserting rights he otherwise would have had against another when his conduct renders assertion of those rights contrary to equity.”  (Id. at p. 1713.)  However, arbitrating defendants are not held to this standard:  they may simply refuse to pay their share of arbitration fees, and the private arbitration services then dismiss the proceedings unless the arbitrating plaintiffs cover 100% of the fees.

This bad faith shifting of all fees to the plaintiff(s) happens even when the contract calls for an equal split of fees.  For example, in a recent case tried by this law firm, the governing contract stated that, “[e]ach party involved in an arbitration proceeding . . . will pay his or her own expenses.  The cost of conducting the arbitration proceeding itself will be borne by each party to it in proportion to the number of shares of the Corporation owned prior to the commencement of the proceeding.”  The plain language of the agreement should have estopped the defendants from asserting and “mak[ing] use of the [agreement] so long as it work[s] to [their] advantage” while concurrently avoiding their obligations thereunder.  (Metalclad Corp. v. Ventana Environmental Organizational Partnership, supra, 109 Cal.App.4th at p. 1714.) 

Despite the well-established principle of equitable estoppel, however, no California case law requires arbitrating defendants to pay their portion of the fees, and none of the arbitration services presently do more than potentially bar the defendants’ cross-complaints, if any, and then shift all the fees to the plaintiffs pending the outcome of the dispute.  (See, e.g., JAMS Rules 6, subd. (c) & 31 [“Parties are jointly and severally liable for the payment of JAMS Arbitration fees and Arbitrator compensation and expenses” but the only remedy for the nonpayment of fees by one party is through an award of fees issued by the arbitrator]; AAA Rule R-54 [“If arbitrator compensation or administrative charges have not been paid in full, the AAA may so inform the parties in order that one of them may advance the required payment”].)   Unfortunately, until California establishes such a law, arbitrating plaintiffs in California may be forced to shoulder this substantial monetary burden in order to recover their damages.

Other states have specifically ruled on the issue of arbitration fees, and have ruled, as one would expect of our justice system, in favor of fairness and equity.  For example, in the Mississippi case of Sanderson Farms, Inc. v. Gatlin (2003) 848 So.2d 828, the parties’ contract contained a provision stating that “cost of [] arbitration will be divided amongst the parties of the arbitration.” (Sanderson Farms, Inc. v. Gatlin, supra, 848 So. 2d at p. 836.)  Arbitration commenced and then the defendant, Sanderson Farms, refused to pay its half of the arbitration costs.  (Id. at p. 837.)  Thereafter, the plaintiff filed suit in the state circuit court, prompting Sanderson Farms to file a motion to compel arbitration on the basis of the parties’ agreement.  The Supreme Court of Mississippi held that Sanderson Farms had breached the parties’ agreement by failing and refusing to pay its half of the arbitration costs, and as a result, could not “seek the protections of the arbitration provision in the [] contract.”  (Id. at p. 838; see also Simmons Housing Inc. v. Shelton (2010) 36 So.3d 1283, 1287 [“[i]n the arbitration context, equitable estoppel prevents a party from embracing the benefits of a contract while simultaneously trying to avoid its burdens”].)

III. PRELIMINARY ISSUES DECIDED BY CASE ADMINISTRATORS

It is also a real possibility that an arbitration tribunal’s case administrator—who generally has little to no legal training—can facilitate a bad faith shift in fees, in addition to making other important procedural decisions.  This is because case administrators make substantive preliminary rulings before appointing an arbitrator to a case.  For example, the American Arbitration Association (“AAA”) allows case administrators to unilaterally waive a party’s filing fees based upon an ex parte plea of indigence, with no requirement that the party actually prove indigence with competent and admissible evidence.  AAA Rule R-49 provides, in relevant part:

The filing fee shall be advanced by the party or parties making a claim or counterclaim, subject to final apportionment by the arbitrator in the award. The AAA may, in the event of extreme hardship on the part of any party, defer or reduce the administrative fees.

(AAA Rule R-49 [emphasis added].)

According to AAA’s website, it will consider deferring or reducing its administrative fee for parties whose gross annual income falls below 200% of the federal poverty guidelines.  (American Arbitration Association, Administrative Fee Waivers and Pro Bono Arbitrator Services [available at www.adr.org/aaa/ShowPDF;

jsessionid=R295PCqYD5MkNKhQqm9H7jhSMwYh2NnsYFSbG6yrMhgmGVB299lc!1082660915?doc=ADRSTG_004098].)  However, AAA merely requires a signed affidavit from a party claiming “extreme financial hardship” and does not, as a practice, require admissible and reliable proof of salary or net worth.  In fact, AAA does not even notify the opposing party about the ex parte application, nor does it allow the opposing party to respond.  (Ibid. [“the AAA reserves the right to deny or grant any request based on the information given by the requesting party”].)

Additionally, “a party may make a request for a pro bono or reduced rate arbitrator . . . However, prior to appointment every effort is made to have the non-indigent party agree to pay the arbitrators [sic] fees.”  (Ibid. [emphasis added].)  AAA again directs that this request “be made to the Case Manager.”  (Ibid.)

Judicial Arbitration and Mediation Services (“JAMS”) allows case administrators to determine the location of the hearing and whether separate arbitrations should be consolidated.  (JAMS Rule 6, subd. (a) & (c).)

In both state and federal court, all of the above-described scenarios would be subject to a judge’s ruling.  It is troubling that an administrator who has no legal education can make those same adjudications in arbitration forums. 

IV.         ARBITRATOR BIAS AND FEES

California Courts widely discuss the importance of an arbitrator’s duty to disclose potential conflicts of interest.  (See Benjamin, Weill & Mazer v. Kors (2011) 195 Cal.App.4th 40, 67 (“Benjamin”); see also Code Civ. Proc., §§ 1281.85, 1286.2, subd. (a)(3).)   The United States Supreme Court also directs that “we should, if anything, be even more scrupulous to safeguard the impartiality of arbitrators than judges, since the former have completely free rein to decide the law as well as the facts and are not subject to appellate review.”  (Ibid.; citing Commonwealth Coatings Corp. v. Continental Casualty Co. (1968) 393 U.S. 145, 147.) 

Thus, California law requires arbitrators to disclose “any matter that reasonably could create the appearance of partiality.”  (Haworth v. Sup.Ct. (2010) 50 Cal.4th 372, 384-385 [emphasis added].)  Likewise, under American Arbitration Association Rule R-16, arbitrators have a standing obligation to disclose “any circumstance likely to give rise to justifiable doubt as to the arbitrator’s impartiality or independence, including any bias or any financial or personal interest in the result of the arbitration or any past or present relationship with the parties or their representatives.  Such obligation shall remain in effect throughout the arbitration.”  (AAA Rule R-16(a) [emphasis added]; see also Guseinov v. Burns (2006) 145 Cal.App.4th 9444, 956.) 

In California, where the failure to disclose relates to the subject matter and issues in contention, the superior court is ostensibly required to vacate the arbitration award.  (See Code Civ. Proc., § 1286.2, subd. (a)(6).)  For example, in Benjamin, supra, a law firm initiated an arbitration against a former client for unpaid fees.  The arbitration panel found for the law firm and ordered payment of the fees.  After the panel issued the award, the client discovered that the chair had failed to disclose that his practice focused on representing law firms in client fee disputes and that he was currently litigating a law firm’s fee dispute case in the California Supreme Court.  (Id. at p. 51.)  The client petitioned to vacate the award.  The court found that “representation of clients in the same position as one of the parties to the current arbitration in matters involving the same subject matter” should have been disclosed because it raised reasonable questions about the impartiality of the arbitrator.  (Id. at p. 53.) 

The Federal Arbitration Act uses a narrower standard: it permits the vacating of an arbitration award on the ground of bias only on a showing of “evident partiality” by the arbitrator.  (9 U.S.C. § 10(a)(2).)  When the issue is the arbitrator’s failure to disclose, the Ninth Circuit interprets “evident partiality” to mean that the undisclosed facts must create a “reasonable impression of partiality.”  (Schmitz v. Zilveti (9th Cir.1994) 20 F.3d 1043, 1046.)

Regardless of which standard applies, there is a clear incentive for attorney-arbitrators to conceal their conflicts of interest:  it pays quite well to be an arbitrator.  In a complex matter, the fees paid to organizations such as AAA, ADR, or JAMS, in addition to the fees paid to a panel of three arbitrators, can reach into the hundreds of thousands of dollars.  An arbitrator’s ability to make a living provides quite the incentive for practicing lawyer-arbitrators to spin their résumés to appear more neutral than they actually are.  For example, hourly rates for arbitrators in the Los Angeles area typically range from $300 to $500 per hour.  These high rates also provide arbitrators with an incentive to prolong hearings, entertain frivolous discovery motions, take multiple telephone conferences, and require both closing arguments and post-hearing briefs.  This monetary incentive also goes against the foundation of why parties generally choose to arbitrate in the first place—to expedite proceedings.

Furthermore, there is generally no way to research what kind of decisions arbitrators have made in previous arbitrations.  While court decisions are matters of public record, few arbitration venues publish awards.  The Financial Industry Regulatory Authority (“FINRA”), which is limited to those cases rooted in securities litigation, is one arbitration tribunal that does.

Notably, the fact that FINRA publishes its awards has allowed for scholarly studies of “neutral” bias in securities arbitration.  In fact, “securities arbitration has been consistently criticized as favoring the securities industry over the interests of investors.”  (Choi, Fisch & Pritchard, Attorneys as Arbitrators (2010) 39 J. Legal Studies 109, 110.)  A recent study[1] of securities arbitration in FINRA—designed to shed empirical light on the role that attorney-arbitrators play as arbitrators in securities arbitration—confirmed this criticism, finding that attorney-arbitrators who also represent brokerage firms or brokers typically award significantly less compensation to investor-claimants than do other arbitrators.  (Id. at p. 111.)  The study found that this relation is particularly prevalent when an attorney who has represented a brokerage firm chairs the arbitration panel.[2]  (Ibid.) 

The implications of this study show that parties negotiating a contract with an arbitration clause should carefully consider the possibility that the appointed arbitrators may not be neutral per se.  This potential for bias does not conform to the principles of fairness and equity that arbitration proceedings should enforce, especially in light of the fact that arbitrating parties waive their Seventh Amendment right to a trial by a jury of their peers. 

V.  LIMITED RIGHTS OF APPEAL

California allows only limited appellate rights after an arbitrator has rendered a decision.  California Code of Civil Procedure section 1286.2 provides, in relevant part:

 (a) Subject to Section 1286.4, the court shall vacate the award if the court determines any of the following:

   (1) The award was procured by corruption, fraud or other undue means.

   (2) There was corruption in any of the arbitrators.

   (3) The rights of the party were substantially prejudiced by misconduct of a neutral arbitrator.

   (4) The arbitrators exceeded their powers and the award cannot be corrected without affecting the merits of the decision upon the controversy submitted.

   (5) The rights of the party were substantially prejudiced by the refusal of the arbitrators to postpone the hearing upon sufficient cause being shown therefor or by the refusal of the arbitrators to hear evidence material to the controversy or by other conduct of the arbitrators contrary to the provisions of this title.

   (6) An arbitrator making the award either: (A) failed to disclose within the time required for disclosure a ground for disqualification of which the arbitrator was then aware; or (B) was subject to disqualification upon grounds specified in Section 1281.91 but failed upon receipt of timely demand to disqualify himself or herself as required by that provision. However, this subdivision does not apply to arbitration proceedings conducted under a collective bargaining agreement between employers and employees or between their respective representatives.

(Code Civ. Proc., § 1286.2)

California courts hold that these are the exclusive means by which an award reached by an arbitrator is subject to judicial review.  (Moncharsh v. Heily & Blasé (1992) 3 Cal.4th 1, 33.)  The merits of the controversy are not reviewable by the court.  (Id. at p. 11.)  Nor will courts pass judgment upon the validity of the arbitrator’s reasoning.  (Ibid.; Department of Public Health of City & County of San Francisco v. Service Employees Int’l Union, Local 790 (1989) 215 Cal.App.3d 429, 433.)  Where the arbitrator’s award, on its face, “represents a plausible interpretation of the contract in the context of the parties’ conduct, judicial inquiry ceases and the award must be affirmed.”  (Screen Actors Guild v. A. Shane Co. (1990) 225 Cal.App.3d 260, 265.) 

In fact, an arbitrator’s error of law, no matter how gross, provides no basis to challenge the arbitrator’s award under California law.  (Moncharsh v. Heily & Blasé, supra, 3 Cal.4th at p. 11; Marsch v. Williams (1994) 23 Cal.App.4th 238, 244; Baize v. Eastridge Co. (2006) 142 Cal.App.4th 293, 300-302.)  The rationale for this rule is twofold: (1) the parties contracted that the arbitrator’s decision, right or wrong, would be conclusive, and (2) the risk of arbitral error has been reduced by statutory provision allowing courts to vacate or correct for “serious problems with the award itself or with the fairness of the arbitral process.”  (Moncharsh v. Heily & Blasé, supra, 3 Cal.4th at p. 12.) 

The same concerns arise in federal courts.  The Federal Arbitration Act is similar in many respects to California’s statute set forth above.  (See 9 U.S.C. §§ 10, 11; Baravati v. Josepthal, Lyon & Ross, Inc. (7th Cir. 1994) 28 F.3d 704, 706.)[3] 

VI.         CONCLUSION AND RECOMMENDATIONS

There are still many appealing aspects of arbitration, such as the ability to try a case much faster than it would take in court, but these advantages must be weighed against real risks that are present in arbitration.  Before recommending—or signing—a contract that includes an arbitration clause, read through it carefully, and make sure it conforms to your wants and needs.  Attorneys should explain the potential dangers of arbitration to their clients, to fully inform them before they enter into a contract that waives their Constitutional rights.  Attorneys should also consider negotiating out of an arbitration clause when it does not meet their clients’ needs.  For example, if the client is an individual, about to enter into a contract with a large corporation that regularly appears before a certain arbitration service, the client might want to carefully consider the implications of agreeing to the arbitration clause.  It is better to consider striking an arbitration agreement during the formation of the contract, rather than being left several years down the road with an arbitration decision that has been rendered by a biased arbitrator, costing tens of thousands of dollars, with minimal appellate recourse. 

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[1] The study analyzed a data set of 422 randomly selected arbitrators and their 6,724 securities arbitration awards from 1992 to 2006.  (Attorneys as Arbitrators, 39 J. Legal Studies, at p. 111.)  The authors hypothesized that “attorneys who represent brokerage firms and brokers in arbitration are likely to be skeptical of investors’ claims for compensation generally, which leads them to be less generous with arbitration awards.”  (Id. at p. 119.)  This is in part because “arbitrators need to follow existing law only loosely, do not need to provide reasons, and face only a remote possibility of judicial review [and therefore] have substantial discretion in handling any particular case,” which may allow the ideological perspective of attorney-arbitrators to influence their awards.  (Id. at p. 120.)

[2] The study noted that “[t]he chair of the panel appears to exercise the greatest degree of control over the arbitration proceedings and is typically responsible for the overall administration of the proceeding, including the resolution of discovery disputes, ruling on evidentiary issues, and so forth.”  (Id. at p. 114.) 

[3] Some corporations have recently started providing for rights of appeal within arbitration in their contracts to protect against the limited appellate rights of arbitration awards. 

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