The fate of arbitration

Congress has deemed arbitration to be unworthy of Wall Street — so what place does it have in real estate transactions?

Arbitration reconsidered

first tuesday is among the first and most outspoken critics of arbitration as the preferred method of dispute resolution in real estate transaction agreements. We have been consistent and clear on this issue for over 30 years: arbitration is a deeply flawed form of alternative dispute resolution (ADR) that ought to be banished from all real estate purchase agreements.

In addition to its predominance in the real estate trade union “standard” forms, arbitration has wriggled its way into all variety of transaction agreements. The clause has found near universal acceptance and integration into nearly every form we are expected to sign in even the most mundane daily transactions. Indeed, one cannot see a new physician, open a bank account or purchase a vehicle without being expected to sign away their rights to litigate in a court of law.

When it comes to transactions of greater financial significance and risk, such as purchasing stock in a publicly traded company, regulators are beginning to pay closer attention to arbitration’s myriad flaws. Since the financial crisis and the inception of the Consumer Financial Protection Bureau (CFPB) under the Dodd-Frank Wall Street Reform and Consumer Protection Act, arbitration provisions in legal agreements of weighty financial consequence are being scrutinized with a very critical eye.

Related articles:

Bargaining for justice: arbitration and the loss of judicial review

Bargaining for Justice: deconstructing the arbitration provision

Not good enough for Wall Street

Arbitration’s latest rejection has taken place in the financial services world. A huge player in private equity, the Carlyle Group has taken considerable heat from investors and the Securities and Exchange Commission (SEC) over its recent filing for an Initial Public Offering (IPO).

Carlyle’s IPO included a controversial arbitration provision that would have barred investors in its stock from bringing a class-action lawsuit against the firm in the event of wrongdoing. Instead of allowing its shareholders the right to litigate against the firm in a court of law, the Carlyle Group proposed to limit all disputes to a confidential, compulsory and binding arbitration proceeding.

Although shareholders were up in arms over the provision from first blush, it took a stern letter from the Senate before the SEC got on board. The Senate urged the SEC to reject the inclusion of the arbitration provision, as “private securities litigation is an indispensable tool with which defrauded investors can recover their losses” without government intervention.

The Senate letter goes on to state that the inclusion of a forced and confidential arbitration provision in the Carlyle Group’s IPO “would deprive investors of important, congressionally established rights.” After much consternation among investors, the Senate and the SEC, Carlyle pulled the arbitration provision from its IPO. Step one, in the movement to recover contract rights.

Related article:

U.S. Senate: Letter on Carlyle IPO Provisions

The case of Carlyle’s failed attempt at forcing an arbitration provision on its shareholders is significant for two reasons:

• it shows how pervasive arbitration has become; and
• it provides a very current and powerful message from the Senate that arbitration is not an acceptable form of dispute resolution.

This begs the question: if arbitration is unacceptable for Wall Street investors, why is it tolerated for end-user buyers of real estate? Investors in a private equity firm are savvy enough to recognize that forced arbitration is a raw deal, and the Senate is willing to stand up for them. Yet the notion remains that agreeing to binding arbitration in real estate transactions is “standard practice.”

Not good enough for the CFPB

The SEC isn’t the only regulator keeping tabs on arbitration. We recently reported that the CFPB has begun inquiries into the arbitration provisions found in consumer financial services agreements as well.

Real estate purchase agreements differ by state and do not constitute a legal contract for a financial product. Thus, real estate purchase agreements do not fall under the purview of the CFPB. Instead, the CFPB is focusing on arbitration clauses mandated by corporations covering credit cards, bank accounts, gift cards and loans from payday lenders. While mortgages have yet to make the arbitration watch list, they are the subject of a broader inquiry into mortgage lending practices, including a mandate for a revised good faith estimate (GFE).

Related articles:

Lender GFE abuse

CFPB: Request for information for upcoming study on use of arbitration agreements in consumer transactions

The study of arbitration provisions in agreements for consumer products and services is required by Dodd-Frank and still within the public comment period. Although referred to as “public”, these comment periods are typically a time for industry professionals and lobbyists to argue against change.

Arbitration has been adopted by members of the financial services industry for one reason: it maintains an asymmetry of power in the corporation’s favor, eliminating the consumer’s right to judicial review and keeping the control on the corporation’s side, as they pick the arbitrator and typically have close “relationships” with providers of arbitration services.

But, it appears the CFPB is on to them. No changes have occurred yet, but rest assured those who have a vested financial interest in keeping arbitration provisions in their contracts are very worried with the new sheriff in town breathing down their necks.

However, we must once again ask the obvious question: what about buyers and sellers of real estate? If arbitration does not belong in a contract for a credit card or an investment in assets such as stocks, what business does it have in a real estate purchase agreement?

Not good enough for real estate

A brief look through the annals of first tuesday’s Recent Case Decisions reveals one glaring truth: the arbitration provision does not belong in real estate purchase agreements. It leads to:

• misinterpretation of the law;
• erroneous awards;
• the lost right to judicial review; and
• a lack of legal precedent.

Unfortunately, it seems that average buyers and sellers of real estate have yet to win the favor of any regulatory watchdogs. Transactions are made everyday with flawed trade union purchase agreements, used as a matter of “standard practice” and all-to-often signed with a blind eye for the highly damaging arbitration provision.

Fortunately, average buyers and sellers of real estate have their own personal watchdog built in to every transaction: their agent.

Usually from erroneous fear of engaging in the unauthorized practice of law or of killing the deal, many agents refuse to address the ramifications of their client initialing the arbitration provision in their purchase agreement. This is one aspect of real estate broker/agent custom that must change as it is inconsistent with law.

It is not engaging in the unauthorized practice of law to explain the consequences of a provision in a contract you have furnished your client with. It is, in fact, your duty to explain it. Further, fear not killing the deal — your client will thank you for your candor and you will be rewarded for looking out for their best interest. Transparency is the free flow in information, and most agents and all brokers have this information on their mind.

Although arbitration provisions in real estate trade union purchase agreements have yet to garner any scrutiny from regulators, there are a number of readily available solutions to this insidious issue:

• use a purchase agreement form that does not include an arbitration provision; or
• counsel your client that they are not required to initial the provision in order to enter into or close the deal.

The first solution is a no-brainer. There are many real estate forms superior to those produced by the trade unions and they do not include an arbitration provision (first tuesday has been publishing California real estate purchase agreements free from the provision for over 30 years).

If you are among the ranks of those who stalwartly refuse to change their forms provider, or if you are an agent who does not have a choice as your broker is intractable and refuses change, simply warn your client of the consequences involved in agreeing to binding arbitration and inform them that they are not required to initial the provision.

Until one of our regulatory agencies in the real estate industry (the DRE?) steps up and recognizes the deleterious effects of arbitration, it remains the responsibility of brokers and agents to protect their clients from agreeing to the clause. If it’s not good enough for Wall Street investors, it’s not good enough for your clients.

Mediation is the happy medium

Arbitration was born out of a genuine desire to save on court costs, expedite the dispute resolution process and generally improve the efficiency of the real estate marketplace. It has become quite clear, however, that arbitration has grown into a monster that now rages out of control, demolishing the reason and practical purposes it was founded upon.

There is a very simple solution — mediation. Mediation provides all of the benefits of arbitration but without the costs. Rather than requiring parties to a transaction agreement to sign away their rights and lose the benefit of judicial review, mediation allows for an alternative to litigation while allowing for judicial recourse if necessary.

Also key: contracts containing mediation provisions rather than arbitration provisions eliminate the “need” for an attorney fees provision. By requiring each party to bear their own court costs win, lose or draw, the lack of an attorney fees provision discourages complainants from escalating the dispute to full-blown litigation — an organic means of fostering low-cost, low-consequence dispute resolution by way of eliminating legal jargon rather than adding it ad infinitum.

If you haven’t done so lately, pull out a copy of your “standard” purchase agreement. If it includes an arbitration provision or attorney fee provision, seriously consider switching forms — it will save you and your client from dire consequences.