Article Summary of Why Do Businesses Use (or Not Use) Arbitration Clauses?*

Christopher R. Drahozal and Stephen J. Ware, both professors at the University of Kansas School of Law, have written an interesting article about business' use of arbitration clauses, which is upcoming in Volume 25, Issue 2 of the Ohio State Journal on Dispute Resolution: Why Do Businesses Use (or Not Use) Arbitration Clauses? The article addresses two assertions in recent scholarship: 1) arbitration is not successfully competing with litigation; and 2) parties are interested t in arbitration for illegitimate reasons, specifically to help avoid class actions. According to Professors Drahozal and Ware, these assertions have been supported by two empirical studies by Theodore Eisenber, Geoffrey Miller, and Emily Sherwin (Ms. Sherwin was only involved in the more recent study). The 2007 study examined the use of arbitration clauses in a sample of material contracts filed with the Securities and Exchange Commission (SEC). The 2008 study compared the use of arbitration clauses in consumer contracts to the same companies’ material corporate contracts. This article argues that while these studies “provide a fascinating and valuable look into the use of arbitration clauses in the types of contracts they studied,” the contracts reviewed by these studies are not representative of business or consumer contracts. Thus, the authors conclude that the studies’ findings much be construed narrowly.

First, Professors Drahozal and Ware summarize the two studies. The 2007 survey reviewed 2,858 material contracts files with the SEC in 2002. There were thirteen types of contracts; the contracts were mostly merger agreements, commercial lending contracts, and related corporate agreements, but there were also some executive employment contracts and licensing agreements. The study found that the inclusion of arbitration clauses in these contracts was “surprisingly low” in frequency (10.6% of the contracts). This study was interpreted by its authors to indicate that sophisticated actors prefer litigation to arbitration, which led them to wonder about why some consumer contracts include arbitration clauses. Thus, the 2008 survey reviewed consumer contracts and material contracts of telecommunications and financial service companies for arbitration clauses. The consumer contracts reviewed were much more likely to have arbitration clauses then the material contracts; 20 of 26 of the consumer contracts had arbitration clauses, but only 9 of 147 material non-employment contracts did. Additionally, all 20 of the consumer contracts with arbitration clauses contained class action waivers.

Next, Professors Drahozal and Ware challenge the assertion that arbitration is less efficient because the studies show that sophisticated parties tend not to use arbitration clauses in their contracts. They argue that there are “several important factors that parties should consider in choosing between arbitration and litigation.” A main factor is that litigation is subsidized by the government, while parties bear the full cost of arbitration. Therefore, arbitration may be the more efficient process, but given the government subsidy of litigation, sophisticated parties might not choose arbitration.
The article asserts that “[n]o competent lawyer would advise a client to use arbitration clauses in all of its contracts, for the sake of consistency,” while the hypothesis of the 2008 study is that within an industry, companies “should be ‘consistent’ in their use of arbitration clauses accross different types of contracts.”

The article sets forth a “more nuanced set of hypotheses” about when parties are likely to prefer litigation over arbitration: “(1) when the governing law and contract terms are well-developed and relatively certain in application; (2) in ‘bet-the-company” cases with very high stakes; and (3) when emergency relief is likely to be important for resolving disputes.” From the 2007 study, commercial loan agreements fall into the first category (well-developed law) and merger agreement are often in the second and third categories (high stakes and emergency relief). This article claims that there are two reasons sophisticated parties will chose arbitration over litigation: better process or better outcomes. Some examples of contracts likely to have arbitration clauses are contracts for the sale of goods, construction, and joint ventures. Taking these ideas into consideration, this article’s authors explain how the contracts in the 2007 study are unrepresentative of contracts between sophisticated parties. Additionally, the contracts studied were all filed with the SEC, which has “opposed the use of arbitration to resolve disputes between public corporations and shareholders.” By focusing on contracts not likely to have arbitration agreements and leaving out those likely to contain them, the 2007 study “likely significantly understates the use of arbitration clauses in contracts between sophisticated parties.”

Finally, the authors explain how the 2008 study also used an unrepresentative sample. The authors describe the study as “a comparison of the types of business contracts least likely to include arbitration clauses (material contracts) to the types of consumer contracts most likely to include class arbitration waivers in their arbitration clauses.” The 2008 study looked at credit card and cell phone contracts, which are very likely to have arbitration clauses and class action waivers, according to data from the American Arbitration Association. In contrast, contracts for car or mobile home sales, with home builders, real estate brokerage agreements, and single casualty insurers had much different occurrences of class action waivers. Professors Drahozal and Ware assert that perhaps the 2008 study shows “that the industries they studied use arbitration clauses to reduce their exposure to class actions,” but not that “the concern over class actions” explains “the prevalence of arbitration clauses in consumer agreements.”

The professors conclude that interpreting the 2007 and 2008 studies to show that sophisticated parties prefer litigation over arbitration and that concern over class actions is the main reason for prevalence of arbitration clauses in consumer contracts is simply not justified.

*Article Summary written by Amanda McNeil, Class of 2010.