Litigation can be expensive and time-consuming. As a result, “alternative dispute resolution” (ADR) has increased in popularity over the past several decades. Legislatures, bar associations, legal scholars, and even the courts themselves have pushed for more ADR. Indeed, most courts now require that parties mediate cases before trial.

ADR’s increased use is premised on the notion that ADR is cheaper and faster than litigation. Accordingly, many companies include “arbitration clauses” in their contracts that require the parties to arbitrate disputes. Although companies only included arbitration clauses in large, complex contracts initially, arbitration clauses have since permeated even the simplest contracts. For proof of this, pull out your credit card agreement or mobile phone service contract. Historically, insurance policies rarely included arbitration clauses. For better or worse, more carriers now include arbitration clauses in their form policies. Before purchasing a policy that contains an arbitration clause, policyholders should consider arbitration’s often surprising pros and cons.

Understanding Arbitration Clauses

Arbitration clauses include several important elements. Spotting these different elements will help you determine whether the clause is beneficial. The following is a non-exclusive list of common arbitration clause elements:

Binding Effect—These provisions provide that the parties must arbitrate disputes and that the arbitration award is binding on the parties.

Choice of Law—A choice of law provision states which state’s laws will apply to policy disputes.

Locale—The clause may dictate where arbitration will take place. Chances are that the locale selected in the policy will be a city and state where the carrier has a major office or its headquarters. The locale may not be convenient for the policyholder.

Number of Arbitrators—Although many arbitration clauses only require a single, neutral arbitrator, some clauses provide for a multiple-arbitrator panel. As discussed in more depth below, arbitration becomes more expensive and less efficient when multiple arbitrators are involved.

Timeline—Some clauses include timelines for selecting arbitrators or detailed discovery, briefing, and hearing deadlines.

Governing Procedural Rules—Arbitration clauses often prescribe which arbitration service’s procedural rules apply to disputes. The American Arbitration Association (“AAA”) is a widely-used arbitration service and many companies include its rules in mainstream arbitration clauses. Other organizations also provide specialized arbitration services (e.g., employment, banking, etc.) and have separate rules governing related arbitrations.

Style of the Award—Some arbitration clauses require that the arbitrators issue a written decision and explain the reasoning behind their decision. In most cases, however, the arbitration award will simply state the arbitrators’ decision and the award amount, if any.

Factors to Consider Before Buying a Policy Containing an Arbitration Clause

Policyholders should also consider the arbitration clause’s practical effects. Policyholders should understand that arbitration can be less expensive and faster than litigation, but this is not always the case. Policyholders also “contract away” numerous important rights by agreeing to binding arbitration. The following factors might help guide your decision making when considering whether to purchase a policy with an arbitration clause.

Binding Effect

Most arbitration clauses provide that arbitration is binding. This means that, unlike litigation, the award is not appealable if either party is dissatisfied with the award or believes that the award is just flat wrong. Further, courts rarely overturn arbitration awards. Courts presume that arbitration awards are correct and must enforce awards unless a party shows that the award resulted from fraud, gross mistake, or misconduct. Additionally, binding arbitration is a policyholder’s exclusive remedy. A policyholder may not file a lawsuit instead. If it does, the court will dismiss the lawsuit upon learning the parties have agreed to binding arbitration. Thus, before agreeing to binding arbitration, policyholders should consider that they are contracting away their right to a trial and jury, and submitting themselves to the will of one or more arbitrators whose decision is conclusive.

Cost

The government largely subsidizes the court system, and it is available to litigants for a nominal fee. For example, filing a lawsuit in state court costs about $250. The government pays for the court room facilities, case administration, and the judge’s salary.

Unlike litigation, the parties bear all arbitration-related expenses. For example, the AAA usually charges initial filing fees between $2,000 and $5,000 to cover administrative costs. If the case proceeds to an initial hearing, the claimant must pay an additional fee (usually between $1,000 and $2,000).2

In addition to administrative fees, parties to arbitration must pay the arbitrators for their time studying the case facts, reviewing filings, resolving disputes, attending preliminary and final hearings, evaluating the parties’ cases, and preparing the final award. As most arbitrators are experienced lawyers, legal scholars, or former judges, their time is very valuable. Arbitrators usually bill at an hourly rate between $300 and $500, but rates can be significantly higher. The arbitrators will likely also charge for their travel time and expenses. The arbitrators’ fees can thus be substantial, especially when the arbitration clause provides for a multiple-arbitrator panel. When the arbitration clause calls for a three-party panel, for example, the parties are essentially paying for three lawyers: their own lawyer, the arbitrator they appointed, and half of the panel chairman.

Considering this, it easy to see that arbitration expenses alone are often tens of thousands of dollars, in addition to the parties’ attorneys’ fees. In smaller cases, the arbitration expenses may be prohibitively high and might even dwarf the claim amount. Therefore, although the total arbitration expenses ultimately may be less than the total costs associated with litigation, policyholders need to understand that this is not always the case.

Time

One of arbitration’s selling points is that it is faster. Although true that arbitration generally resolves disputes more quickly than litigation, this is not always so.

Unlike litigation, there are few firm deadlines. Most arbitration clauses do not contain strict deadlines or timelines detailing arbitration’s progress through a final hearing. The parties and the arbitrators usually agree on deadlines, which may or may not be expedited. This flexibility can benefit all parties when the parties work together to resolve the dispute. If an opposing party does not meet an agreed upon deadline, however, it might cost thousands of dollars in attorneys’ and arbitrators’ fees to enforce the deadline. Further, parties may wait months for the arbitrators to issue a decision after the final hearing. This is particularly true with multi-arbitrator panels where the arbitrators must agree on the award and their reasoning for it.

Applicable “Law”

Many arbitration clauses contain “choice of law” provisions. These clauses provide that a particular state’s laws govern any disputes relating to the policy. The carrier drafting the policy will likely chose governing law it believes is convenient and favorable to its position.

Also, arbitrators may not strictly apply the applicable jurisdiction’s law. Arbitrators might instead issue awards based on “weighing the equities.”3 As mentioned above, such awards are binding and virtually impossible to appeal, especially when the arbitrators do not explain their reasoning.  

Arbitrator Experience and Bias

The power to select arbitrators brings with it the opportunity to have arbitrators with specific knowledge and experience resolve disputes. It may be beneficial in some complex cases—patent infringement disputes, for example—to have experienced arbitrators. Industry experience, however, can lead to bias. Because arbitration is informal, confidential, and not appealable, there is an increased risk that the arbitrators will not leave those biases at the door.

Deciding Whether an Arbitration Clause is Right for You

The decision whether to purchase a policy containing an arbitration clause will depend on each policyholder’s individual circumstances. Above all, policyholders should understand what they are bargaining for and make an informed decision.

If the arbitration clause is not favorable, policyholders can consider an alternative carrier or try to negotiate away the arbitration clause altogether. Alternatively, policyholders can negotiate for an arbitration clause that “levels the playing field” by including provisions that are more specific and more favorable. For example, a policyholder may insist that the laws of a state that is more policyholder-friendly apply or that the parties arbitrate in the city and state where the policyholder is headquartered. These changes could have a significant impact if a coverage dispute arises.