Negotiating Real Estate Arbitration Provisions

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There is a growing trend in the real estate industry to include binding arbitration clauses in leases, purchase agreements, financing documents, joint venture agreements, construction contracts, architects’ agreements and other real estate agreements due to the perceived benefits of arbitration. Because of the increased use of arbitration clauses in real estate agreements, it is important for real estate professionals to have an understanding of the arbitration process as well as an understanding of the advantages and disadvantages of resolving disputes by arbitration. By understanding the mechanics of the arbitration process, one can effectively manage and minimize the cost of dispute resolution and avoid much of the distractions such disputes often cause.


A party to a real estate agreement can always choose to resolve a dispute through arbitration once it arises and, at the time of the dispute, tailor the arbitration provisions to best serve its purposes. Unfortunately, once a dispute has arisen, the parties are less likely to agree to resolve their dispute through arbitration since one party often perceives that its interests may be better served by resolving the dispute through litigation.


While the parties are more likely to agree prospectively to resolve disputes by arbitration, it is important that one determine, at the time the real estate agreement is being negotiated, the types of disputes that might arise under the real estate agreement, the types of disputes appropriate for resolution by arbitration, and the types of arbitration provisions which will best serve one’s interest. The failure to carefully consider the nature and scope of the arbitration clause at the time the real estate agreement is negotiated may result in disagreements over the intent of the arbitration clause, disputes over the scope of the arbitration or the applicable arbitration procedures, arbitration of disputes the parties never expected to be resolved by arbitration or arbitration awards which are inconsistent with the resolution that most likely would have been attained through litigation.


There are many disputes that should not be resolved by arbitration. For instance, unlawful detainer disputes should not be resolved through arbitration. Similarly, it may be inappropriate for joint ventures to arbitrate business disputes that are so fundamental to the joint venture that it may be better to terminate the joint venture than arbitrate the dispute.


Even where a dispute is susceptible to resolution by arbitration, one party may prefer to have the dispute resolved by litigation. For example, while some landlords prefer to resolve as many disputes by arbitration as is feasible due to the savings in dispute resolution costs, others prefer to resolve disputes by litigation because of the perception that the low cost of arbitration encourages tenants to seek dispute resolution for minor concerns, or worse, use the arbitration process to harass a landlord into granting rent concessions.


When the parties prospectively agree to resolve a dispute by arbitration, the parties should tailor the arbitration clause for each type of potential dispute. Thus, the arbitration clause in a construction contract may include different arbitration provisions for different types of disputes. For example, while it may be appropriate to have a lawyer arbitrate a dispute relating to an indemnity provision, an engineer should arbitrate whether shop drawings are accurately dimensioned. In the lease context, an appraiser is best suited to determine the fair market rent for an option term, but an attorney is probably best suited to resolve a dispute as to the intent of a lease provision.


How one modifies the arbitration clause for each potential dispute may determine how successful one will be in managing and minimizing future dispute resolution risks. More often than not, thoughtful management of such risks will result in the inclusion of several different arbitration provisions in a single real estate agreement so that each type of dispute can be resolved in a timely and cost effective manner.


Valuation disputes are a type of dispute susceptible to inexpensive and speedy resolution through the use of specialized arbitration procedures. Such disputes typically involve a lease which contains a renewal option in which the rent payable during the option term is based on the fair market rent of the premises or purchase options in leases or option agreements in which the purchase price will be based upon the fair market value of the property.


The resolution of these disputes is susceptible to specialized arbitration procedures due to the availability of arbitrators who have a detailed knowledge of the rents paid and concessions received by other tenants for comparable space, or prices paid by purchasers of comparable properties. By having disputes resolved by expert arbitrators rather than a judge interpreting expert testimony, the parties frequently will resolve their disputes much faster by arbitration and at a much lower cost.


Typically, the expert in the valuation dispute is either a real estate broker or an appraiser (often an appraiser who has earned an MAI designation from the Appraisal Institute or a similar designation from similarly recognized appraiser organizations). Some real estate professionals prefer that valuation arbitrators be MAI appraisers because MAI appraisers are recognized as having a superior level of valuation skill and because of the ethical constraints by which MAI appraisers are bound.


Other real estate professionals prefer to use real estate brokers to resolve valuation disputes because real estate brokers’ day-to-day involvement in the market tends to give them a better firsthand knowledge of current values. This enables real estate brokers to render arbitration decisions quickly (and before the valuation analysis becomes stale). This may further minimize the cost of resolving the dispute by arbitration. And, if the arbitration uses the “baseball arbitration approach,” the requirement that the arbitrator choose one of two awards submitted by the parties minimizes any concern pertaining to the lack of precision of analysis by the real estate broker.


In negotiating the valuation provisions pertaining to the determination of fair market rent or fair market value, one should consider whether it is more appropriate to use conventional arbitration procedures, to include a “baseball arbitration” provision or some other specialized procedures. In conventional arbitration, both parties present their case and the arbitrators decide on the appropriate result. Unfortunately, there is a tendency for arbitrators to concentrate their efforts on reaching a compromise award rather than reaching a “correct” award. As a result, the parties often submit high ball and low ball valuation proposals. The tendency of the parties to submit high ball and low ball proposals may also sour the relationship between the parties, thus inhabiting future cooperation.


The submission of high ball and low ball valuation proposals in turn encourages the arbitrators to reach compromise awards. The tendency of the arbitrators to “split the baby” is especially great when the arbitrators are experts in a particular field (as opposed to professional arbitrators) because those arbitrators may fear that reaching a result in which one of the parties is a clear and convincing loser would adversely affect the arbitrators’ ability to perform both arbitration and non-arbitration business in the future.


Baseball arbitration (so named because of its use by major league baseball to resolve disputes over players’ salaries) requires each side to submit what it believes to be the proper outcome of the valuation dispute. A neutral arbitrator is then required to pick the value submitted by the party that is closer to the arbitrator’s independent determination of the proper value. Because baseball arbitration prohibits an arbitrator from reaching a compromise award, the party that submitted the more reasonable valuation proposal is rewarded. The all or nothing nature of baseball arbitration encourages the parties to submit reasonable valuation proposals (as opposed to high ball or low ball valuation proposals). This frequently results in the difference between the party’s valuation proposals being small enough that the dispute can be resolved without the need for arbitration.


Some real estate professionals dislike the use of baseball arbitration provisions where one wants to eliminate the risk that one will be a clear loser. Where one’s primary goal is to avoid a dramatically unfavorable arbitration award, one can modify conventional arbitration provisions to insure a “split the baby” outcome. For example, one can require that three estimates of value be prepared and that all estimates of value which are not within a certain percentage (for example 10%) of the middle estimate be disregarded. The remaining estimates of value will then be averaged.


Whether one chooses conventional arbitration, baseball arbitration or a “split the baby” arbitration depends on one’s tolerance of the potential risks of each approach. However, no matter which approach one prefers, the use of valuation experts as arbitrators is important for reducing the cost and duration of the arbitration.


For disputes relating to the determination of fair market rental or fair market value, it is important to have an appraiser or real estate broker serve as the arbitrator in a dispute. For other types of disputes, the appropriate arbitrator may be an engineer, an architect or a lawyer. For example, if the parties prefer that disputes relating to the construction of a building or tenant improvements be resolved by arbitration, the appropriate arbitrator probably is an architect, engineer, or contractor. Although the factual issues involved in these types of disputes may be less clear cut than in disputes related to fair market rent or fair market value, the time and cost saving benefits of resolving a construction related dispute quickly may be so important and even the loser of an expedited arbitration is better off in the long run than if the losing party had litigated the dispute and won.


In addition to factual disputes, the parties may also prefer to use arbitration to resolve disputes regarding the interpretation of a term or provision of the real estate agreement. In this instance, the most appropriate arbitrator often will be a real estate attorney. By specifying that the arbitrator have experience in real estate law, the parties can minimize the expense required to educate the arbitrator with respect to common real estate practices and understandings.


Similarly, where a lease prohibits a tenant from subletting or assigning the tenant’s interest in the premises without first obtaining the prior consent of the landlord and the landlord is prohibited from reasonably withholding the landlord’s consent, the tenant may want the ability to arbitrate, on an expedited basis, the question of whether the landlord’s denial of consent is reasonable. Otherwise, the tenant’s only remedy is to challenge the landlord’s withholding of consent in court. Although the tenant may ultimately prevail in court, the prospective sublessee or assignee will most likely have found substitute space.


When negotiating an arbitration clause in a real estate agreement, one should not just consider the types of disputes subject to arbitration and the qualifications of the arbitrators. Among the other provisions one should also consider include whether disputes of related matters should be arbitrated in one arbitration, the number of the arbitrators, the method of selecting the arbitrators, the powers of the arbitrators, the information the arbitrators may consider during their deliberations, the types of relief the arbitrators may grant, and the finality of the arbitration award. While the consideration of these provisions is relevant to valuation disputes, it is particularly important for non-valuation disputes.


An important provision to consider including in an arbitration clause where it is possible that there will be multiple parties and multiple claims (typically a construction contract) is the requirement that a single arbitration be used for resolving all claims relating to the transaction. This allows the arbitrators to resolve all common claims at once, saves time and money, and avoids the possibility of conflicting outcomes.


Another issue to be considered when drafting an arbitration clause is the appropriate number of arbitrators. Depending on the type of dispute, the parties may prefer to have a single neutral arbitrator to minimize the cost of the arbitration. Some real estate professionals prefer arbitration provisions which allow each party to select its own arbitrator and let the party appointed arbitrators select a neutral third arbitrator. The purpose for this is to allow the party appointed arbitrators to serve as advocates for the party who appointed them, thus minimizing the need for expert witness and attorney involvement. However, the use of party appointed arbitrators may result in two hearings: the first in which the parties present their cases to the arbitrators, and a second, held in private, in which the party appointed arbitrators re-argue the case to the neutral arbitrator.


Since the arbitration will be resolved by a neutral arbitrator, the fairness of the process by which that neutral arbitrator is selected is vitally important. A variety of methods can be used for the selection of the neutral arbitrator. In any event, the neutral arbitrator should be required to disclose any circumstance likely to affect its impartiality, such as bias, any financial or personal interest in the outcome of the arbitration, or any past or present relationship with the parties.


The arbitration clause should specify and limit the powers of the arbitrators, the types of information the arbitrators may consider during their deliberations, and the types of relief the arbitrators may grant. For example, one party may want to preclude the arbitrators from awarding specific performance or punitive damages.


Finally, the arbitration provision should specify that the award is final and binding on the parties. The arbitration provision should further specify whether the arbitrators are to deliver a written opinion. Some real estate professionals prefer including a provision prohibiting the arbitrators from specifying the basis for the award so as to make it very difficult to appeal the award. Others prefer to require the arbitrators to issue findings of fact and a statement of the legal basis for the award with the understanding that the arbitration award will not be binding or enforceable if the arbitrators incorrectly apply applicable laws. While this approach provides the parties with a remedy if the award is clearly erroneous, the arbitration will then be susceptible to legal challenge.


In conclusion, when negotiating a real estate agreement, one should consider all of the potential types of disputes which can arise under the agreement and consider which disputes, if any, might be resolved faster and cheaper by arbitration. Further, once one identifies the types of disputes for which arbitration might be appropriate, one should further determine whether separate arbitration procedures should be used for different types of disputes. By going through this analysis, one can affectively “manage” the potential costs of dispute resolution and reduce the distractions disputes inevitably cause.