The pros and cons of arbitration in construction defect cases

The effective management of risks sometimes hinges on the selection of the appropriate forum for resolution of potential disputes. Contractors working in the construction industry routinely enter into arbitration agreements as a matter of course, operating under the belief that it is a favorable forum for dispute resolution. In practice, however, the consequences and limitations of arbitration may outweigh the perceived benefits. As a result, contractors must evaluate at the contract negotiating stages of a project whether agreeing in advance to arbitrate potential disputes is in their best interest. Fortunately, if the choice of arbitration is unavoidable in a given instance, certain safeguards can be implemented during contract negotiations to help address arbitration’s potential drawbacks.

How arbitration became dominant in the sector

Arbitration is a private dispute resolution process that is typically presided over by an arbitrator, or a panel of three arbitrators, who are jointly selected by the parties to the arbitration. Arbitrators are commonly attorneys or retired judges, and may have expertise in a particular field of law or class of business. They resolve discovery disputes between the parties and issue rulings on dispositive motions in much the same manner as a judge. Arbitrators also preside over the final arbitration hearing, which is similar to a trial. At the conclusion of this hearing, the arbitrator enters an award that is either binding or non-binding, depending on what the arbitration agreement provides. A binding arbitration award is the functional equivalent of a judgment issued by a court. Today, the majority of construction contracts that require arbitration call for binding arbitration.

For over one hundred years, arbitration agreements have been used as an alternative to resolving civil disputes through the traditional court system. The United States Arbitration Act, commonly referred to as the Federal Arbitration Act, was enacted into law in 1925. It sought to protect the enforcement of arbitration agreements and to establish a national policy favoring arbitration. Over the years, the U.S. Supreme Court has expanded the scope of the Federal Arbitration Act. Currently, all 50 states have enacted legislation regarding the validity and enforceability of arbitration agreements. All of this has led to a climate that favors the enforceability of arbitration agreements and as a result has led to an increased use of arbitration to resolve disputes involving contractors. 

In many instances, an agreement to arbitrate a dispute is entered into before a dispute arises between the parties. An agreement to arbitrate is generally a clause or provision within a larger written agreement but can also be a separate, stand-alone agreement. A well-drafted arbitration agreement will, at the very least, identify the types of disputes that will be submitted to arbitration. It will also identify the arbitration forum and the rules that will apply.

There are undoubtedly benefits to using arbitration, including increased privacy expectations, expedited procedures and the selection of a neutral professional to preside over the matter.

Privacy: Arbitrations, unlike the traditional court system, are typically not a matter of public record. Parties to the arbitration can agree prior to or at the time of arbitration that the process will remain private and confidential, which is generally not a possibility when a dispute is litigated in court. This safeguard can limit the disclosure of potentially embarrassing or commercially damaging information.

Expedited process: Arbitration procedures often expedite dispute resolution. For example, written discovery may be more limited in arbitrations, resulting in a less burdensome discovery process that is less likely to lead to “fishing expedition” discovery requests. Arbitration also requires fewer formal filings or hearings than disputes litigated in court. This streamlined procedural process typically results in disputes proceeding to the final arbitration hearing more quickly than those litigated in court. Depending on the complexity of the dispute, the matter may proceed to a final arbitration hearing within 18 to 24 months from the date the arbitration demand is made. By contrast, a dispute litigated in court commonly takes 36 months or more before it proceeds to trial.

Professional neutral: An arbitrator essentially serves as the judge and jury, making evidentiary rulings and issuing the final arbitration award. Parties who use the traditional court system to resolve their disputes do not have the ability to select their judge, who may be either more plaintiff or defense oriented. Arbitrators are also less likely than a jury to be swayed by sympathy or bias. As a result, arbitration may appear as an appealing option to a contractor when the dispute involves non-economic damages, such as those associated with a bodily injury claim, punitive damages, or a highly politicized matter, like taxpayer-funded projects.

Parties to an arbitration can also select an arbitrator with a background or skill set suited to the nature of the dispute—for example, someone with architectural, engineering or construction experience to preside over construction disputes. By comparison, a judge may have little to no knowledge or expertise in the construction industry.

There are instances where the consequences and limitations of arbitration will weigh against entering into an arbitration agreement. Such consequences include increased costs, the arbitrator’s lack of power over third parties, the lack of evidentiary rules, the propensity of arbitrators to take a “split the baby” approach, and the inability to appeal an arbitration award except under narrow circumstances.

Increased costs: Arbitration, in its purest form, should be less expensive than litigating a matter in the traditional court system, as little to no discovery is conducted prior to the final arbitration hearing. Under such circumstances, the parties potentially stand to incur lower attorney fees and expenses. However, for two reasons, contractors rarely achieve any cost savings through the use of arbitration. First, in recent years parties using arbitration have begun conducting discovery in much the same way as the traditional court system—exchanging numerous written documents, deposing multiple witnesses and engaging in expert discovery. This expansion of discovery in the context of arbitration has led to increased attorney fees. Second, unlike the traditional court system, where litigants do not pay compensation to the judges, the parties to an arbitration are required to compensate arbitrators for their time. These factors can add up to make arbitration more expensive than traditional litigation.

No authority over third parties: The agreement to arbitrate is contractual in nature and, as a result, only the parties to the arbitration agreement can be compelled to arbitrate. This creates a problem when there are multiple parties who may bear a share of liability but who are not involved in the arbitration agreement. This scenario often arises during disputes involving construction defects, resulting in contractors being required to participate in an arbitration without all potentially liable or culpable parties. This in turn may make it difficult to allocate liability to other parties. When this scenario arises, contractors usually must file a separate action in court—under theories of equitable indemnification, contribution or breach of contract—to recover portions of an arbitration award that should have been allocated to another tortfeasor who was not a party to the arbitration.

The doctrine of stare decisis and the rules of evidence: Judges presiding over disputes litigated in court are required to adhere to the doctrine of stare decisis and the rules of evidence when ruling on legal issues. In Latin, stare decisis means “let the decision stand”—a legal principle requiring judges to follow rulings, opinions and decisions that were entered in past cases. The rules of evidence are a set of rules that regulate evidence and its admissibility in civil trials. Arbitrators have more flexibility than judges when it comes to complying with the principle of stare decisis or the rules of evidence. This sometimes results in arbitrators disregarding or ignoring legal principles and rules, which makes arbitration an unpredictable forum to resolve a dispute and can result in inconsistent outcomes. The potentially unpredictable nature of arbitration is further compounded by the privacy associated with the process, since there is no historical public record of how an arbitrator has previously ruled on a specific issue. The lack of a public record also makes it difficult to fully evaluate an arbitrator during the selection process, and accordingly, the outcome of an arbitration can be more difficult to forecast than a dispute litigated in court.

“Split the baby” approach: Disputes resolved through arbitration are more likely than those litigated in court to produce “split the baby” results where, instead of a clear winner or loser, both the claimant and respondent are awarded some of their requested relief. This result is typically most pronounced in the context of the final arbitration hearing, where the arbitrator is unlikely to rule totally in favor of the claimant or respondent. Instead, the arbitrator issues an arbitration award for damages in an amount less than what the claimant requested, and more than the amount requested by the respondent. Arbitrators also tend to be less inclined to grant respondents dispositive relief in the form of a Motion to Dismiss or a Motion for Summary Judgment.

Limited appeal rights: Parties who agree to arbitrate a matter under the Federal Arbitration Act have little recourse to challenge, vacate or set aside an arbitration ruling they believe is unfair or incorrect. Generally, parties may only appeal an arbitration award based on arbitrator misconduct such as fraud, collusion or claims that the arbitrator exceeded their powers. The lack of appeal opportunities under the Federal Arbitration Act means that arbitration awards tend to be more final than verdicts rendered by a judge or jury. In turn, this means a party seeking to settle an adverse arbitration award for less than the amount awarded has less leverage to do so because the party cannot use the threat of an appeal as settlement leverage.

How to implement safeguards

Contractors must consider at the outset of project negotiations whether the benefits of arbitration outweigh its consequences and limitations. When the consequences outweigh the benefits, a contractor ideally should not agree to arbitrate potential construction disputes. However, contractors who lack negotiating power or the financial capacity to simply walk away from a project that requires an arbitration agreement can nonetheless implement certain safeguards to better control the consequences and limitations of arbitration. These safeguards include the implementation of monetary thresholds, requirements for arbitrator expertise and experience, expanded appeal rights and flow-down provisions.

Monetary thresholds: Contractors deciding when and how arbitration will be conducted should consider using monetary thresholds as a determining factor. For example, the arbitration agreement could call for disputes involving alleged total damages of $1 million or less to be arbitrated, and disputes involving damages in excess of $1 million to be litigated in court. Using a monetary threshold to tie the use of arbitration to the size of the alleged damage model will drive disputes involving larger damage models to court, which may result in more predictable outcomes and more reliable forecasting of adverse jury verdict awards. If an owner or developer is steadfast on using arbitration as a forum to resolve all disputes, a monetary threshold can also be used to dictate the number of arbitrators used. For example, disputes involving alleged damages of less than $15 million could be decided by a single arbitrator and disputes involving damages in excess of $15 million could be decided by a panel of three arbitrators. The use of a panel of arbitrators for disputes involving more significant damage models may result in arbitration results that are better thought out and reasoned.

Arbitrator expertise or experience requirements: Construction defect disputes can be technical and complex in nature, which is why it is imperative to ensure presiding arbitrators are knowledgeable in the construction industry. Contractors should therefore also consider requiring the arbitrator to have a certain skill set or level of experience—such as a minimum of 15 to 20 years’ prior experience as a construction defect litigator, or a degree in architecture or engineering.

Expanded appeal rights: There are several steps that contractors can take at the contract negotiating stages to expand their arbitration appeal rights. For arbitrations conducted through the American Arbitration Association (AAA), JAMS, or the Institute for Conflict Prevention & Resolution (ICPR), parties may request review of an arbitration award by a senior panel of arbitrators for factual findings unsupported by the evidence or errors of law. However, the parties to the arbitration must mutually agree to the review of the final arbitration award. An agreement to appeal should be obtained in writing during the initial project contract negotiations because it is unlikely an owner or developer who receives a favorable arbitration ruling will agree to an appeal after the fact. The majority of arbitration agreements are governed by the Federal Arbitration Act, which as mentioned above only allows for appeals of the final arbitration award under limited circumstances. However, certain state arbitration acts, including those in California, New Jersey and Texas, allow parties to request that a state court review the final arbitration award for errors of law. Contractors who are domiciled or conducting business in these states should consider drafting arbitration agreements that expressly adopt the appropriate state arbitration act and expressly state that the parties have agreed to allow for the judicial review of the final arbitration award.

Flow-down provisions: Flow-down provisions—sometimes referred to as pass-through or conduit provisions—apply the terms and conditions of a prime contract to the lower-tier subcontracts. Contractors serving as general contractors should ensure their subcontracts include flow-down provisions incorporating the arbitration agreement from their prime contract with the owner or developer. Doing so will help ensure that all potentially liable or culpable parties to a dispute can be joined in the arbitration. In turn, this should make the litigation process more efficient because a separate action will not need to be filed in court, to recover portions of an adverse arbitration award that should have been allocated to another tortfeasor who was not a party to the arbitration.

Other considerations: Contractors are not limited to the safeguards discussed above and should consider whether other terms need to be added to the arbitration agreement. For example, it may be beneficial to set forth the process by which the arbitrator or arbitrators will be selected. Contractors should also contemplate whether the arbitration agreement should include discovery limitations and rules that will aid in controlling litigation costs and may contribute to a more favorable outcome for the arbitration. Finally, contractors should give thought to whether the arbitration agreement needs to identify the arbitration venue and the applicable state law.

Given the landscape outlined, contractors should not assume arbitrations are necessarily beneficial in all instances for resolving disputes. Rather, contractors should first perform an analysis during the contract negotiating phase of a project to determine whether the benefits of arbitration outweigh its consequences and limitations. They should consider seeking to remove arbitration agreements from their contracts when the consequences and limitations outweigh the benefits. In instances where it is not feasible to do this, contractors should consider implementing the safeguards discussed above in order to better control the consequences and limitations of arbitration. Arbitration agreements are contracts. Those contracts should be negotiated as carefully as any other provision in a contractual undertaking.