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Punitive Damages Decision Highlights Pitfalls of Arbitration

October 1989

Arbitration clauses are very popular in technology-related contracts. However, often they are incorporated with little thought as to how they might change the outcome of litigation should they come into play.

Some of the better known consequences of arbitration affect the procedures by which a dispute is decided. Discovery rights (the right to take depositions, obtain relevant documents from the opposing party and obtain answers under oath to written questions) may be curtailed and the rules on admissible evidence may be limited or ignored; unlike a court, arbitrators are also free to render their decisions with little or no explanation of how the decisions were made.

A recent case decided by the federal appeals court in Boston illustrates the extent to which the choice of arbitration over a court proceeding may directly affect the monetary outcome of a case. Automated Business Systems, Inc. alleged breach of contract and fraud in connection with a distribution agreement which contained an arbitration clause. The arbitrators awarded Automated not only its actual damages, but an additional $250,000 in punitive damages. Raytheon, the defendant, sued in federal court in Massachusetts, asking the court to rule that the arbitrators lacked the authority to award punitive damages. The court refused to do so, and on appeal the First Circuit Court of Appeals agreed, holding that it is within the authority of arbitrators to make punitive damage awards.

The most notable aspect of the decision was the court’s observation that the arbitrators’ authority to award punitive damages was inherent under the federal law of arbitration, and did not depend on whether the law of the state controlling the dispute permitted punitive damages. For example, in the Raytheon case, Raytheon’s contract with Automated specified that California law would control the dispute. California law permits courts to award punitive damages in commercial disputes, while Massachusetts law does not. Under the court’s ruling, the Raytheon arbitrators could have awarded punitive damages against Raytheon even if the contract had specified that Massachusetts law would govern.

TLB Comment : The Raytheon court stated that parties to a contract are free to draft arbitration clauses which expressly exclude punitive damage claims, and we expect that such exclusions will now become a commonly negotiated issue in many contracts. However, there are innumerable arbitration clauses currently in effect where the issue of punitive damages is not addressed. Claims for punitive damages will soon become the norm when disputes arise under these contracts, adding a powerful wildcard to arbitration proceedings.

Another pitfall of arbitration is the ability of the owner of technology to obtain a “preliminary injunction”– that is, a court order — to stop the illegal use of its technology. If the preliminary injunction can’t be obtained, the plaintiff may not survive long enough to see the case through to trial. Conversely, the preliminary injunction may effectively put the defendant out of business immediately.

For this (and other) reasons, it is often a far more attractive strategy for a plaintiff to attempt to immediately stop the defendant’s use or distribution of the technology, rather than permit the use to continue and hope to obtain damages in the distant future.

Arbitrators are sometimes reluctant (or may even lack the authority) to hear and decide an emergency preliminary injunction motion. For this reason, well-drafted arbitration clauses should reserve each party’s right to seek preliminary injunctive relief from the courts, while leaving all other issues, including the ultimate decision on liability, to the arbitrators.