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This article is the initial installment in first tuesday’s ongoing article series analyzing the use of arbitration in real estate transaction disputes. What follows is an historical analysis of arbitration within the context of real estate transactions, paying particular attention to arbitration’s chief defect — the lost right of judicial review.

Arbitration is arbitrary

Originally conceived as an instrument of community empowerment, arbitration quickly degenerated into a travesty of the American judicial system.

The framers of arbitration were the progenitors of the modern legal apparatus — lawyers, judges and politicians who restructured the fundamental concepts of the judiciary and placed the power of adjudication into the hands of every citizen who desired to contract for an alternative to litigation. Thus, arbitration promises the justice provided by the American legal system but is all too often a risky and uncertain venture — a crapshoot.

Although arbitration in America originated in the colonies as the preferred form of non-legal dispute resolution, arbitration as we know it today is an effort to circumvent jury awards by the dominant organized trade groups and corporate enterprises, which began during the industrial revolution and reached near ubiquity in the late 1970s. Today, arbitration is losing favor among the rank and file of the California real estate trade union, and for good reason.

The concept of alternative dispute resolution (ADR) arose due to society’s general dissatisfaction with the complex and often costly judicial system. If parties agreed to arbitrate their disputes, they avoided court entirely by giving a “neutral” third party the authority to make a final and binding decision for them.

However, it quickly became evident that the absence of judicial accountability in an arbitrator’s decision was not worth the binding arbitration bargain they contracted for when arbitrators misinterpreted the law or gave erroneous awards — leaving disputants with an unpredictable and arbitrary decision with no chance of remedy.

Discretion outside the law

One of the primary avenues for introducing arbitration into the mainstream real estate market was the widespread use and acceptance of ADR imposed on members of the predominant California real estate trade union. Arbitration became their favored method of ADR in real estate transaction disputes as it provided trade union members recourse for resolving disputes among themselves without the need to squander their resources on costly litigation.

More importantly, the advent of arbitration allowed trade union leaders to maintain control over their constituents by requiring all disputes be settled internally without the influence and involvement of state or federal governments, and outside the influence of the law. [The People v. National Association of Realtors (1984) 155 CA4th 578]

Thus, members of the trade union are required to settle disputes amongst each other via arbitration. Since what’s good for the goose is good for the gander, arbitration has also crept into the real estate forms published by the trade unions and now the unlicensed, ordinary citizens looking to buy or sell real estate have become subsumed into the arbitration machinery.

Editor’s note — As a matter of policy, first tuesday’s purchase agreements and addenda have never contained an arbitration provision or an attorney fee provision in an effort to reduce the risk of litigation to brokers and agents by making litigation less economically feasible for sellers and buyers along with their attorneys, and to better protect buyers and sellers from the perils of arbitration.

The real estate market has since been flooded with agents and brokers trained to reassure their buyers and sellers that initialing the arbitration provision is a “standard” practice, a custom that bears multiple benefits with no risks — that is, if any guidance is given at all.  [For more information regarding erroneous real estate customs, see the November 2010 first tuesday article, Holmes v. Summer: dilatory disclosures and the damage done.]

Most homebuyers (and misguided real estate agents) know little about arbitration beyond  its guise of being less costly and more efficient than litigation. Arbitration has become one of the sacred cows of real estate transactions. The myth of arbitration’s benefits has become so ingrained that it is no longer questioned — buyers and sellers do not know enough to inquire and agents are not equipped with sufficient knowledge and awareness by their brokers to advise. Thus, the virtuous view of arbitration is passed down as tradition, while widespread ignorance of its risks persists among agents.

What follows is a rigorous review and analysis of recent case decisions and common scenarios in real estate transactions that bear out the full extent of the inherently flawed and ultimately irredeemable approach to arbitration as an appropriate method of dispute resolution.

Lost right to correct a decision gone awry

The chief flaw of arbitration lies in the loss of the disputants’ right to judicial review. Parties involved in arbitration often enter this action with hopes for all the benefits offered by the American justice system and none of the costs. Rather, these naïve disputants all too often invest as much time and money as they would have in litigation, only to be scorned by a misinterpretation of the law or a host of other fatal flaws.

The chief flaw of arbitration lies in the loss of the disputants’ right to judicial review.

Consider a seller who enters into a listing agreement with a real estate broker, negotiated by the broker’s listing agent.  The listing agreement contains a provision calling for disputes to be submitted to binding arbitration — no judicial oversight permitted.

A buyer is located and a purchase agreement offer is submitted by another agent employed by the same broker, called a selling agent. Both the agents and the broker are aware the buyer is financially unstable and may encounter difficulties closing the transaction.

However, confirmation of the buyer’s creditworthiness and net worth are not made the subject of a contingency provision by the selling agent who prepared his buyer’s offer. More importantly, the listing agent does not include a further approval contingency provision in a counteroffer. The clearing of such a contingency would have put the seller on notice that the buyer’s financial status needed his further approval (or cancellation of the purchase agreement), if the buyer’s creditworthiness proved unsatisfactory.

When the listing agent, acting alone, submits the buyer’s offer to the seller, the buyer’s financial status is not discussed even though the listing agent was duty-bound to the seller to disclose it. The supervising broker fails to catch or correct the oversight. The seller accepts the purchase agreement offer.

Later, the buyer fails to close the transaction due to his disabling financial condition, resulting in the seller losing money on a resale. The seller discovers that the listing agent, broker and selling agent all knew of the buyer’s financial condition and failed to advise him of this fact.

The seller makes a demand on the broker and both agents for his losses resulting from the failed transaction. The seller claims the buyer’s financial condition interfered with the buyer’s ability to perform and thus was a material fact in the transaction known by the agents and broker who failed to disclose it at the time of acceptance.

The dispute is submitted to binding arbitration. The arbitrator awards money damages to the seller based on the professional misconduct of the listing agent and employing broker for failure to disclose their knowledge of the buyer’s unstable financial status on acceptance.

Further, the arbitrator erroneously issues the seller a money award against the selling agent, ruling the selling agent and the listing agent were “partners” since they shared in the fee the broker received on the transaction. Thus, the selling agent is improperly held liable as a partner of the listing agent for the seller’s money losses resulting from the misconduct of the listing agent and the broker.

The selling agent then seeks to vacate the portion of the arbitration award holding him liable as a “partner” of the listing agent, claiming the arbitrator incorrectly applied partnership law to a real estate agency and employment relationship.

Can the award against the selling agent be corrected by a court due to the arbitrator’s erroneous application of partnership and agency law?

No! An arbitrator’s award, based on an erroneous application of law, is not subject to judicial review. The requirement for judicial review of the arbitrator’s award was not included in the wording of the arbitration provision. The arbitrator acted within his powers granted by the arbitration provision, even though he applied the wrong law and produced an erroneous result.

A court of law confronted with a binding arbitration agreement without a provision for judicial review cannot review the arbitrator’s award for errors of fact or law even if the error is obvious to the court and causes substantial injustice when the court enters judgment for collection of the award. [Hall v. Superior Court (1993) 18 CA4th 427]

Unless the arbitration provision states an arbitration award is “subject to judicial review,” as in all fairness it must, the award resulting from arbitration brought under the clause is binding and final. Without judicial review of an award in an arbitration action, the parties cannot be assured the award will be either fair or correct. Currently, the prevailing arbitration provision used in purportedly “standard” purchase agreements has not yet evolved to include language allowing for judicial review.