Arbitration Clauses in Commercial Contracts: Benefits, Risks, and Drafting Considerations

An arbitration clause is a contract provision requiring the parties to resolve disputes through private arbitration rather than through the court system. Arbitration clauses appear in everything from major commercial agreements and employment contracts to consumer terms of service and residential leases. For business owners, arbitration clauses are both a tool for managing litigation risk and a potential source of unexpected disadvantage, depending on how they are drafted and what type of dispute arises.

How Arbitration Works

Arbitration is a private dispute resolution process in which the parties submit their dispute to one or more neutral arbitrators — private individuals (typically retired judges or experienced attorneys in the relevant field) — rather than a judge or jury. The arbitrator holds a hearing, reviews evidence, and issues a binding award. That award can generally be confirmed as a court judgment and enforced in the same manner as any court judgment.

Arbitration is governed by the Federal Arbitration Act (FAA), which reflects a strong federal policy favoring arbitration and preempts most state laws that would otherwise restrict arbitration in commercial contexts. The FAA requires courts to enforce written arbitration agreements as written, with limited exceptions for fraud, unconscionability, or other grounds that would apply to any contract. Grounds for vacating an arbitration award are narrow: the award can be vacated only for corruption, fraud, evident partiality of the arbitrator, misconduct in the hearing, or an arbitrator exceeding their powers.

Advantages of Arbitration for Businesses

The primary advantages that lead businesses to include arbitration clauses in their contracts are confidentiality (arbitration proceedings and awards are private, unlike court proceedings which are public record), speed (well-administered arbitration typically concludes faster than federal or state court litigation), cost (when disputes are modest in size, arbitration can be less expensive than court litigation, though this is not always the case for complex disputes), the ability to select a decision-maker with expertise in the relevant industry or type of dispute, and the finality of the award (limited grounds for appeal provide certainty, though they also limit the ability to correct errors).

Class action waivers — provisions in arbitration clauses that require disputes to be arbitrated individually rather than as class actions — are particularly valuable to businesses facing consumer or employment claims. The Supreme Court has repeatedly upheld class action waivers in arbitration agreements as enforceable under the FAA, making them a powerful tool for businesses that face potential class action exposure.

Disadvantages and Risks of Arbitration

Arbitration is not always advantageous for businesses, particularly when the business is the claimant rather than the respondent. Limited discovery in arbitration can make it difficult to build the kind of evidentiary case that would prevail at trial. The narrow grounds for vacating an award mean that arbitrators’ legal errors generally cannot be appealed, which can produce outcomes that are correct in the arbitrator’s judgment but inconsistent with applicable law. For high-stakes commercial disputes, the combination of limited discovery and unreviewable decisions can be a significant disadvantage.

Arbitration filing fees and arbitrator compensation can be substantial for complex commercial disputes. Cases administered by major providers like the American Arbitration Association (AAA) or JAMS can cost more in arbitrator fees alone than the total cost of litigating a straightforward commercial case in some courts. The ‘repeat player advantage’ — the documented tendency of arbitrators who regularly receive cases from the same institutional clients to rule more favorably for those clients — is a concern in consumer and employment arbitration contexts, though its significance in commercial arbitrations between sophisticated parties is more debated.

Key Drafting Provisions

A well-drafted commercial arbitration clause should specify the administering institution and applicable rules (AAA Commercial Rules, JAMS Comprehensive Arbitration Rules, or others), the seat of arbitration (the legal place where arbitration is deemed to occur, which affects which courts have supervisory jurisdiction), the number of arbitrators (one is sufficient for smaller disputes; a three-arbitrator panel is common for larger ones), the governing law for the substantive dispute, the language of the arbitration, any limitations on discovery, provisions regarding confidentiality, and whether class arbitration is waived.

Carve-outs from arbitration are also important. Most commercial arbitration clauses carve out injunctive relief for intellectual property disputes, trade secret matters, and other situations where emergency court relief may be needed. The ability to seek a temporary restraining order or preliminary injunction from a court — on an emergency basis before the arbitrator is appointed — is often essential for IP and confidentiality disputes where the harm from delay would be irreparable.

Arbitration in Employment Contracts

Mandatory arbitration of employment disputes is permitted under the FAA but is subject to significant limitations. The Ending Forced Arbitration of Sexual Assault and Sexual Harassment Act, enacted in 2022, prohibits enforcing pre-dispute mandatory arbitration agreements with respect to sexual assault and sexual harassment claims — employees can choose court or arbitration for such claims regardless of any arbitration agreement. Some states impose additional restrictions on employment arbitration, and the NLRB has at various times challenged the use of class action waivers in employment arbitration agreements.

The Bottom Line

Arbitration clauses are not generically good or bad for businesses — their value depends on the type of disputes likely to arise, the relative bargaining positions of the parties, the size and complexity of potential disputes, and how the clause is drafted. Businesses should approach arbitration clauses thoughtfully, with specific attention to the administering institution and rules, discovery provisions, the number of arbitrators, and the class action waiver. An arbitration clause that is appropriate for a consumer services agreement may be poorly suited for a major commercial supply agreement, and vice versa.