An arbitration clause is a written provision in a contract which states that all disputes between parties will be settled through the process of arbitration, rather than in the courts. Arbitration clauses are included in many business and commercial contracts, as well as contracts with individuals.
Businesses include arbitration clauses in contracts with individuals because it allows them to settle disputes quickly and quietly, without going through the often expensive and time-consuming legal system. By resolving problems through arbitration, businesses feel that they can save time and money. Businesses also prefer arbitration because it allows them to select neutral decision makers who often specialize in that field.
The Federal Arbitration Act (FAA) creates a strong national policy in favor of enforcing arbitration clauses. The Act states that arbitration clauses will be enforced in all cases where there is a maritime transaction, or where a contract involves a transaction crossing state lines.
However, in cases where the Federal Arbitration Act does not apply, State law determines whether the arbitration clause is enforceable. For example, some courts require that there be a contract for interstate commerce for the Federal Arbitration Act to apply. Thus, if a contract is not covered by the Federal Arbitration Act, State law will determine whether the arbitration clause is enforceable.
If the Federal Arbitration Act does not apply, it is then important to determine which State’s law applies. Jurisdictions use different methods to determine which State’s law to apply. The most common choice of law methods that are used are:
- The State where the contract was made
- The State specified in the contract
- The State where arbitration is specified by the contract to take place
- The State that has the most significant relationship to the arbitration provision
Each State has different laws concerning the enforceability of an arbitration provision. Many States’ laws mirror the Federal Arbitration Act and require the enforcement of arbitration clauses. However, most States do allow for several exceptions to the general mandate to enforce the arbitration provisions.
California, for example, allows arbitration clauses to be disregarded if the parties agree to take out the clause, if the contract itself is not valid, or if a party in the arbitration agreement is joined by a third party in pending court action which arose out of the same transaction or series of related transactions. Conversely, other States, like New York, prohibit mandatory arbitration clauses from being included in consumer contracts altogether.
Obviously, this answer will differ from state to state. However, there a few limits to arbitration clauses built into the FAA itself. First, arbitration clauses can be voided based on the same contract defenses that other contracts could be subject to.
For instance, state courts may rule that certain arbitration clauses are unconscionable. This means that the contract is so unfair and one-sided that a court cannot, in good conscience, enforce the contract. Arbitration clauses may be unconscionable if the arbitration created or used by the contract fails to meet certain requirements. These requirements may differ by state, but generally:
- The arbitrator should be neutral and non-biased.
- The terms should be bilateral – both parties are bound by the rules.
- The plaintiff(s) should have a means of discovering evidence.
Second, arbitration are contracts between the parties. If a government agency brings a lawsuit, then the case will go directly to court instead of arbitration. A few states have private attorney general laws: private citizens may bring a lawsuit against other parties on behalf of the state. Since the state itself is not bound by the contract, the case would likely go to court instead of arbitration. The drawback to private attorney general cases is that most of the awards, if any, will go to the state instead of the party who brings the case.
Arbitration is a complex and evolving legal field. A business attorney would be useful in helping determine if the arbitration clause in your contract is binding. Should the arbitration clause be enforceable, your attorney would be able to guide you through the arbitration process and would be knowledgeable on specific state laws which may apply.