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AN EMPLOYEE OF Hooters of America, Inc., brought a sexual harassment claim against the company. Hooters wanted the employee to have to address the claim through arbitration, rather than in court, but a federal appeals court found that Hooters “had breached the arbitration agreement by promulgating rules so egregiously unfair as to constitute a complete default of its contractual obligation to draft arbitration rules and to do so in good faith.” (Hooters of America, Inc. v. McGowan, U.S. Court of Appeals for the Fourth Circuit, 1999)

Among the rules to which the court referred was a provision where the employee had to select arbitrators from a list compiled by Hooters. The rules also allowed Hooters, but not the employee, to move for summary dismissal of the proceedings. In addition, the rules provided that only Hooters, not the employee, could decide not to arbitrate. And finally, the arbitration agreement gave Hooters the right to modify the arbitration rules at any time, with or without notice to the employee.

A similar case involved Ryan’s Family Steak Houses. In this case (Walker v. Ryan’s Family Steak Houses, U.S. Court of Appeals for the Sixth Circuit, 2005), an employee pursuing a discrimination claim contended that his employer’s arbitration rules were unfair and filed a lawsuit. The court found that the arbitration forum selected by the company was not neutral because it was a for-profit entity receiving 42 percent of its annual gross income from Ryan’s.

The court also found that the arbitration agreement limited the employee’s ability to conduct discovery. This, when coupled with the prospect of a potentially biased arbitration panel—which decides discovery questions—provided grounds for denying arbitration.

Companies increasingly require employees to sign agreements that commit them to resolve disputes by arbitration. The companies hope, thereby, to avoid costly litigation. But as these cases show, there are limits to what companies can put in arbitration clauses. Before a business sets its policy, management needs to understand the process, the legal precedents, and the way to stay within the law when writing arbitration into contracts.

How it Works

Arbitration procedures differ from court proceedings not only because they occur in less formal settings but also because they follow different rules. Rather than strict rules of evidence and rights to appeal to a higher court, arbitration typically uses flexible rules for presenting cases, with limited rights to challenge the final decision.

Some companies have every employee as a condition of employment enter into a binding agreement to resolve disputes through arbitration, while other companies include arbitration clauses only in executive employment contracts. Another approach that companies take is to adopt dispute resolution plans for their employees that include binding arbitration.

Arbitration agreements have been used to decide employee claims related to wrongful termination, federal and state discrimination, wages, sexual harassment, family and medical leave, benefits, and employment contracts. Similarly, employers have initiated arbitration to protect against unlawful competition, to enforce covenants not to compete and confidentially agreements, protect trade secrets, recover stolen money or property, and resolve and address other employment contract controversies.

Arbitration is usually initiated by the complaining party, who makes a written demand that a workplace or employment agreement dispute be resolved by arbitration. The proceedings are overseen by a third party or panel chosen by the agency designated as the administrator.

The arbitration agency is compensated by the parties, as is the arbitrator. The third-party arbitration agency works with the arbitrator to ensure that any award is delivered to the parties in a timely fashion.

Legal Precedents

Over the past 15 years, the U.S. Supreme Court has decided several important cases that offer guidance on when and how employers may require employees to resolve disputes through arbitration, rather than in court. In one of the earliest landmark cases, the Court held that an employee was required to arbitrate a statutory age-discrimination claim with his employer based on an arbitration clause in a securities registration application (Gilmer v. Interstate/Johnson Lane Corp., U.S. Supreme Court, 1991).

In 2001, in Circuit City Stores, Inc. v. Saint Clair Adams (U.S. Supreme Court, 2001), the Court clarified and strengthened the rights of companies to impose arbitration on employees through contractual agreements. One case addressed a clause in the Federal Arbitration Act (FAA), which, it was argued, exempted any workers engaged in interstate commerce from arbitration agreements. The Court ruled that only workers directly engaged in the movement of goods in interstate commerce are exempt under the clause.

The attorneys general of many states opposed the Circuit City decision, arguing that states should be allowed to pass legislation preventing employees from contracting away their right to pursue claims against their employers in court. The Supreme Court ruled that states are not exempt from the federal mandate of the FAA, and thus states cannot interfere with the rights of employers and employees to arbitrate their disputes.

The Circuit City case, however, did not give employers a license to stack the deck against employees through the arbitration process. The decision does not mean that any arbitration agreement between an employer and an employee will be enforceable. If an agreement is too one-sided in favor of the employer, as in the Hooters and Walker cases, it is subject to legal challenge. (More on this later.)

Then in 2003, the U.S. Supreme Court decided an arbitration case that involved consumers, rather than employees, but it had implications for employers who use arbitration agreements (Green Tree Financial Corp. v. Bazzle, U.S. Supreme Court, 2003). In this case, a group of homeowners forced to arbitrate their claims sought to band together in an arbitration action, as they would have in a court class action lawsuit against a commercial lender. The lender complained that class action arbitration was inappropriate, seeking instead to arbitrate with individual homeowners one at a time.

The Court decided that because class arbitration was not specifically excluded from the arbitration agreement, the FAA did not prevent its use. In response to this decision, the American Arbitration Association (AAA), a long-time third-party provider of dispute resolution services, adopted a policy on class arbitrations in 2003. It provided that the association would accept class arbitrations if the agreement did not specifically prohibit them. If an arbitration agreement prohibits such claims, the AAA would not accept them absent a court order.

Fairness. There have also been a number of court cases where the courts have made it clear that companies cannot skew the process against the employee.

The U.S. Court of Appeals for the Fourth Circuit ruled, for example, that limitations on the damages an employee can recover are unacceptable and may be the foundation for revoking the arbitration agreement (Murray v. United Food and Commercial Workers, Fourth Circuit Court of Appeals, 2002).

In another example, a federal appeals court ruled that a cost-sharing provision should be severed from the arbitration agreement because it would have a deterrent effect on potential litigants. The provision would have required that employees bear the entire cost of the arbitration if they were unsuccessful (Scovill v. WSYX/AVC, Sinclair Broadcast Group, Inc., U.S. Court of Appeals for the Sixth Circuit, 2005).

In a third example, an arbitration clause was determined to be unconscionable because of its one sidedness. The company was not required to arbitrate all disputes, but only the ones it chose (Iberia Credit Bureau, Inc. v. Cingular Wireless, LLC, U.S. Court of Appeals for the Fifth Circuit, 2004).

In another case, the court found it to be unconscionable that an employer initially refused to arbitrate an employee’s wrongful discharge claim. When the employee sued in court, the employer then moved to compel arbitration, but the court essentially said it was too late. By breaching its own arbitration agreement, the employer lost the opportunity to require the employee to arbitrate (Brown v. Dillard’s, Inc., U.S. Court of Appeals for the Ninth Circuit, 2005).

Setting Policy

Companies should carefully establish the terms and conditions of their arbitration agreements to meet due process requirements. To that end, one resource is the National Rules for the Resolution of Employment Disputes established in the mid-1990s by the AAA and updated since then as needed.

The rules note the right of the employee to be represented. They also recommend that the employer provide some level of reimbursement for the employee’s fees and costs, and that the arbitrator have the authority to provide for fee reimbursement, in whole or in part, as part of the remedy.

They further recommend that parties be given “adequate but limited pretrial discovery.” This provision makes it clear that companies should not try to use arbitration to prevent employees from gaining access to the information necessary to put on their cases. Some amount of discovery within the strictures of a cost-efficient arbitration process is critical.

Finally, the rules call for the use of independent arbitrators with labor and employment experience, who receive training and who are selected according to a standard protocol that is not controlled by the employer.

The rules also give arbitrators the power in their awards to “grant any remedy or relief the arbitrator deems just and equitable, including any remedy or relief that would have been available to the parties had the matter been heard in court.”

For disputes arising out of employer-promulgated arbitration plans for employees that use the services of AAA, the filing fee of the employee is limited to $125, unless the plan calls for the employee to pay less, with the remaining filing and administrative fees being paid by the employer.

The rules provide that unless the employee chooses to pay a portion of the arbitrator’s fee, the employer pays all the arbitrator’s fees, and these fees are not subject to reallocation against the employee except where the employee’s claim is judged to have been filed for the purpose of harassment or is patently frivolous. This rule appears to be designed to level the playing field between the employer and the employee, where the employer has imposed a companywide plan requiring all employees to arbitrate workplace disputes.

The payment rules are a little different where the employer and the employee sign an individual contract with an arbitration clause, such as in a top-executive employment contract. In those situations, unless the specific agreement provides otherwise, the employee gets no break in the filing fee, and the arbitrator can assess arbitration fees, expenses, and compensation in favor of any party and may provide for the reimbursement of a representative’s fee as part of the remedy. This makes sense, because parties with negotiated employment agreements typically have more bargaining power than the employee subject to an employer-promulgated arbitration plan that is imposed on new-hires as a condition of employment.

To minimize the risk that an arbitration agreement or plan will be struck down by a court, it is a good idea to incorporate rules like those promulgated by the AAA into the arbitration agreement or plan. In addition, any arbitration agreement or plan should be easy to understand. It should also allow employees to file outside claims with governmental agencies.

The AAA rules, while a good starting point, do not address all the terms that may be important to address in an arbitration policy. Here are some additional factors that should be considered.

The company should ensure that the agreement or plan is broad enough in scope to require arbitration of all matters that the company wants to be subject to arbitration. If a company intends to arbitrate all disputes arising out of the employment relationship with its employees, including statutory and common law claims, it should say so. If a company intends to exclude certain claims, such as workers’ compensation or benefits claims, it should state the exclusion specifically in the agreement.

The company should have someone knowledgeable about arbitration review the applicable rules used by the selected arbitration provider to ensure that they satisfy the goals and needs of the company.

The company should also address the physical site of arbitration proceedings. Having an arbitration agreement without a designated location for the arbitration typically leaves that decision in the hands of the arbitration agency. Thus, it is a good idea to identify a definite location for the arbitration.

If there is a need to designate any special discovery or evidentiary rules, the agreement should state these rules, keeping in mind, of course, that courts will expect that employees be allowed to conduct some discovery consistent with due process and that arbitration is meant to be less formal than traditional litigation. In the absence of any discussion about these rules, the decision about discovery and evidence usually will be determined by the selected arbitration rules or left to the arbitrator’s discretion.

Companies may also decide to limit what relief the arbitrator can grant. This is a bit risky, given the due process concerns, but on the other hand, there may be a valid reason for setting some limits. A company may decide, for example, that it is important to make clear that the arbitrator may not award relief where the claim is barred by the applicable statute of limitations, the period of time during which by law an employee must bring a claim or forfeit the right to do so. If so, these special provisions should be stated clearly in the agreement.

Finally, if there are to be any requirements for pre-arbitration mediation or other nonbinding dispute resolution procedures before the parties enter into arbitration, this should be spelled out in the arbitration agreement. By using a mediation program in advance of arbitration, a company may be able to resolve some complaints more amicably, leaving those cases for arbitration that truly require that process.

While these suggestions are good guidelines, it is sometimes difficult to predict how well an arbitration agreement will hold up under judicial challenge. This is because federal courts in different jurisdictions have conflicting views about due process and fairness.

Take the class action issue, for example. The U.S. Court of Appeals for the Ninth Circuit has held that an agreement that bans class actions is unconscionable under California law and that the FAA does not interfere with state law contract defenses such as fraud, duress, and unconscionability (Ting V. AT&T, U.S. Court of Appeals for the Ninth Circuit, 2003).

More recently, however, the U.S. Court of Appeals for the Eleventh Circuit ruled that a ban on class actions is not unconscionable, using the U.S. Supreme Court as authority to explain that the “fact that certain litigation devices may not be available in an arbitration is part and parcel of arbitration’s ability to offer simplicity, informality and expedition” (Caley v. Gulfstream Aerospace Corporation, U.S. Court of Appeals for the Eleventh Circuit, 2005).

Arbitration between employers and employees offers a workable alternative to traditional litigation for resolving workplace controversies. Companies that wish to use this process, however, need to be sure that the arbitration agreement is carefully crafted so that it complies with notions of due process and fair play.

Landis Wade is an attorney with Helms Mullis & Wicker, PLLC in Charlotte, North Carolina.