Big Risks and Disadvantages of Arbitration vs. Litigation

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1 Big Risks and Disadvantages of Arbitration vs. Litigation Aaron Foldenauer, Corporate Counsel July 29, 2014 Three recent high-profile arbitral awards highlight the risks of arbitration and demonstrate that, contrary to widespread belief, arbitration is often not cheaper, faster or more predictable than litigation. These three awards, as well as emerging trends in arbitral proceedings, call into question the common practice among corporations of including contractual provisions mandating arbitration in the event of any disputes. In May of this year, in arbitration proceedings that have been pending for nearly eight years involving a patent license agreement between the technology companies Amkor Technology and Tessera Technologies, Tessera was awarded $145 million. And this was on top of $64 million Amkor had already paid to Tessera in connection with a prior, related ruling. These adverse awards far exceeded even Amkor s publicly disclosed worst-case estimates of its possible exposure. The Amkor proceedings present a recent example of the delays, costs and unpredictability often associated with arbitration. But they are by no means a worst-case scenario. The dangers of arbitration hit two prominent retail corporations on a far greater scale.

2 Specifically, Starbucks Corporation and Tiffany & Co. were recently on the wrong side of decisions by arbitrators who imposed massive awards against each awards that were expected by neither management nor by shareholders. Coffee giant Starbucks lost an arbitral award totaling $2.76 billion, including $527 million in interest and legal fees, to Kraft Foods Group Inc. in connection with a dispute related to the termination of an agreement that allowed Kraft to distribute Starbucks coffee in grocery stores. Even for a successful corporate stalwart like Starbucks, the size of the arbitral award was of enormous significance. Starbucks net profits for the years 2011 and 2012 were $1.2 billion and $1.4 billion, respectively. Thus, standing alone, the award wiped out two years worth of Starbucks profits. And late last year, jeweler Tiffany lost $449.5 million, plus interest, costs and attorney fees, in an arbitral proceeding to Swatch SA concerning a failed partnership in which Swatch was to develop watches for Tiffany s brand. Tiffany s loss surpassed the profits it had earned during all of As is commonly the case in arbitrations, neither Tiffany nor Starbucks apparently has the ability to effectively appeal the decisions, and in fact, Starbucks was forced to issue $750 million of additional debt to help raise money to satisfy the adverse award. That risk-averse, well-represented corporations would willingly put such large sums of money in the hands of ultimately unaccountable arbitrators, whose decisions are almost always nonappealable, is surprising. The instinctive decision to do so should be revisited. This is particularly so given that the oft-touted benefits of arbitration that it is cheaper, faster and more predictable than litigation are routinely untrue in practice. In fact, the disputes that caught Starbucks, Tiffany and Amkor off guard each have taken years to resolve, caused each side to incur significant legal fees and yielded unpredictable results. Arbitration Is Problematic for Risk-Averse Corporations That these three major corporations were taken aback by the size of the awards may surprise those, including many corporate in-house counsel, who believe that arbitration is inherently more predictable than litigation. Although corporate defendants are often concerned about runaway juries in the context of cases in which there is a sympathetic victim, in contractual and other business-related disputes juries may, in fact, be less likely than an arbitrator to award unreasonable damages or issue an unexpected, highly lopsided verdict. In other words, in connection with business-related disputes, an experienced arbitrator in the industry may be more inclined than a jury to view the parties conduct in black-and-white terms and thus rule in a way that overwhelmingly favors one side over the other. Indeed, the arbitrator in the Kraft-Starbucks dispute apparently did precisely that. In that dispute, Kraft asserted that it was owed $2.9 billion, plus attorney fees. The arbitrator ultimately awarded Kraft a total of $2.76 billion, thus giving Kraft just about everything it wanted. In other words, after considering the underlying agreements and the parties positions, the arbitrator read the contract and calculated damages in a way that essentially mirrored Kraft s demands.

3 One-sided awards in arbitration underscore what are ultimately larger concerns for risk-averse corporations: The absence of meaningful checks and balances in arbitration proceedings and the extraordinarily wide latitude that arbitrators have in rendering decisions. For instance, arbitrators have broad discretion to decide disputes and may disregard the factual evidence presented by the disputing parties. Furthermore, unlike judges and juries, arbitrators are typically unconstrained by statutes, case law or the rules of evidence. The consequence is that an arbitrator s subjective notion of fairness in a given case can easily translate into a lopsided award against the losing party, even when the facts and the law are on the losing party s side. For risk-averse companies seeking some semblance of predictability concerning their legal affairs, the very nature of arbitration which some have called ad hoc justice, given the lack of accountability and predictability renders arbitration a highly precarious prospect. To be sure, the fact that some parties are less successful than others says little about the intrinsic merits of the process. After all, the results of arbitration were favorable for Tessera, Kraft and Swatch, the prevailing parties. The difficulty is that, for companies looking to manage their business and legal risks, it is impossible to know, ex ante, on which side of the win-lose column they will ultimately end up following an arbitration and how much it will cost them if they end up on the wrong side. Arbitration Is Often More Expensive Than Litigation It is routinely argued often without empirical support that arbitration is cheaper than litigation. Although litigation can be costly, many of the costs incurred in litigation are also incurred in arbitration, and additional costs are incurred during the course of a typical arbitration to pay for what is essentially a private judicial system. The Tiffany-Swatch arbitration provides concrete evidence of the often-significant costs associated with arbitration. Not only was Tiffany required to pay the $449.5 million award, plus interest, to Swatch, but Tiffany was also required to pay two-thirds of the cost of the arbitration and two-thirds of the reasonable attorney fees and expenses incurred by Swatch. As a publicly listed U.S. company, Tiffany publicly disclosed these amounts, lifting the veil on how both attorney fees and forum costs (including arbitrator fees) can be surprisingly high in arbitration proceedings. Swatch alone incurred approximately $13.3 million in reasonable attorney fees, costs and other expenses (of which the arbitral panel required $8.8 million to be paid by Tiffany). For an arbitration that lasted less than three years, $13.3 million in attorney fees and related expenses is striking, particularly in comparison to reported legal fees in complex litigations in federal court. For example, patent litigations which are among the most complex litigations that are adjudicated in federal court are often reported to result in legal fees averaging approximately $4 million to $5 million per side through trial. The amount of legal fees that Swatch incurred in arbitration a supposedly cost-effective venue was more than twice that of the average total fees for patent litigation in federal court, again showing that the common contention that arbitration is inexpensive is often plain false. Indeed, features of arbitration that once may have made it a less-costly alternative to litigation

4 are increasingly a thing of the past. In many arbitrations today, for instance, discovery is as common as it is in litigation, increasing both the cost of arbitration and the time required to complete it. And recalcitrant parties to an arbitration can often employ dilatory and other tactics that result in significant attorney fees to both sides as the parties spar over procedural and other issues. In contrast, many courts and judges have established, routinely enforced rules that parties must follow and which are not subject to challenge. But in arbitrations, more flexible rules often apply, which give litigious parties and their attorneys more things to argue about, thus further increasing the cost of arbitral proceedings. Furthermore, litigations often can be dismissed at a preliminary stage, such as decisions on motions to dismiss or motions for summary judgment, but such preliminary determinations are less-frequently used in arbitration. On top of attorney fees, the parties to an arbitration must pay fees to the arbitral tribunal and to the arbitrators themselves. In the Tiffany-Swatch arbitration, the costs of the arbitration, which was heard by a panel of three arbitrators pursuant to the rules of the Netherlands Arbitration Institute, totaled $1.2 million ($800,000 of which was paid by Tiffany). In comparison, had the parties used a court in the United States, these costs would have essentially been nonexistent, given that courts and judges are paid for by the public. Indeed, a 2013 study described in the Global Arbitration Review found that costs for the arbitrators themselves and the arbitral tribunal with respect to one type of arbitral proceeding have risen by 56 percent in just the past eight years. Contributing to the growing cost of arbitration is the fact that unlike in litigation, for which judges are appointed to preside over a case, in an arbitral proceeding the parties will first have to decide on mutually acceptable arbitrators, which often takes time and runs up the attorney fees of the parties. Once an arbitrator is agreed upon, the parties then have to pay for their services. Since arbitrators are often top lawyers or retired judges with steep hourly rates, this is almost always a significant expense. Concerns about the costs of arbitration and the time it takes to arbitrate disputes are not limited to high-stakes and international arbitrations. A 2012 study of single-plaintiff cases found that, on average, arbitration is significantly more expensive than litigation and results in each side s incurring significantly higher attorneys fees. The study found that even in these less prominent cases, the average attorney fees incurred by parties in arbitration were 25 percent greater than those incurred in equivalent litigation. Factoring in total cost and outside counsel fees, arbitration was 31 percent more expensive than litigation in these small-scale cases. In fact, corporate clients are beginning to appreciate the potential costs involved in arbitrating disputes. A 2013 survey by PricewaterhouseCoopers found that the top two reasons corporations avoid arbitration were the costs and the delays associated with arbitration. The Bottom Line Despite the disadvantages of arbitration, there always will be circumstances under which arbitration is preferable and perhaps even required. For example, an arbitral proceeding may be the only venue in which a party can secure an enforceable judgment against the assets held by a counterparty in a given country. The fact remains, however, that even as arbitration can, in theory, offer some advantages over litigation, in practice it is often an inefficient method of dispute resolution. Arbitration, despite its promise of efficiency, often drags on for years and

5 results in substantial fees and costs which can add up to more than the parties would have spent in traditional litigation. Most worryingly, for companies seeking to effectively manage their legal risks, arbitration places their financial fortunes in the uncertain hands of arbitrators bound by only their own sense of the proper outcome, and which may have only a tenuous connection to the law. The lesson for corporate parties is that, instead of agreeing to arbitrate disputes as a matter of course, they should carefully consider whether arbitration will actually be beneficial in a particular instance. As companies like Amkor, Starbucks and Tiffany have discovered, the downsides of choosing arbitration can be significant indeed. Aaron Foldenauer is a senior attorney at Chadbourne & Parke. As a litigator in the firm s intellectual property group, he represents clients in connection with litigations, transactions and investigations that involve complex technical issues spanning a vast array of subject matters. He can be reached at [email protected]. (He has not represented any of the companies mentioned in this article.)