ADR: Considerations in Drafting the Arbitration Clause

Two of the most oft-cited reasons for seeking alternative dispute resolution (ADR)—specifically arbitration—as an alternative to litigation are the potential savings in time and costs to the parties, including the greater likelihood of final resolution due to the limited bases upon which a court will review and reverse an arbitration decision.

Two of the most oft-cited reasons for seeking alternative dispute resolution (ADR)—specifically arbitration—as an alternative to litigation are the potential savings in time and costs to the parties, including the greater likelihood of final resolution due to the limited bases upon which a court will review and reverse an arbitration decision.

Whether or not an arbitration clause should be included in a commercial lease is a question to be determined by the particular needs and circumstances of the parties, and in the context of the other provisions of a particular lease. The scope of an arbitration clause and the nature of the disputes covered will determine the extent if any of the cost and time savings of selecting arbitration.

Below are lessons learned from three recent cases, which highlight key issues to consider in determining the advantages of, and drafting, an arbitration clause in a commercial lease.

It May Be an ‘Arbitration Clause’ Even If It’s Not Labeled that Way

When drafting or reviewing a commercial lease be aware that a binding arbitration agreement may be found to exist even when the label of “arbitration” is not specified. In a recent unpublished California case, a lessor unsuccessfully appealed a trial court’s confirmation that the results of a broker appraisal process was an “Arbitration Award.”

The lease at issue provided that where the parties could not agree on a fair market rental rate for a renewal term—with specified time frames and notice provisions—a real estate appraisal process would be conducted. The process set out in the agreement provided that each party would select a real estate broker. If the two party-appointed brokers failed to agree, they would be required to select a third broker, who had not previously acted in any capacity for either party. A majority of the three brokers would then determine the fair market rental rate.

Here, the court found that that appraisals were expressly provided for in the California Arbitration statute and that it is not the “label” of arbitration that is determinative but rather whether the basic elements of arbitration existed:

  • A third-party decision maker (the neutral third broker); and
  • A final and binding decision (the majority decision of the brokers, which sets the fair market rental rate); and
  • A mechanism to assure a minimum level of impartiality (the qualifications of the brokers, the requirement that the party-appointed brokers agree on the third broker, and the fact that the third broker cannot have a relationship with the parties) [Northrop Grumman Sys. Corp. v. Goldentop Rd 4731, June 2016].

Define the Scope of the Arbitration

The arbitration clause may cover all disputes arising from the commercial lease. However, you may want to carve out exceptions to a broad arbitration clause, such as for disputes relating to rent or amount in dispute. Or you may want to provide for a limited scope of arbitration to address specific areas, commonly disputes arising from operating expenses or common area maintenance (CAM) costs.

The reason that owners often prefer to resolve such disputes using arbitration is that litigation relating to a CAM cost dispute with one tenant can impact other tenants within the property. As described in Best Commercial Lease Clauses (Eighth Edition), Chapter 17, “Disputes about the attribution or allocation of CAM costs, whether in office buildings or retail properties, are best resolved for owners using arbitration—but it has to be done carefully,” and the owner should insist on a confidentiality clause that will apply to all parties in the arbitration proceeding.

In a recent New York case, where the lease expressly provided for arbitration of operating expense claims, the court dismissed without prejudice in favor of arbitration the tenant’s claim that it had been overcharged for its share of operating expenses [Segal Co. (E. States), Inc. v. 333 W34 SLG Owner LLC, May 2016].

Practical Pointer: Consider providing that the parties seek to resolve disputes through mediation first, before seeking arbitration. There are significant differences between the processes and goals of mediation and arbitration. The role of a mediator, unlike an arbitrator, is not to decide the outcome of a dispute; rather, a mediator’s role is to facilitate a discussion between the parties. The impartiality of the mediator, voluntariness of the parties to participate, and the concept that resolution should be reached through self-determination are hallmarks of the mediation process.

Define the Method for Choosing Arbitrators

Use of the American Arbitration Association or other ADR organizations to administer arbitration is a common option, whether the parties elect to use a three-party panel of arbitrators, or an individual arbitrator. Sujata Yalamanchili, a partner in the New York firm of Hodgson Russ, suggests that where cost considerations are strong, selecting an individual neutral arbitrator can be quite attractive to both parties.

A common method for selecting arbitrators is to provide that each party designate a person, who then jointly selects a neutral third arbitrator. This method carries some risk as illustrated in a recent Court of Appeals case in Washington state, where parties to a cash rent farm lease option sought arbitration on the issue of whether the option was invalid for lack of consideration.

The history of the case is also an example of how arbitration isn’t always a more cost-effective alternative to litigation.

Disputes between the parties arose shortly after the document was executed, with a court confirming two previous arbitration awards in favor of the tenant, and additional rounds of arbitration pursued. When arbitration was sought to determine the owner’s claim that the option was invalid for lack of consideration, the neutral arbitrator from previous arbitrations was no longer available and the parties were unable to agree on a replacement. The issue ended up before the lower court, which pursuant to statute appointed a replacement “neutral” arbitrator. A decision was rendered in favor of the tenant and confirmed by the court.

The owner appealed on a number of grounds, including that the trial court erred when it appointed the nonparty arbitrator, claiming that it had not been established that the parties’ agreed method for appointing an arbitrator had failed. The owner further claimed that the court erred in not vacating the arbitration award on the basis that there existed a prior professional and personal relationship between the tenant’s attorney and the appointed arbitrator, who was a former attorney at the firm representing the tenant.

The appeals court found that the trial court properly selected the third arbitrator based on proof that the other arbitrators had been deadlocked, and that neither the arbitrator’s prior membership in the tenant’s counsel’s firm, nor his undisclosed social relationship with the tenant’s counsel established a sufficient basis for vacating the arbitration award [Garrett Ranches LLC v. Larry Honn Family LLC, March, 2016].