How to Create a Lease Arbitration Clause

Make sure your clause covers 10 key elements.

 

 

Going to court is an expensive, time-consuming, and stressful way to work out problems with your tenants. That’s why increasing numbers of landlords incorporate arbitration clauses into their leases.

Arbitration is an Alternative Dispute Resolution (ADR) mechanism in which an impartial third party, known as an arbitrator, makes a binding decision to resolve a contractual dispute based on the evidence presented by both parties. While resolving disputes without litigation certainly sounds like an attractive proposition, arbitration doesn’t work for all situations. To reap its benefits, landlords must do two things:

• Make an informed decision about how and when to use arbitration to resolve lease disputes; and
• Create a legally sound lease arbitration clause that will work for you and your tenants.

This briefing explains what you need to know to accomplish both of these objectives.

Phase 1: Weigh the Pros & Cons of Arbitration

Because it’s informal and easier than litigation, arbitration is a godsend for both landlords and tenants alike. At least, that’s the theory. Unfortunately, it doesn’t always work out that well in the real world of leasing disputes.

Advantages of arbitration. Arbitrating commercial lease disputes offers a number of advantages, notes Sujata Yalamanchili, a real estate partner in the New York law firm of Hodgson Russ:

• Cheaper and faster: “Arbitration can save time and money when the parties are motivated to resolve disputes quickly and the issues are non-complex,” Yalamanchili explains;
• Confidentiality: Unlike in litigation where results are publicly reported, parties to an arbitration can agree to conduct proceedings confidentially and request a confidential award;
• Flexibility: The arbitration process allows for customization to the extent that the parties can specify the number of arbitrators, timelines, language, and venue of the proceedings;
• Selection: While judges are assigned to cases, arbitrators are selected by the parties themselves, which ensures that the dispute will be heard by persons with specific expertise in the issues involved; and
• Deterrence: Just having an arbitration clause in the lease gets landlords and tenants talking, which may result in a mutually acceptable resolution without the need for an actual proceeding.

Disadvantages of arbitration. Arbitration also carries certain risks. “The notion that arbitration is always cheaper quicker and always yields better results than litigation is a misconception,” Yalamanchili cautions:

• Costs: Arbitration may be as expensive as litigation due to discovery and depositions. In addition to attorneys’ fees, the parties also have to pay arbitrator fees, unlike with judges in litigation;
• Time: While it’s often faster, arbitration may also drag on for months at a time;
• No appeals: Arbitration awards are binding with very limited grounds for appeal, which likely means that one side will walk away unhappy;
• Enforcement issues: One of the downsides of arbitration is the unavailability of judicial remedies—that is, those that require the judgment and enforcement of a court, such as eviction. Moreover, arbitration awards themselves must be enforced by a court. Result: You may end up going to court anyway if there’s a default on the arbitration award; and
• Sophistication disconnects: Court processes might actually be quicker and more suitable when you’re dealing with a less sophisticated opponent to the extent that a judge understands and does more than an arbitrator to assist a pro-se litigant—that is, one that represents itself in the proceedings without an attorney. 

Phase 2: Create the Right Arbitration Clause

Once you determine that you want to go the arbitration route, be sure to craft a fair, balanced, and legally sound lease clause. Here are the 10 elements such a clause should address:

1. Limit scope of arbitration clause. Not all commercial lease disputes are suitable for arbitration. So, avoid broad clauses that provide for arbitrating any and every dispute that “arises under the lease.” Yalamanchili suggests limiting the scope of the clause to disputes involving monetary amounts that are or may be payable under the lease. Examples:

• Operating expenses or common area maintenance (CAM) charges owed by the tenant;
• Fair market rent that a tenant renewing its lease must pay during the renewal term;
• Improvement allowances that a tenant earned or didn’t earn; and
• Monetary losses suffered by a landlord for which the tenant must pay.  

Option 1: Specifically list the disputes that are subject to arbitration under the lease; or

Option 2: Use a broader arbitration clause but carve out disputes that shouldn’t go to arbitration, including matters involving:

• Interpretation of complex laws or lease language;
• Determination of whether a party has defaulted on the lease or is liable to the other; and
• Eviction or other legal remedies that require court action to execute.

2. Consider requiring negotiation before arbitration. As we noted, arbitration isn’t necessarily a quick, cheap, or painless process. So, rather than having to proceed directly to arbitration, landlords and tenants may want to give themselves a window for avoiding having to resort to the process. For example, the lease may stipulate that disputes won’t go to arbitration unless and until the parties first try to negotiate a solution.

Model Lease Language

Landlord and Tenant shall use their best efforts to settle the dispute, claim, question, or disagreement that is subject to arbitration under the Lease. To this effect, they shall consult and negotiate with each other in good faith and, recognizing their mutual interests in avoiding arbitration, attempt to reach a just and equitable solution that is satisfactory to both parties. If they do not reach such a solution within a period of [insert #, e.g., 60] days, then, upon notice by either party to the other, all disputes, claims, questions, or differences shall be finally settled by arbitration in accordance with the provisions set forth below. 

3. Consider requiring mediation if negotiation fails. For major disputes likely to involve particularly lengthy or expensive arbitration, you may also want to require the parties to seek to resolve the dispute via mediation if negotiation fails. Explanation: Mediation is another ADR process in which a mediator, or neutral and independent third party with no personal interest in the dispute, meets privately with and gets the views of each party and tries to broker a mutually acceptable solution.

Model Lease Language

In the event that Landlord and Tenant do not promptly resolve their dispute, claim, question, or disagreement that is subject to arbitration under the Lease through negotiation, the parties shall submit the dispute, claim, question, or difference to mediation under the then-applicable [insert, e.g., the Mediation Rules of the American Arbitration Association] rules. Landlord and Tenant shall bear their own expenses for the mediation, however, shall share equally the mediator’s fees and any administrative fees. 

4. Specify method of selecting (and number of) arbitrators. One of the key provisions of the arbitration clause is the method for selecting the arbitrator. Most arbitrations are resolved by either an individual or panel of three or more odd-numbered arbitrators. While using a single arbitrator is cheaper, having a panel guarantees a variety of interests will be heard and deliberated.

Many landlords and tenants use the American Arbitration Association (AAA) listing process rules. The way it works: An AAA case manager gives each party a list of proposed arbitrators who are familiar with the subject matter the dispute involves. The landlord and tenant have a certain number of days to strike any unacceptable names and rank the names that remain in order of their respective preference. The AAA case manager then invites the individuals left on both sides’ list to serve, in the designated order of mutual preference. The case manager may also have discretion to determine the number of arbitrators if the sides can’t reach agreement on the issue.

5. List required qualifications of arbitrator. The lease clause should also state the credentials the arbitrator must have, if that’s important to the parties. Thus, for example, the parties may want at least one of the arbitrators to be a lawyer, accountant, or other professional with specific kinds of knowledge and experience. 

Model Lease Language

The arbitrator shall be a lawyer who has been admitted to the [state] bar and has at least [number] years of continuous experience of practice primarily in the field of real estate law.

6. Set out the arbitration procedures. Outline the rules and procedures that will govern the arbitration process, including with regard to:

• How evidence will be presented;
• Deadlines for submission; and
• Overall timelines for a ruling.

You may also come to an agreement on the methods the arbitrator will use to make a decision.

Example: Disputes over renewal rent or other specific dollar amounts may be suitable for what’s known as “baseball” arbitration (named for the method Major League Baseball and the players’ union use to resolve player salary disputes) in which each party submits a number to the arbitrator knowing that after the hearing, the arbitrator will select either their number or the number submitted by their adversary—and nothing else. This either-or methodology gives both parties an incentive to submit a reasonable proposal. In some cases, the submitted numbers turn out to be so close to one another that the sides are able to reach an agreement without the arbitrator’s having to actually choose a number.

Model Lease Language

Landlord and Tenant shall submit to the arbitrator and exchange with each other in advance of the arbitration hearing their final, best offers. The arbitrator shall then be limited to awarding only one or the other of the two figures submitted.

7. List location of the arbitration. Arbitration may be carried out in-person or digitally. In the former case, the lease should specify the location. In addition to affecting convenience, travel considerations, and witness availability, choice of venue may be critical to the extent it determines the law governing the arbitration procedures and enforceability. For example, in Illinois, arbitrators must be lawyers, while in New York non-lawyers can also serve as arbitrators. 

8. Allocate responsibility for costs and fees. The lease clause should expressly spell out who’s responsible for paying the arbitrator’s fee and administrative expenses. While it’s customary for landlords and tenants to share the costs of arbitration, the provision may also require the losing party to bear the entire costs or allow for the arbitrator to allocate the costs between the sides based on the outcome of the arbitration in the interest of fairness.

9. Provide for remedies. Under standard arbitration rules, arbitrators generally have authority to grant “any remedy or relief” that they deem “just and equitable” within the scope of the parties’ agreement and the arbitrator’s powers under applicable statutes. However, parties may want to impose limits or exclude specific remedies, such as punitive damages or attorneys’ fees. Example:

Model Lease Language

Any award in an arbitration initiated under this clause shall be limited to monetary damages and shall include no injunction or direction to any party other than the direction to pay a monetary amount. The arbitrator shall have no have no authority to award punitive, consequential, or other damages not measured by the prevailing party’s actual damages, except as may be required by statute. Any monetary award in an arbitration initiated under this clause shall include pre-award interest at the rate of ____% from the time of the act or acts giving rise to the award. In no event shall any award in any arbitration initiated under this clause exceed $__________________.

10. Provide for confidentiality. Landlords may want to keep arbitration proceedings and awards confidential, especially if the dispute involves the landlord’s trade secrets, confidential business information like the landlord’s internal pricing formula, or matters directly affecting other tenants at the property, such as what a tenant should pay in operating expenses or CAM charges.

Model Lease Language

Except as may be required by law, neither Landlord nor Tenant that is a party to arbitration initiated under this clause nor an arbitrator appointed to rule on the case shall disclose the existence, content, or results of any such arbitration hereunder without the prior written consent of both parties.

 

The editors thank Hodgson Russ law clerk Rani Patel, a third-year student at the University of Buffalo Law School, for her help in preparing this article.