Specs and the Single Arbitration Clause

Thomas W. Lyons

[Reprinted by permission from "The Business Suit," the newsletter of the Defense Research Institute's Business Litigation Committee].

Many businesses prefer to resolve commercial disputes through arbitration rather than a trial. They include in their transaction forms a provision requiring arbitration of all disputes arising from the transaction. For example, a form may say "This contract is subject to all the terms and conditions printed on the reverse side." The back of the form will typically include a clause such as:

Arbitration: Any controversy arising under, or in relation to, this contract shall be settled by arbitration. If the parties are unable to agree respecting the time, place, method or rules of the arbitration, then such arbitration shall be held in the City of New York, in accordance with the laws of the State of New York and the rules of the American Arbitration Association.

However, other businesses do not include such a provision and may prefer to avoid arbitration, generally or selectively.

Typically, these two views will clash when one business sends out a standardized form specifying goods or services it offers to purchase. The seller sends back its standardized form agreeing to fill the order, oftentimes with the goods requested. The so-called "battle of the forms" can occur when the parties' pre printed terms and conditions, including arbitration provisions, are not in complete agreement. The documents rarely mirror each other, however, many business people do not pay much attention until the deal goes sour. See, Ionics, Inc. v. Elmwood Sensors, Inc., 110 F.3d 184, 189 (1st Cir. 1997)("The reality of modern commercial dealings....is that not all participants read their forms."). The question then arises whether the party which prefers arbitration can enforce its clause.

The Supreme Court has held that the Federal Arbitration Act, 9 U.S.C. §1, et seq., preempts any state statute which imposes special requirements on the enforceability of arbitration clauses. Doctor's Associates, Inc. v. Casarotto, 517 U.S. 689, 116 S.Ct. 1652 (1996). State laws which apply generally to all contractual provisions are not preempted. Id. The Act does not address whether a unilateral arbitration clause becomes part of the parties' agreement. State commercial law decides the issue.

Most courts hold under the Uniform Commercial Code that if the initial written specification or similar offer contains an arbitration clause, it becomes part of the contract unless the offeree explicitly rejects it. See, e.g., Southeastern Enameling Corp. v. General Bronze Corp., 434 F.2d 330, 333-34 (5th Cir. 1970); Polyclad Laminates, Inc. v. Vits Maschinenbau Gmbh, 749 F.Supp. 342, 345 (D.N.H.1990). However, if only the offeree's written acceptance contains an arbitration clause, the clause does not necessarily become part of the bargain.

Article 2 of the Code devotes Section 207 to this question. It provides in part:

(1) A definite and seasonable expression of acceptance or a written confirmation which is sent within a reasonable time operates as an acceptance even though it states terms additional to or different from those offered or agreed upon, unless acceptance is expressly conditional on assent to the additional or different terms.

(2) The additional terms are to be construed as proposals for addition to the contract. Between merchants such terms become part of the contract unless:

(a) the offer expressly limits acceptance to the terms of the offer;

(b) they materially alter it; or

(c) notification of objection to them has already been given or is given within a reasonable time after notice of them is received.

U.C.C. §2-207. Thus, in the usual course, an arbitration provision in the acceptance becomes part of the contract when the offeree expressly conditions its acceptance on inclusion of the clause or when the clause is not considered a "material" alteration.

If, as sometimes happens, both parties' forms state the transaction depends on the other's acceptance of their terms or there are explicitly conflicting provisions, then "[t]he contract....consists of the terms originally agreed to, terms on which the confirmations agree, and terms supplied by [the UCC], including subsection 2 [of Section 207]." Official Comment 6. Accordingly, under either of these two scenarios, whether a unilateral arbitration provision becomes part of the contract usually still depends on whether it materially alters the agreement.

The Code does not define what constitutes a "material" alteration. Instead, it gives hints and examples in the Official Comments to Section 207. Comment 4 indicates that material alterations are clauses which "result in surprise or hardship if incorporated without express awareness by the other party." Examples include:

  • clauses negating standard warranties such as merchantability or fitness for purpose in circumstances in which the warranties normally apply;
  • clauses reserving to the seller the power to cancel upon the buyer's failure to meet any invoice when due; and,
  • a clause requiring that complaints be made in time materially shorter than customary or reasonable.

Comment 5 states that clauses which "involve no element of unreasonable surprise" are incorporated in the contract unless the other party gives a seasonable objection. Examples of these are:

  • clauses fixing a reasonable time for complaints;
  • clauses providing for interest on overdue invoices;
  • clauses limiting the right of rejection; or
  • clauses otherwise limiting remedy in a "reasonable manner" under Section 2-718 and 2-719.

Comment 5.

Suffice to say, the Comments do little to clarify what is a material alteration in other circumstances. One court has described Section 2-207 as a "murky bit of prose." Southwest Engineering Co. v. Martin Tractor Co., 205 Kan. 684, 694, 473 P.2d 18, 25 (1970). Professors White and Summers use more colorful language:

Unfortunately, the section is like the amphibious tank that was originally designed to fight in the swamps but was sent to fight in the desert. The original drafter of 2-207 designed it mostly to keep the welsher in the contract.....Where pre printed forms are used to structure deals, they rarely mirror each other, yet the parties usually assume they have a binding contract and act accordingly. Section 2-207 rejects the common law mirror image rule and converts many common law counter offers into acceptances under 2-207(1)....Here the courts are not deciding whether there is a contract. They are answering a different question: What are its terms? This is not only a different but a more difficult question for the law than that of keeping the welsher in.

White and Summers, Uniform Commercial Code, Vol. 1, 8-9 (4th ed. 1995). Notably, in the circumstance where the buyer's standard order form contains an arbitration clause but the seller's standard acceptance form has some sort of no-arbitration provision the professors themselves cannot agree whether the arbitration clause becomes part of the contract. Id. at 10-14.

They do concur that if the parties reach an oral or other informal agreement and the offeree's written confirmation contains a unilateral arbitration clause, the clause, standing alone, is a material alteration. They add that course of dealing or trade usage are relevant to determine whether arbitration is implied in the parties' initial informal agreement. Id. at 27-28 citing Schubtex, Inc. v. Allen Snyder, Inc., 49 N.Y.2d 1, 424 N.Y.S. 2d 1154, 399 N.E.2d 1154 (1979). They also note:

Accepters rarely win the argument that their additional terms are only immaterial alterations under 2-207(2). A principal reason for their losing record is that their non-verbal acts contradict their verbal argument. Who goes to the appellate court with lawyers hired at hundreds of dollars per hour to dispute a term that is not material?

Id. at 19. The problem with this argument is that is confuses the common law meaning of "material," i.e., substantively important, with the Section 2-207 meaning, i.e. "result[ing] in surprise or hardship." Comment 5 uses the adjective "unreasonable" indicating these terms have objective meaning, not subjective. A business person's subjective surprise or hardship is irrelevant under Section 2-207 (unless he or she makes a seasonable objection). In any event, a contractual term can be surprising, objectively or subjectively, without being substantively important to the formation of the contract, and vice-versa.

In other words, a business person might not have expected the other side to propose an unusual term but would have willingly agreed to it during negotiations. Nevertheless, this term is material under 2-207. Conversely, a business person might object to a term which is otherwise common in the industry. In this situation, the term is not "material" and Section 2-207(c) puts the burden on the objector to respond to the term in the other's form.

For example, Professors White and Summers include in a footnote two appellate decisions holding that provisions establishing choice of law and shortening the statute of limitations to one year are not material alterations, Coastal Industries, Inc. v. Automatic Steam Products Corp., 654 F.2d 375 (5th Cir. 1981) and Thermo-Coustics Manufacturing Co. Inc. v. Borden Inc., 167 Cal.App.3d 282, 213 Cal.Rptr. 611 (1985), respectively. Id. at n.36. Both these provisions are far more likely to be dispute dispositive, and, thus, more "material" in a substantive sense, than an arbitration clause. However, they are not objectively surprising which is why they are not material under Section 2-207. As we shall see, the professors' assumption that an arbitration clause is material in the Section 2-207 sense seems factually unsupported.

The courts are split on whether the offeree's unilateral arbitration clause is a material alteration. Those courts following the "New York" rule usually hold that an arbitration requirement is per se "material." Diskin v. J.P. Stevens & Co., Inc., 836 F.2d 47, 50-51 (1st Cir. 1987)(applying New York law); Coastal Industries, Inc. v. Automatic Steam Products Corp., 654 F.2d 375, 379 (5th Cir. 1981)(applying New York law); Supak & Sons Manufacturing Co. v. Pervel Industries, Inc., 593 F.2d 135 (4th Cir. 1979)(applying New York and North Carolina law); Stanley - Bostitch, Inc. v. Regenerative Environmental Equipment Co., Inc., 697 A.2d 323, 329 (R.I. 1997); Marlene Industries Corp. v. Carnac, 45 N.Y.2d 327, 380 N.E.2d 239 (1978). Indeed, in Diskin v. J.P. Stevens & Co., Inc., the court indicated that a "vague, unspecific reference" to the textile industries' custom of arbitrating disputes was not an acceptable substitute for a specific agreement to arbitrate. 836 F.2d at 51-52 quoting Jones Apparel Group, Inc. v. Petit, 75 A.D.2d 504, 426 N.Y.S.2d 799 (1st Dept. 1980).

However, some New York decisions indicate the "New York" rule may not be absolute. In Hatzlachh Supply Inc. v. Moishe's Electronics, Inc., 828 F.Supp. 178 (S.D.N.Y. 1993), the court found the applicable Code provisions of New York and Texas law to be similar in all respects. The court rejected the "New York" rule as contrary to the spirit of both the Uniform Commercial Code and the Federal Arbitration Act. Id. at 183-84. It held that the purchaser could not have been surprised by the seller's standard arbitration provision when the seller had used the identical invoice in forty-two previous transactions over two years. Id. at 184. It also noted the purchaser used arbitration provisions in its invoices.

In Schubtex, Inc. v. Allen Snyder, Inc., 49 N.Y.2d 1, 399 N.E.2d 1154, 424 N.Y.S.2d 133 (1979), the New York Court of Appeals reaffirmed its holding in Marlene that an arbitration provision on the back of a standard acknowledgment form did not bind the purchaser. 399 N.E.2d at 1155-56. The court went on to state that while a course of dealings could result in the a provision becoming part of the parties' agreement, such forms alone did not establish a course of dealings no matter how many times the seller sent them to the buyer. Id. at 1156. It indicated that relevant evidence of a course of dealings would be that the parties had previously arbitrated or that the arbitration provision was "material" in the parties' negotiations. Id. (This reasoning appears to be a misuse of the Section 2-207 meaning of "material.").

Other courts, including the Seventh Circuit, sharply disagree with the New York rule and hold materiality must be determined on a case by case basis. Schulze and Burch Biscuit Co. v. Tree Top, Inc., 831 F.2d 704, 715 (7th Cir. 1987)(applying Illinois law); Dorton v. Collins & Aikman Corp., 453 F.2d 1161 (6th Cir. 1972)(Georgia and Tennessee law); Bergquist Co. v. Sunroc Corp., 777 F.Supp. 1236, 1245 (E.D.Penn. 1991)(Pennsylvania and Minnesota law); Dixie Aluminum Products Co. Inc. v. Mitsubishi International Corp., 785 F.Supp. 157 (N.D.Ga.1992)(Georgia law).

In Schulze and Burch Biscuit Co., the Seventh Circuit considered facts similar to those in Schubtex. The parties had nine prior transactions each involving the identical confirmation form. The court said the purchaser had "ample notice" the arbitration provision would also be in the tenth form and could have objected within a reasonable time. The court held the tenth identical form was not "unfair surprise" and, therefore, the arbitration provision was not a material alteration. 831 F.2d at 715.

The courts also disagree on whether the party favoring inclusion of the clause bears the burden of proof. One court has held it was the burden of the party opposing arbitration to establish that it was surprised by the inclusion of the arbitration provision. Bergquist Co. v. Sunroc Corp., 777 F.Supp. 1236 (E.D.Pa. 1991) citing Dale Horning Co., Inc. v. Falconer Glass Industries, Inc., 730 F.Supp. 962, 966 n.2 (S.D.Ind. 1989). The same also held that where inclusion of the arbitration provision in the parties' agreement depends on trade custom or course of dealings there may be a question of fact which must be resolved by a jury. Id. at 1245. However, it appears most courts have said the party seeking to include the arbitration provision has the burden of proving it is part of the agreement. See, e.g., Diskin v. J.P. Stevens & Co., 836 F.2d at 51. Given the language of Section 2-207, i.e. that the additional terms become part of the contract unless they are a material alteration, it seems the objecting party should bear the burden.

Those decisions which apply the New York rule do so based on a perceived public policy which enforces arbitration clauses only when the parties expressly agree to them. In the leading case establishing the rule the New York Court of Appeals said:

The reason for this requirement, quite simply, is that by agreeing to arbitrate a party waives in large part many of his normal rights under the procedural and substantive law of the State, and it would be unfair to infer such a significant waiver on the basis of anything less than a clear indication of intent.

In the Matter of Marlene Industries, 45 N.Y.2d at 333-34, 380 N.E.2d at 242.

Other courts have rejected the idea that arbitration imposes a hardship on commercial parties. See, Trans-Aire International v. Northern Adhesive Co., 882 F.2d 1254, 1262 (7th Cir. 1989); Dixie Aluminum Products Co., Inc. v. Mitsubishi International Corp., 785 F.Supp. at 160-61. In Trans-Aire, the Seventh Circuit explained its decision in Schulze and Burch Biscuit Co.:

. . . it is clear that the term [providing for arbitration] would impose no substantial hardship upon the non assenting party. True, the term deprived the party of certain rights. However, for all practical purposes, the term had little effect upon the non assenting party's economic welfare. That is, the non assenting party still had an opportunity to prosecute or defend its interests albeit in a different forum.

882 F.2d at 1262. The court in Dixie Aluminum Products held that any argument under state law that arbitration was a hardship compared to a trial had to yield to the policy favoring arbitration set forth in the Federal Arbitration Act. 785 F.Supp. at 161.

Most importantly, however, the New York rule entirely confounds the purposes of the Uniform Commercial Code:

(a) To simplify, clarify, and modernize the law governing commercial transactions;

(b) To permit the continued expansion of commercial practice through custom, usage, and agreement of the parties;

(c) To make uniform the law among the various jurisdictions.

Section 1-102. This is particularly true when the court fails to consider or even rejects evidence that merchants in general or merchants in that particular trade or industry routinely include arbitration provisions in their order or invoice forms. If anything is clear about the Code it is that commercial transactions should be governed by what business people think, not by what judges learned in contracts class.

The Code emphasizes that it is the business person's expectations which should predominate when it provides that a "usage of trade" and a "course of dealing" will "give particular meaning to and supplement or qualify terms of an agreement." Section 1-205(2) and (3). The Code defines a "usage of trade" as ". . . any practice or method of dealing having such regularity of observance in a place, vocation, or trade as to justify an expectation." Section 1-205(2). The Code says a course of dealing "is a sequence of previous conduct between the parties to a particular transaction which is fairly to be regarded as establishing a common basis of understanding for interpreting their expressions and other conduct." Section 1-205(1). The Official Comments add "...a sequence of conduct after or under the agreement may have equivalent meaning." Comment 2.

There is substantial evidence that many business people consider arbitration the preferred way to litigate commercial disputes. Indeed, in certain industries arbitration appears to be the expected way to litigate these disagreements. For example, a 1997 survey of the general counsel or chief inhouse litigators for over 600 of the Fortune 1000 corporations found significant experience with and appreciation for arbitration, especially in commercial disputes. David B. Lipsky and Ronald L. Seeber, "The Appropriate Resolution of Corporate Disputes," Cornell/PERC Institute on Conflict Resolution (1998). Eighty-five percent of the responding corporations had used arbitration in commercial or contract disputes. This was a much higher response rate than for any of the survey's other categories of disputes, e.g., employment (62 percent), construction (40 percent), intellectual property (21 percent) and consumer rights (17 percent).

There were some variations among the different kinds of industries in their views of arbitration. For example, 100 percent of the corporations in "mining/construction" had used arbitration. (This was the smallest category among the types of corporations surveyed). The lowest usage was in the "trade" industry, 73 percent. There were similar variations in how frequently different corporations used arbitration. Ninety percent of the "mining/construction" corporations used it "occasionally" "frequently" or "very frequently." However, only 44 percent of "trade" corporations fit into those categories. Even so, the number of corporations in any category who used arbitration "not at all" was small. The largest percentage was 14, in the "finance" industry. In fact, only in the "trade" sector did a majority of the corporations (56 percent) state they used arbitration "rarely" or "not at all."

Perhaps, more pertinently, a high percentage in all types of industries reported using arbitration in commercial and contractual disputes. The numbers ranged from a low of 81 percent in the "insurance" industry to 100 percent in "mining/construction."

Savings in time and litigation expenses, contractual requirements and management desire are the major reasons why corporations use arbitration. Management desire seems to be the big difference between those corporations which arbitrate very frequently and those which do not. Sixty-nine percent of the former respondents cited it as a reason they arbitrate. Among those corporations which arbitrate rarely or not at all, only 32 percent and 37 percent, respectively, said management favored arbitration. Many corporations also believe arbitration allows them increased ability to handle the dispute, particularly because arbitration provides some control over who decides the dispute and scheduling (which may be very important if senior executives must participate).

Some corporations object to arbitration when the subject of the arbitration requires specialized expertise. One respondent told Professors Lipsky and Seeber: "We have a lot of intellectual property disputes, but we don't think arbitrators do a good job with them. There simply aren't any qualified arbitrators in this area." Id. at 29. The overwhelming reason given for why the corporations did not use arbitration more frequently was the "unwillingness of opposing party." (Possibly, that "unwillingness" arises only ad hoc and post hoc when one party decides traditional litigation provides a tactically superior forum).

These statistics naturally raise the question of what distinguishes those corporations which make use of arbitration and other alternative dispute resolution methods from those which do not as a matter of principle. The report's writers found:

...the strongly pro-ADR companies tend to be the very largest ones in the Fortune 1000 and to be known for adopting so-called progressive policies in other areas. For example, many pro-ADR companies were among the first to embrace total quality management and team-based production systems....Most faced significant global competitive pressures and engaged in downsizing in the 1980s. A pro-ADR policy seems closely linked to this array of corporate policies.

The companies in the group that never used ADR tended to be smaller than average (although all corporations listed in the Fortune 1000 are very large indeed). They also tended to be very profitable and under much less cost pressure than the pro-ADR group. Several have reputations for dealing with unions in a militant fashion.

Lipsky and Seeber, id. at 21-22. The writers later comment that the latter group of corporations were "sometimes controlled by one or two families." In sum, even a business' "principled" avoidance of arbitration may well be highly subjective, or at least, have little to do with objective surprise or hardship.

A number of judicial decisions acknowledge that in certain industries, especially textiles, arbitration is the trade custom (regardless of the size of the companies involved). See, e.g., Lehigh Valley Industries, Inc. v. Armtex, Inc., 19 UCC Rep. 744 (N.Y. App. 1976); Silverstyle Dress Co. v. Aero-Knit Mills, Inc., 11 UCC Rep. 292 (N.Y.Super. 1972). Certainly, in those industries a businessperson should not be surprised to find an arbitration provision in an agreement, unless of course, he or she had specifically rejected arbitration in negotiations. However, it seems unlikely that arbitration would come up in the usual course of business negotiations.

In any event, the Cornell study and some of the cases support the position that no major business should be surprised by the appearance of an arbitration clause in a commercial contract or find it a hardship to arbitrate a commercial dispute. Any business which wants to avoid arbitration should include in its standard commercial forms a provision refusing to participate in it. See, e.g., Stanley-Bostitch, Inc. v. Regenerative Environmental Equipment Co., Inc., 697 A.2d 323 (R.I. 1997)(rejecting seller's argument that arbitration provision on its invoice was part of the contract where purchaser's form included a provision that any dispute would be determined by the courts in purchaser's state). Even so, given the courts' and commentators' disagreements over the issues, a party which does not want arbitration should also respond to the other party's standard arbitration provision with a specific objection.

A number of recent studies have found that the largest category of lawsuits are contract and commercial claims. This is particularly true in state courts where the backlogs may be longer. Moreover, state court commercial claims are often smaller and less able to bear the cost of extensive litigation. Greater use and enforcement of arbitration provisions in standardized commercial documents could improve the speed, efficiency and certainty with which those claims are resolved.