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Non-signatory bound by agreement to arbitrate

In a recent federal case, Southern Illinois Beverage Inc. v. Hansen Beverage Co., 2007 WL 3046273 (S.D. Ill., Oct. 15, 2007), the court held that a non-signatory to a contract that contained an agreement to arbitrate could be bound by the arbitration requirement. Normally, only a party to an agreement to arbitrate is bound by the arbitration provision. However, there are several exceptions to this rule: (1) assumption; (2) agency; (3) estoppel; (4) veil piercing; and (5) incorporation by reference.

In this case, SIB claimed benefits under a contract between Hansen and a third party. That contract contained a broad form arbitration provision. This third party granted SIB the right to distribute a beverage in a six-county area. When Hansen terminated the subcontract, the distribution right was affected and SIB sued Hansen. Hansen demanded arbitration, but SIB argued that it was not bound by the arbitration clause. The court disagreed. A party cannot rely on the contract when it works to its advantage, and repudiate it when it works to its disadvantage.

Finality in the Initial Decision under the 2007 A201

One of the new provisions of the 2007 AIA Documents is the establishment of an Initial Decision Maker. See Section 15.2 of AIA Document A201. In the past, this role was fulfilled by the architect, but there were often problems with this setup. Many contractors, justifiably or not, believed this to be a conflict of interest for the architect. This new provision, if implemented by the parties (the owner and contractor), calls for a third-party neutral to be named in advance and to make preliminary decisions concerning disputes between the owner and contractor. If no one is named, then the architect undertakes this role by default.

Buried within the various paragraphs that discuss how this will work, is an opportunity for owners to limit future litigation if done properly. Here is the relevant paragraph:

§ 15.2.6.1 Either party may, within 30 days from the date of an initial decision, demand in writing that the other party file for mediation within 60 days of the initial decision. If such a demand is made and the party receiving the demand fails to file for mediation within the time required, then both parties waive their rights to mediate or pursue binding dispute resolution proceedings with respect to the initial decision.

What this contemplates is that an initial decision will be made by the Initial Decision Maker (either the architect or a third party) concerning a dispute between the owner and contractor. Most of these disputes will likely revolve around changes or extras to the contract. Often, the contractor will make a claim for additional money that will be the subject of such an initial decision. Once that initial decision is made, under most circumstances, nothing else will happen until the conclusion of the project, when the unhappy party (most likely the contractor) will aggregate all of these decisions and begin the final claims process consisting of mediation first, followed by either arbitration, if selected, or litigation (the default). The more of these unsuccessful claims there are, the more likely it is that the contractor will pursue litigation to obtain relief after the conclusion of the project.

However, if the owner is aware of Section 15.2.6.1, he can, effectively, cut off such future litigation by making a 30 day demand. Under this procedure, within 30 days of the date of an initial decision, the party in whose favor the decision is made can file a written demand with the other party to commence mediation within 60 days after the date of the initial decision. The failure to commence mediation (this would be done by filing a written demand for mediation with the American Arbitration Association) within this time period cuts off that particular claim and waives it for all future purposes.

Of course, this theoretically works the other way, with a decision in favor of the contractor by the Initial Decision Maker, followed by a 30 day written demand by the contractor served on the owner to commence mediation. If the owner fails to commence mediation within 60 days, the initial decision is final and, presumably, a change order to reflect that would be processed by the architect. In most cases, it can be assumed, this will not work in favor of the contractor, since most claims are by the contractor against the owner, not the other way around.

The parties, and their attorneys, should be aware of this powerful tool. While this is similar to Section 4.4.6 of the 1997 version of A201, this does not require any special language in the initial decision itself. The burden is on the parties to invoke this for their own benefit.

The new AIA Documents and Arbitration - What Rules Apply?

One subtle change in the new 2007 AIA documents involves the incorporation of the Rules of the American Arbitration Association into the agreement, assuming that arbitration is selected as the dispute resolution method. For example, AIA Document B101, Owner-Architect Agreement, states:

§ 8.3.1 If the parties have selected arbitration as the method for binding dispute resolution in this Agreement, any claim, dispute or other matter in question arising out of or related to this Agreement subject to, but not resolved by, mediation shall be subject to arbitration which, unless the parties mutually agree otherwise, shall be administered by the American Arbitration Association in accordance with its Construction Industry Arbitration Rules in effect on the date of this Agreement.

The end of this sentence sets the applicable rules as those "in effect on the date of this Agreement," at least according to the AIA, and this does appear to be what this says. However, if one reads the AAA rules, the very first rule of the AAA reads as follows:

R-1. Agreement of Parties

(a) The parties shall be deemed to have made these rules a part of their arbitration agreement whenever they have provided for arbitration by the American Arbitration Association (hereinafter AAA) under its Construction Industry Arbitration Rules. These rules and any amendment of them shall apply in the form in effect at the time the administrative requirements are met for a demand for arbitration or submission agreement received by the AAA. . . .

Thus, the AIA agreement incorporates this, and other, rules into the agreement. Note that Rule 1 states that the rules that apply are the ones "in effect at the time the administrative requirements are met for a demand for arbitration..." Thus, the rules that will govern the arbitration are not necessarily the ones in effect on the date of the Agreement, but the ones in effect at the time the arbitration is filed with AAA.

One might argue that the AIA agreement trumps Rule 1, but the reverse is true. The AIA document incorporates the AAA Rules, which specify which actual rules will apply. The AIA document does not change that, although a more careful drafting of the above-quoted language could have done so.

So what, you might ask. Do the Rules ever change? Absolutely! Several years ago, the AAA instituted "consumer-friendly" rules. These were intended to apply to situations involving consumers and shifted most of the costs to the business. For instance, if a small architect or contractor were doing work for Michael Jordan (this is an example only, because he is very wealthy. I am not picking on him) on his multi-million dollar residence. Suppose that a dispute developed and a massive arbitration ensued. Under those rules (since changed, because of the ensuing uproar), the owner’s share of the fees was capped at less than $500, while the contractor or architect might have paid tens of thousands of dollars! Because of the ensuing outrage over this, the rules were again revised, but there is no telling when the rules may again be amended to the detriment of architects or contractors.

If the parties truly want the rules that are in effect as of the date of the agreement to be applicable, the standard AIA language needs to be tweaked. Since we are not giving legal advice, we will not make a suggestion, but any competent construction attorney should be able to structure something that will work.

New AIA documents and Arbitration

Much is being written about the 2007 AIA Documents, which were released in early November. One of the much-discussed differences in these documents is the fact that arbitration is no longer the default dispute resolution mechanism, being replaced by a "check-box" system whereby three options are provided: arbitration, litigation and "other." If none of the boxes is checked, then litigation is the default mechanism, following mandatory mediation.

It was with great interest that I opened the new documents using the AIA's Electronic Documents software system. I immediately printed out several of the new documents, including various owner-architect agreements and an owner-contractor agreement. At this point, I had not filled in anything. I was, therefore, astonished to find that the "arbitration" box had been checked on all of the documents where that option appeared. Thinking that I had made some type of mistake, I again started a brand new document and made sure not to check anything.  Once again, the arbitration choice was checked.

I mentioned this to several other people, one of whom apparently has a friend that worked on the electronic version of the documents, and I was informed (this was third or fourth-hand) that the reason this had occurred was that one of the boxes had to be initially checked in order to make the program work, and that the AIA did not favor arbitration. (note that I did not actually speak to this person directly, so I can't vouch for what was actually said). After thinking about this for about half a second, I realized that they could just as easily have selected the "litigation" check box as the one that was initially selected by the software, particularly as that choice is supposed to be the default.

The reason I bring this up is not to blame the AIA for anything. After all, arbitration was the preferred method in the AIA documents for decades. And, the paper documents do not have anything pre-checked. However, most users today are using the electronic documents and may not be aware that they actually need to check the litigation box if that is what they intend. If they just read the articles that claim that litigation is the automatic "default," they may not even look at this provision when drafting the documents if they actually want to have litigation as the real default. They may be surprised years later to receive a demand for arbitration. If they are attorneys, they may be open to a claim for legal malpractice if their client insisted on not using arbitration and they relied on the "default" litigation story.

Perhaps the real lesson is to always read every word of every contract.

Optional Arbitration clause

In Higley v. N/S Corporation, 2006 WL 985753 (6th Cir., April 17, 2006), the contract contained this arbitration clause:  “Should [N/S] and [Higley] be unable to resolve said dispute(s) through mediation, any and all dispute(s), at the sole discretion of [Higley], shall be decided by arbitration in accordance with the Construction Industry Arbitration Rules of the American Arbitration Association." Higley filed suit and N/S sought to compel arbitration. The trial court denied the motion to compel and the Sixth Circuit affirmed, finding that a contract that gives one party the option to pick either arbitration or litigation will be upheld.

Termination of contract bars arbitration

Thanks to the Construction Owners and Builders Law Blog for this case. In Aberdeen Golf & Country Club v. Bilss Construction, the owner terminated the contractor prior to completion of a $2 million project. The contractor filed suit and the owner demanded arbitration pursuant to the parties' AIA contract. The  court held that termination of the contract terminated the arbitration provision, or, alternatively, that there had been a waiver.

The arbitration provision is interpreted and enforced as a part of a contract and does not stand on its own. If the contract is repudiated, the repudiating party cannot avail itself of the very contract it has repudiated. This certainly makes sense, but appears to be at odds with the majority of the courts that want to enforce arbitration at any cost.

California: No contractual jury waiver

The California Supreme Court, on August 4, 2005, in Grafton Partners v. Pricewaterhousecoopers, held that a waiver of a right to a jury trial contained in a contract was not enforceable. The California Constitution states:

Trial by jury is an inviolate right and shall be secured to all, but in a civil cause three-fourths of the jury may render a verdict. A jury may be waived in a criminal cause by the consent of both parties expressed in open court by the defendant and the defendant’s counsel. In a civil cause a jury may be waived by the consent of the parties expressed as prescribed by statute.

The applicable statute lists 6 grounds for waiving a jury trial, none of them including a pre-dispute contractual provision. An attempted analogy to agreements to arbitrate failed because arbitration is permitted by statute, and because an agreement to arbitrate means that the parties are not submitting their controversey to a court of law in the first instance. The court held that, "unless the legislature prescrives a jury waiver method, we cannot enforce it."

The court also reviewed the laws of other jurisdictions, noting that New York enforces predispute jury waivers and that the applicable California statutes were modeled on New York law, but declined to follow New York.

The concurring opinion noted that only one other supreme court -- Georgia -- would not allow predispute waivers of a right to a jury.

These types of waivers are usually seen in contracts where there is a disparity in bargaining positions. Often, these are take-it-or-leave-it propositions. It will be interesting if courts in other states continue to side with the big corporations or help the little guy by adopting this California approach.

No Arbitration for Aesthetic Effect

A recent South Dakota case, Flandreau Public School District v. GA Johnson, 2005 WL 1663791 (July 13, 2005) held that, because of certain provisions found in AIA Document A201, the General Conditions, the contractor could not enforce the mediation and arbitration provisions of the contract. A dispute arose over the appearance of the interior walls of the building and the school sued the general. When the general moved for ADR, the court found that, because the dispute concerned aesthetics, the mediation and arbitration provisions did not apply, based on the following provision:

4.5.1 Any Claim arising out of or related to the Contract, except Claims relating to aesthetic effect ... shall be subject to mediation as a condition precedent to arbitration or the institution of legal or equitable proceedings by either party.

The court held the dispute primarily revolved around issues of aesthetics, thereby triggering the exception. The case apparently will be decided by the trial court instead of an arbitrator. However, nowhere in the decision is another provision of A201 set forth:

4.2.13 The Architect’s decision on matters relating to aesthetic effect will be final if consistent with the intent expressed in the Contract Documents.

This provision would seem to render the entire case moot if the architect made a decision on the claim. It was unclear as to whether the architect in this case actually rendered a decision on the aesthetic issues. It is likely other courts would not follow this case since arbitration is overwhelmingly favored and the exception would do away with arbitration of potentially significant issues. The AIA provision concerning aesthetic effect is not directed at major issues—rather, it is intended for smaller, aesthetic issues that involve little or no money. Of course, A201 does not make this clear. One option for architects is to simply eliminate this exception from the AIA document, thereby taking themselves out of these controversies.

Supreme Court Revisits Prima Paint

On June 20, 2005, the United States Supreme Court agreed to hear the Florida case of Buckeye Check Cashing Inc., v. Cardegna (04-1264).  The Florida Supreme Court's decision in that case will be reviewed in which that court determined that the court, not the arbitrator, must initially determine the validity of an arbitration clause in a contract alleged to be illegal. This is an opportunity to have this issue cleared up, since courts have treated this issue in different ways. If the underlying contract itself is invalid or illegal, then why should an arbitration clause in that contract be upheld?

Arbitrator's Change of Award Upheld

The Colorado Supreme Court upheld an arbitrator's changed award as a clarification in Sooper Credit Union v. Sholar Group Architects (June 13, 2005). The arbitrator held for the petitioner, but the award was internally inconsistent. When the award was issued, the petitioner asked the court to order the arbitrator to correct the award, and the respondent asked for confirmation. The court sent the matter back to the arbitrator who corrected the award. The initial error was not apparent from the face of the award. Initially, the arbitrator had awarded the Respondent some $200,000. The corrected award was for $223,000 in favor of the Petitioner, a swing of over $400,000.  The trial court confirmed the award. Respondent appealed, arguing that the arbitrator exceeded his authority by modifying the initial award and redetermining the merits. The appellate court reversed. The Colorado Supreme Court reversed and reinstated the amended award. An ambiguity need not be apparent on the face of the award, and it is up to the arbitrator to determine if an ambiguity exists. This was not a redetermination of the merits.