Drafting an ADR Clause

Guidance for the Transactional Lawyer[1]

How does one go about drafting an ADR clause? What considerations should one think about? What are some of the options? The goal of this paper is to provide guidance for the transactional attorney (the “Draftsman”) about how to approach the task of drafting an ADR clause.

Why Bother with an ADR Clause?

Before embarking on a discussion about the task of drafting an ADR clause, one should ask a very reasonable threshold question – why bother? At least five objections can be raised against including a pre-dispute ADR clause in a contract. First,the parties can discuss ADR after a problem develops, if it ever does, so why bother including an ADR provision in a contract? Second, the time and effort expended in the process of negotiating an ADR clause is almost always wasted because most contracts in fact do not end in dispute. Third, the potential friction between the parties associated with negotiating an ADR clause does not warrant the speculative benefits. It is better to reserve the effort and risks for other, more important issues between the parties. Fourth, it is bad for the negotiation of any deal to injectthe suggestion that problems will arise. Doing so is similar to introducing the idea of a pre-nuptial agreement into the discussions about marriage, thereby suggesting that one party is already planning for a divorce before the vows have been taken. Fifth, unintended consequences can flow from an ADR clause, even if well written; as good as a Draftsman is, she or he cannot anticipate every contingency, and as such, a dispute resolution process might end up being worse than nothing at all. With respect to an ADR clause that includes the obligation to arbitrate, several additional objections can be raised which are discussed separately below.

Although there is some truth to each of these objections, the author believes these objections are not sufficient to lead to the conclusion that an ADR clause should be avoided. First and foremost, the appropriate point in time to negotiate a dispute resolution procedure is before a dispute arises. As a matter of human nature, parties who are in the midst of creating a deal are usually in a cooperative frame of mine and, in contrast, parties in the midst of dispute are usually in a combative frame of mind. Also, just as with the classic objection to mediation, parties could well be reluctant to suggest an ADR process after a dispute has arisen for fear that doing so would be taken as a sign of weakness. It is better to have a pre-existing ADR clause to which the parties can make reference and thereby avoid these impediments.

An ADR clause should not be seen as either suggestive or causative of future disputes, but rather should be seen from a broader perspective as an effort to prevent the natural course of dispute escalation, encourage productive engagement, and foster de-escalation. In this regard, an ADR clause should be seen as a form of ADR system design, as appropriate to the specific circumstances of the contracting parties. Of dispute resolution system design generally and apropos to the current discussion, Allan J. Stitt has said:

“Organizations can design conflict management systems to deal with…disputes in a productive way that preserves rather than destroys relationships. Instead of resorting to litigation, strikes, work to rule, or withdrawing, disputants can use dispute resolution process that will resolve their conflict efficiently and effectively. Designing an Alternative Dispute Resolution (ADR) system can help improve communication, reduce costs, maximize efficient, and preserve or improve relationships.”[2]

An ADR clause can also be seen in a broader context as an effort at risk avoidance and mitigation, two pillars in the field of risk management, which efforts are very much within the scope of responsibility for transactional attorneys.

The risk of that an ADR clause might “miss the mark” and create bigger problems is not a valid objection. Such is the type of risk transactional attorneys deal with every day. The solution is to understand what is involved and address the potential risks and rewards directly.

A Brief Look at Arbitration Clauses in Particular

Focusing specifically on arbitration, a study published by RAND[3] in 2011 found that while businesses include arbitration clauses in over 75% of their consumer and employment contracts, only 6 percent include such clauses in their business-to-business/non-consumer contracts. Chief among the reasons given for not favoring pre-dispute arbitration clauses in commercial contracts were no right to appellate review in the courts; the fact that arbitrators are not confined to legal precedent; lack of confidence in the arbitrator’s neutrality, especially with “repeat players;” the belief that arbitrators are unwilling to make tough decisions and thus resort to “splitting the baby;” and the belief that arbitration is not less expensive or more expedient than litigation. While there are valid reasons for not preferring arbitration over litigation, the simple fact remains that 95% of all civil litigation matters are resolved without a trial and that over 60% of those resolutions are through settlement. That suggests two things: One, that parties should make an effort early on to discuss and resolve their differences and thereby avoid the professional fees and costs associated with discovery, law and motion and trial preparation activities. Two, that the right to a jury trial and the right to appeal are over rated as a reason for not wanting to submit a dispute to private arbitration because very few cases make it to trial (and fewer still are decided by juries), and of the cases that make it to trial, very few judgments are appealed (and fewer still are reversed).

For example, the California Judicial Council maintains statistics regarding the courts’ workload and publishes those statistics on an annual basis.[4] For fiscal year 2009-2010, over 10 million actions were filed, of which approximately 1.2 Million were civil actions and approximately 8.2 million were criminal actions. Of the 1.2 million civil actions, only about 220,000 were “unlimited jurisdiction” cases, meaning disputes in which the claimed damages were in excess of $25,000. Of those 220,000 “unlimited” civil cases, only 25,500 (or about 11%) were tried, and of those 1,400 (or less than 1%) were decided by a jury.

With regard to appeals, the statistics collected by the California Judicial Council also publishes statistics and “trend reports” that provide a ten-year perspective.[5] The Judicial Council’s ten-year statistics concerning outcomes at the appellate level shows that approximately 20 to 25 percent of the matters decided result in reversal of the trial court, but that percentage is really 10 to 12 percent when compared to total appeals filed because approximately half of all civil appeals filed are resolved without a decision by the court (meaning they are dismissed, abandoned or settled). Additionally the statistics for “civil” appeals does not distinguish between “limited” and “unlimited” cases and thus include all civil matters.

It is true that the arbitration is lately taking longer than in the past and it is also true that the cost advantage of arbitration over litigation has been going down. These trends are associated with the behavior of parties and counsel in general in that both have come to expect and demand more litigation-type procedures as part of the arbitration process.[6] However, the “keys to this cabinet” are truly held by the parties and counsel themselves. Being that arbitration is a process founded upon agreement and the parties are free to fashion a process that works for them, they are free to agree upon faster time limits and greater efficiency. Also it is to be noted that in some states the relative difference between the length of time it takes to get to trial and the length of time it takes to get to an arbitration hearing has begun to move back more in favor of arbitration, not because of any change with respect to arbitration, but because of funding problems for the courts and the hugely disproportionate number of criminal case filings as compared to civil actions.

It is important to note that arbitration is the norm in one context, and this is the international commercial context. A significant reason for this is the United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York, 10 June 1958)[7] (the “New York Convention”), which is codified in Chapter 2 of the of the Federal Arbitration of 1925, as amended[8] (the “FAA”). The New York Convention is one of the more successful international treaties ever created and has been ratified by more than 140 countries out of a total number of approximately190, including virtually all of the countries of commercial importance.[9] The significance of the New York Convention is that it requires signatory countries to enforce as binding both a contractual requirement for arbitration and any resulting arbitral award, in accordance with national law, consistent with the provisions of the Convention.[10] To emphasize the point, for businesses based in the United States, an arbitration award arising from an international commercial arbitration is enforceable in most countries around the world, where a judgment from a United States court would not be; in the absence of an arbitral award, a party who has a judgment rendered in its favor by a US court would generally need to rely on the principles of comity.[11]

Two Basic Types of ADR Clauses

While there is no one-size-fits-all ADR clause,[12] there are two simple questions that will help define which basic type of ADR clause or clauses should be included in any particular contract, those that are essentially consensual and those that provide for a binding decision by a third party:[13]

  1. If a dispute were to arise between the contracting parties, is their relationship such that they want to have an opportunity to talk about the problem and get their respective key decision makers involved in trying to find an amicable resolution before surrendering the determination of the outcome to a judge, jury or arbitrator? If so, the parties should focus on a mediation and/or negotiation clause.
  1. If a dispute were to arise between the contracting parties, do they want to completely avoid the court system because they value privacy,[14] avoid the creation of case precedent, have a subject matter expert as the decision maker, avoid the potential for a “run-away” jury verdict, and/or provide for finality? If so, the parties should focus on an arbitration clause.

At a minimum, the inclusion of an ADR clause in a contract assures that the parties will retain control over the process by which a dispute is resolved – or resolution is explored - if indeed a dispute arises during the course of the contractual relationship.

Drafting a Negotiation Clause

When drafting an ADR clause that requires negotiation, the Draftsman has nine basic issues to consider, and these are:

  1. Whether the requirement for negotiation is a mandatory obligation or precatory;
  2. Whether negotiation in “good faith” is to be required;
  3. Which disputes are to be included within the scope of the obligation;
  4. What is the trigger for the obligation to negotiate;
  5. When is the obligation to negotiate finished;
  6. Who are the required participants;
  7. What is to be done about provisional remedies during the negation process;
  8. What is to be done about any relevant statute of limitations; and
  9. What are the next steps if the negation is unsuccessful?
  1. Mandatory Obligation or Precatory Language

To what extent will the contractual requirement for negotiation be mandatory or merely precatory? As a technical matter, it would be difficult to create a mandatory requirement for negotiation that is enforceable on an action for specific performance. On the other hand, a precatory “obligation” to negotiate can still have a beneficial effect on how the dispute is dealt with by the contracting parties, perhaps by creating a sense of obligation arising from the pressure to act consistently with prior public statements.[15] Also, it is possible to include language that creates some consequences for a failure to engage in a required negotiation process. A tangible consequence could be, for example, a deemed waiver of any claim for attorney’s fees on the part of the recalcitrant party if the document otherwise provides for attorney’s fees to the successful party in litigation.

  1. Good Faith

Should the requirement to negotiate include the obligation to negotiate in “good faith?”Certainly the concepts of “good faith” and “bad faith” are difficult to define as these concepts reference a certain frame of mind, and a requirement that the parties negotiate in good faith is essentially a requirement that they maintain the requisite frame of mind.[16] Nevertheless, just as an “obligation” to negotiate can have a beneficial effect, an “obligation” to negotiate in good faith could have a beneficial effect on the parties’ behavior at the table. Compliance would likely be enhanced if the Draftsman included some measurable definition of what constituted “good faith,” such as participation by the proper people (see below) and that these people at least listen to the positions and arguments of the other party for a prescribed length of time.

  1. Scope of the obligation to negotiate

Which disputes between the contracting parties are to be subject to the obligation to negotiate? Because the use of such a clause is likely to occur in the context of some tension between the parties, it is useful to draft a description of the included disputes with sufficient clarity to avoid a secondary dispute about the required scope of the ADR clause. Certainly issues involving the interpretation of and performance under the involved contract should be included. On the other hand, in certain situations it could be desirable to specifically exclude some disputes from the obligation to negotiate, such as, for example, issues of corporate authority or ownership of intellectual property. Or, it might be beneficial to include only certain issues within the obligation to negotiate, such as, for example, issues of warranty under a manufacturing contract.

  1. Trigger for the Obligation to Negotiate

Parties negotiate every day. Given this, it is important to be able to distinguish between “garden-variety” negotiations and negotiation contractually required to resolve a dispute. As such, it canbe useful for the Draftsman toinclude language that creates a clear triggering mechanism, such as written notice between legal departments, or between divisional vice presidents, contracting officers, etc., whoever makes sense in terms of being likely to respond. Whatever the mechanism, the notice should, at a minimum, identify the nature of the dispute that is to be negotiated. As an aside, the simple act of clearly articulating a problem can sometimes have a beneficial effect on the course of a dispute.

  1. Termination

Just as it can be useful to clearly identifying when the obligation to negotiate begins, it is likewise useful to define when the obligation ends. A drafting option can be to provide for written notice of termination. The clear advantage to this idea is flexibility. Another option is to set a specific time limit after the date of the initial written notice, such as, for example, thirty, sixty, or ninety days (subject to an extension by agreement). The advantage of this option is that it is automatic, and when dealing “next steps” (see below), the parties can avoid accidentally leaving open the obligation to negotiate.

  1. The Participants

Who should participate in a negotiation? If the parties to a contract are natural persons and/or sole proprietors, this is not an issue, but if the parties are corporate entities, and especially if they are large organizations, this could be a very significant issue. At a minimum it should be required that those who participate possess the actual authority to agree to a solution. Additionally, it is generally a good idea to require participation by at least the level of management above where a dispute has arisen, and the Draftsman can create a functional definition along these lines. This approach has the advantage of flexibility, but the disadvantage of being imprecise and subject to interpretation, remembering that if a clause of this sort is triggered, it is likely to be within the context of an active dispute, and as such those involved are unlikely to initially be in an agreeable frame of mind. Another option is for the Draftsman to specify a person of a given rank within an organization, such as, for example, the divisional vice president, or with a contract of sufficient importance, the company president/CEO. One benefit to this approach is, as a matter of human nature, the specter of involvement by a high ranking person with an organization can have a beneficial effect on the actions of those who are interacting on a day-to-day basis such that disputes are less likely to arise without good cause.

  1. Provisional Remedies

What is to be done about provisional remedies, such as, for example, a request for a restraining order, attachment, or an injunction against the use of trade secrets? Where the situation is such that this could be important, then the Draftsman can create an unambiguous carve-out for such provisional remedies.