Introduction

“Arbitration is a creature of contract.” This does not mean that arbitration is a fictional creation or some other-worldly lifeform. But the phrase is shadowy in that it doesn’t convey much useful information. Notwithstanding, it is perhaps the single most repeated phrase found across legal opinions and scholarly articles concerning arbitration.

Many lay people and even legal practitioners fail to perceive arbitration’s contours, perhaps in part because of the use of unilluminating phrases like the above. Specifically, although contracts provide the basis for arbitration, several layers of mandatory or default norms apply in arbitration. At times, arbitrating parties find this surprising. These norms are embodied in statutes, judge-made case law, and the rules of arbitral forums—in addition to contractual commitments. For this reason, dwelling on arbitration’s status as a “creature from the contract lagoon” has limited utility.

To ensure parties adequately consider the implications and consequences of agreements to arbitrate, they must understand the relevant legal background. Further, a nuanced understanding of arbitration can be necessary to successfully evaluate and undertake a dispute. In many respects, dispute resolution through arbitration is much like litigation. In others, there are important differences. This blog introduces key concepts and conveys useful information concerning arbitration to an unfamiliar reader. I intend, in a follow up piece, to discuss and demonstrate practical consequences and applications of at least some of these concepts.

Discussion

Here it goes:

1. Arbitration is a Creature of Contract.

Principally, arbitration’s nature as a “contract-creature” concerns the following three aspects of arbitration law: (1) the legal basis for resolving a dispute through arbitration is the consent of the parties; (2) an agreement to arbitrate is binding; and (3) the parties’ agreement to arbitrate can furnish the rules by which claims are decided.

1. Consent – Agreement to Arbitrate.

Arbitration is a private dispute resolution procedure in which the parties select one or more neutrals—“arbitrators”—to resolve their claims.[i] They do so by evaluating relevant evidence and law, acting as both judge and jury, and rendering a binding legal determination, called an “award.” Consent is necessary to provide an arbitrator with authority to determine the parties’ relative rights in resolving an underlying dispute. Without consent reaching the subject matter of a dispute, arbitrators lack jurisdiction to determine a person’s legal rights and obligations.[ii]

Generally, parties to an arbitration have agreed in advance to arbitrate. Sometimes their agreement is limited in scope to only certain kinds of claims—like those “arising under” a contract—and sometimes the agreement applies more broadly to any kind of claim “relating to” an agreement or a commercial relationship. Arbitrating parties usually commit to arbitrate by agreeing to “arbitration clauses” within broader contracts. But they also often enter separate—sometimes extensive—arbitration agreements. Parties to a dispute also sometimes agree to arbitrate after the dispute arises.

1. Agreements to Arbitrate are Binding and Enforceable

The federal government and all 50 states have arbitration statutes.[iii] In American courts, the general rule is that arbitration agreements will be enforced. With some exceptions, if a party to an agreement to arbitrate files an action against a counterparty in court, the court will grant a motion to compel arbitration and order a party to arbitrate the dispute. If a party refuses to attend an arbitration proceeding, the arbitrator can enter “an award” against the party which, after confirmation by a court of law, is then enforceable in the same manner as the judgment of a court.[iv]

1. Broad—but not Unlimited—Authority to Determine Rules Governing the Arbitration Dispute

Generally, parties to an agreement to arbitrate have broad discretion to determine the rules that will govern the resolution of a dispute. This principle applies to both “substantive” and “procedural” rules. Substantive rules are legal norms applied to determine, based on facts established in a proceeding, whether a party is entitled to compensation or some other remedy. Typically, substantive rules are chosen by refence to a specific body of law, such as “the laws of Texas,” but (subject to some limitations) parties can agree to create their own substantive rules, modify the rules that would apply under state or federal law, or pick and choose from among different sets of substantive rules. “Procedural” norms govern how a proceeding is to be carried out and how the relevant facts and law are established with respect to both (a) the conduct of a dispute resolution forum (whether a court, arbitral tribunal, or other legal venue), in terms of its administration of the process and its powers (e.g., to award remedies), and (b) the parties’ rights and obligations.

However, the contractual freedom of parties in crafting arbitration agreements is not limitless. Parties are constrained by applicable arbitration statutes and other law. For example, parties cannot agree that an arbitral decision will be generally appealable in federal court in the same manner as a judicial decision would be. Hall Street Associates, L.L.C. v. Mattel, Inc., 552 U.S. 576, 578 (2008). Similarly, parties cannot create federal jurisdiction for a petition to vacate an award when there is no statute that provides for federal jurisdiction. See Badgerow v. Walters, 142 S. Ct. 1310 (2022). Additionally, while arbitral forums may endeavor to “respect the wishes of the parties” with respect to any agreed on “procedure that conflicts with otherwise applicable [forum] rules,”[v] some terms may not be acceptable to any forum, rendering those terms (or an entire agreement) unenforceable.

2. Arbitration Should be Seen as an Opt-Out Mechanism

While arbitration is frequently seen simply as a selection of an alternative forum, it can just as accurately and perhaps more meaningfully be seen as an “opt-out” mechanism. Arbitrating parties choose to forego the default rules and processes governing the determination of legal disputes. For certain types of potential litigants and disputes, arbitration makes clear sense. Certain processes and procedural rights, such as discovery and pre-trial motion practice (among other things) have developed reputations as being subject to abuse. This can drive up the cost of litigation, and arbitration rules can be an effective control. Additionally, courts can be unduly overburdened and slow to resolve disputes. Also, juries are sometimes viewed as unfairly biased in favor of “the little guy or gal” and disclosure of certain facts in public litigation can be harmful to reputations.

But on the other hand, the default rules have arguably resulted from collective wisdom and experience developed over centuries by courts and legislatures.[vii] In some cases, they are clearly reasonable and necessary to a proper balancing of the parties’ rights and a fair determination of a matter. Many parties fail to consider the rights afforded by the system of which they “opt out” through arbitration. For example, by agreeing to arbitrate, parties waive their right to a jury trial.[viii] Further, absent contrary stipulations, standard courtroom rules of procedure and evidence don’t apply (though arbitrators sometimes consider them). Typically, arbitral procedures significantly limit parties’ rights with respect to matters like depositions, evidentiary subpoenas to third parties, and other discovery mechanisms. On occasion, to effectively seek justice, it may be necessary for one of the disputants to sue a third party but, generally, non-contracting parties cannot be joined to an arbitration without their consent. If arbitrators are authorized by the procedural rules and a statute to issue subpoenas to third parties, a party must seek the assistance of a court if faced with non-compliance. Finally, without careful drafting of terms to the contrary, parties waive their right to any appeal and, moreover, depending on the relevant jurisdiction, a provision providing for an appeal to a court of law may not be enforceable.

3. The Opt-in Aspects of Arbitration are Complex—the Applicable Rules

Despite authority to craft new substantive and procedural rules, adequately drafting and agreeing to an entirely new set of norms is a practical impossibility. Accordingly, parties frequently determine the procedural rules and substantive law to apply by reference to an existing set of norms, such as “the laws of Texas.” However, parties often fail to adequately understand applicable substantive law, including substantive law that determines the procedural law that applies—which is a distinct matter from determining the applicable procedural rules.

1. Forum-Based Procedural Rules

Frequently parties stipulate to the procedural rules that will govern a dispute by designating a forum that has promulgated one or more sets of arbitration rules, such as the American Arbitration Association or JAMS. Both of those forums have several sets of rules that will apply depending on whether a case involves monetary claims exceeding a certain threshold or a certain subject matter (like construction), or whether it is international or concerns consumers. In other cases, parties can choose a set of rules, such as the Texas Rules of Civil Procedure or the UNCITRAL Arbitration Rules, and establish an ad hoc process for selecting an arbitrator who will—only with her consent—preside over and determine the dispute without institutional support.

1. Substantive and Procedural Law

i.  General Substantive Norms & Choice of Law

Parties frequently include “choice of law” clauses, which select the law of a specific jurisdiction to govern the interpretation of contractual and other rights and liabilities between the parties. If an arbitration dispute is not governed by a contract with a choice of law clause and the parties disagree as to what law applies, an arbitrator should determine the applicable law consistent with conflicts of law principles.

ii. General Choice of Law Clauses do Not Import Procedural Law

For several reasons, a general choice of law clause is construed only to apply to the state’s “substantive” law and not its “procedural law.” As addressed in more detail below, the Federal Arbitration Act (FAA) applies to most arbitration agreements. Pursuant to the FAA, the arbitration provision in a contract is treated as a separate agreement. Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440 (2006). As a result, federal courts “interpret [general choice-of-law clauses] as simply supplying state substantive, decisional law, and not state law rules for arbitration.” Sovak v. Chugai Pharmaceutical Co., 280 F.3d 1266, 1270 (9th Cir. 2002)  Sovak v. Chugai Pharmaceutical Co., 280 F.3d 1266, 1270 (9th Cir. 2002) (discussing Mastrobuono v. Shearson Lehman Hutton, Inc., 514 U.S. 52 (1995)).

This is consistent with the general practice of American courts and with the “cannon of construction” that the law of the forum state governs procedure despite a choice of law provision electing the laws of another state.[ix] Federal courts typically apply the procedural law of the chosen forum. Cole v. Mileti, 133 F.3d 433, 437 (6th Cir. 1998) (observing that “contractual choice-of-law clauses incorporate only substantive law, not procedural provisions”); Woodling v. Garrett Corp., 813 F.2d 543, 551 (2d Cir. 1987) (“The contractual choice of law provision is deemed to import only substantive law, however, not procedural law.”). However, the U.S. Supreme Court has expressly held that parties are free to stipulate rules that vary from the law that would be applicable under the FAA, including by specifying the procedural law they desire to apply.

Because the FAA governs arbitration agreements, arbitrators should usually follow federal law in construing general choice of law clauses to reach only substantive law and should apply the procedural law of the chosen forum (deeper analysis would be required if the relevant agreement specifically elects the procedural law of a different jurisdiction). When parties elect the substantive law of one state but arbitrate in another state, this is important to determining issues like burdens of proof—which are generally considered a matter of procedural law.

iii. Federal Arbitration Act (FAA) and Federal Preemption

The Federal Arbitration Act (the FAA) applies to arbitration agreements in contracts having only a slight nexus or that relate even tangentially to interstate commerce in that the FAA has the full reach of the commerce clause. Allied-Bruce Terminix, Cos., Inc. v. Dobson, 513 U.S. 265 (1995). Essentially, this means that the FAA applies to most commercial arbitration agreements. It contains both procedural and substantive provisions that apply to arbitration proceedings.

The FAA’s substantive provisions require the enforcement of arbitration agreements according to their terms. American Express Co. v. Italian Colors Restaurant, 570 U. S. 228, 233 (2013). It preempts any inconsistent state law that would hinder the enforcement of an arbitration agreement or diminish the powers of an arbitrator. Where federal and state laws are in conflict, the state law is generally supplanted, leaving it void and without effect. See Maryland v. Louisiana, 451 U.S. 725, 746 (1981) (finding state laws that conflict with federal law are “without effect.”). Consequently, state legislatures and courts are severely restrained from innovating laws intended to restrict the arbitration process to make it fairer for weaker parties.[x]

The FAA’s procedural aspects will apply any time a federal court is tasked with addressing a dispute concerning an arbitration. However, the fact that the FAA applies to most arbitration agreements does not give a federal court jurisdiction over all disputes concerning arbitration agreements to which it applies. Rather, federal jurisdiction must be established independently with respect to each petition for court intervention. Badgerow, 142 S. Ct. 1310 (2022).

iv. The Texas Arbitration Act (and other State Arbitration Statutes)

One might assume that because the FAA applies to most arbitration agreements and because it “preempts state law,” the Texas Arbitration Act (TAA) and arbitration statutes in the other states are relegated to having minor importance in connection with non-commercial matters. However, the FAA and TAA (and other state statutes) will typically apply concurrently, unless the parties stipulate that only one of the acts applies (and this election is enforceable in practice). In re LL Kempwood Assocs., L.P., 9 S.W.3d 125, 127-128 (Tex. 1999) (per curiam). Further, even if the FAA governs an arbitration agreement by its terms, without an independent basis to support federal jurisdiction, any dispute concerning a related arbitration will land in a state court that would likely apply its home-state’s statute unless inconsistent with the FAA. Typically, if a state arbitration statute (or judicial interpretation of it) furnishes rules that vary from federal law but are not a hindrance to the enforcement of an arbitration agreement, they will not be deemed preempted by federal law. For example, in contrast to the U.S. Supreme Court, several states including Texas have interpreted their arbitration statutes to allow parties to contract for judicial review of arbitration decisions for error.

Closing

Arbitration law and arbitral proceedings involve many complexities that are difficult to fully consider when negotiating or entering into contracts. As with practically any business decision, choosing arbitration involves trade-offs. Opting into a dispute resolution system offering expedited review, perhaps more focused attention, and confidentiality may be worthwhile in some cases. But as noted by me colleague in a blog post here, arbitration is not always less expensive than litigation, and the expense of arbitration is often compressed into a shorter period than in a court proceeding.

Before deciding to agree to an arbitration clause, parties should consider the potential drawbacks of opting out of the traditional legal system and whether those drawbacks can be limited by carefully crafted arbitration provisions. In addition, they should evaluate whether doing so is worth the associated legal expense.

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[i]     Duke University School of Law, Arbitration (Research Guides), HTTPS://LAW.DUKE.EDU, https://law.duke.edu/lib/research-guides/arbitration (last visited May 28, 2024)..

[ii]     However, statutory schemes can require compulsory arbitration (subject to due process requirements).

[iii]    Shimabukuro, Jon O., Staman, Jennifer A. (Sep. 20, 2017), U.S. Congressional Research Service, Mandatory Arbitration and the Federal Arbitration Act, (CRS Report No. R44960), available at https://sgp.fas.org/crs/misc/R44960.pdf (last visited May 28, 2024).

[iv]    See e.g., Tex. Civ. Prac. & Rem. Code § 171.092 (Judgment on Award); 9 U.S.C § 9 (Award of arbitrators; confirmation; jurisdiction; procedure).

[v]     American Arbitration Association, Drafting Dispute Resolution Clauses-A Practical Guide (2013), WWW.ADR.ORG., Drafting_Dispute_Resolution_Clauses-A_Practical_Guide.pdf (adr.org).

[vi]    This should not be confused with the fact that some agreements allow parties to “opt-out” of arbitration provisions.

[vii]      Jescheck, Hans-Heinrich, Weigend, Thomas, Hazard, Geoffrey, “Procedural Law” 1998, Britannica. https://www.britannica.com/topic/procedural-law/Historical-development (last accessed May 28, 2024).

[viii]     Stephen J. Ware, Arbitration Clauses, Jury-Waiver Clauses, and Other Contractual Waivers of Constitutional Rights, 67 Law and Contemporary Problems 167-205 (Winter 2004). Available at: https://scholarship.law.duke.edu/lcp/vol67/iss1/7

[ix]       Coyle, John. F., The Canons of Construction for Choice-of-Law Clauses, 92 Wash. L. Rev. 631, 647-649. .

[x]     See Note, State Courts and the Federalization of Arbitration Law, 134 HARV. L. REV. 1184 (2021), available at https://harvardlawreview.org/print/vol-134/state-courts-and-the-federalization-of-arbitration-law/.