by Nathan O’Malley
|Nathan O’Malley, USC Gould Lecturer in Law
In the ADR world the term “carve-out” refers to an exception within an alternative. Arbitration is a popular alternative tocourt litigation, but contracting parties may not wish to commit all potential disputes to that forum. Frequently, negotiations over the choice for litigation or arbitration will lead contractual parties to draft a court litigation exception, or “carve-out”, within an arbitration clause. Advocates for such clauses argue that they provide for greater flexibility and customization of the dispute resolution process, however, as a number of recent court decisions show, the application of a “carve-out” can be prone to problems in practice. This piece considers some of those problems and potential solutions.
“Carve-out” provisions are frequently used to distinguish claims regarding a certain subject matter, such as those concerning intellectual property, from general commercial disputes. An arbitration clause that contains a “carve-out” may resemble the following sample (“carve-out” language in bold):
“Any dispute arising out of or related to this Agreement shall be submitted to binding arbitration under the [specified rules (the “Rules”)] to be heard by a sole arbitrator appointed in accordance with the Rules, except for those causes of action brought in connection with the ownership or right to use [specified intellectual property] which shall be submitted to the exclusive jurisdiction of the courts of [specified jurisdiction].”
Other variations of “carve-outs” may see parties excepting to the jurisdiction of courts those actions brought for specific types of relief, such as injunctions, while requiring damage claims to be heard in arbitration.
Drafting a “Carve-Out” — Issues to Consider
Litigation over the intent and meaning of a contractual dispute resolution clause exemplifies the phrase a “lose-lose scenario”. The intended benefit of a detailed disputes clause is to provide all contractual parties with a clear path to resolving their differences, but that value is lost and extra costs are incurred when contentions arise over the scope and meaning of such provisions. Unfortunately, “carve-out” clauses have been known to generate disputes of this kind, but a survey of available precedents suggests that much of that can be avoided through careful drafting. The following points summarize some key takeaways drawn from recently published decisions regarding disputes over “carve-out” provisions:
1. Designate “who”, arbitrator or court, is to decide where the dispute belongs.
It is not always easy to define a dispute and thus whether it is subject to a “carve-out.” Therefore, someone, court or arbitrator, will have to decide this preliminary issue. In the Ninth Circuit case of Oracle America Inc. v. Myriad Group A.G [i], the parties had drafted a clause that read in part “[a]ny dispute arising out of or relating to this [agreement] shall be finally settled by arbitration as set out herein (…).” In the same sentence, the parties specified that some claims regarding intellectual property were to be litigated in court. A dispute later arose which would eventually come before the Ninth Circuit on the issue of who should decide whether the case was subject to litigation or arbitration. The Court considered that the broad choice in the clause for arbitration of any dispute, plus the incorporation of rules that vested arbitrators with authority to rule on their own jurisdiction, meant that the issue should be sent to the arbitrator to decide.
The opposite outcome occurred in the case of Archer and White Sales Inc. v. Henry Schein Inc.[ii] There, the litigation “carve-out” was, in the Fifth Circuit’s view, placed in a position within the clause so as to modify the delegation of authority to an arbitrator that would normally accrue under the language assigning to him or her any dispute to decide. Consequently, after much litigation, the Court proceeded to determine itself whether the matter was to be heard in court or in arbitration. [iii]
These cases highlight the fact that seemingly innocuous drafting choices can significantly impact the course of dispute resolution. If possible, it is best to anticipate, instead of litigate the “who decides” question by including express language in the clause to the effect that: “Any controversy or disagreement regarding whether a dispute (or claim within a dispute) arising pursuant to this clause is to be submitted to arbitration or to the designated court, shall be referred to [designate arbitrator or/ court] for a final determination.” [iv]
2. Beware of broadly framed “carve-outs.”
Including a broad or imprecisely defined “carve-out” for litigation may lead to a summary disposition of the entire claim. This is what happened in the Second Circuit case Nasdaq OMX Group Inc., v. UBS Securities LLC [v], in which the parties to a service agreement carved-out from the general arbitration clause any claim that could not be arbitrated according to the internal rules of the NASDAQ exchange [vi]. In accordance with its understanding of the “carve-out” language, the Court determined that it was required to analyze the merits of the claim under the NASDAQ rules, and subsequently denied arbitration because the claim was substantively defective. Although the Court’s purpose in conducting its analysis was to determine the arbitrability of the dispute, the outcome was, in essence, akin to what would occur in a motion to dismiss [vii]. Parties should be aware that overly broad “carve-outs” may lead to the unintentional summary disposition of claims.
3. “Carve-outs” based upon remedies may lead to the entire matter being sent to the courts. S
ome “carve-outs”are predicated on the type of relief sought, as opposed to the subject matter of the claim. In the Archer and White case mentioned above, the Fifth Circuit determined that the litigation “carve-out” for “actions seeking injunctive relief” meant that if a claim for injunctive relief appeared in a dispute, the entire matter could not be arbitrated [viii]. The Court accepted that its interpretation meant that a party could simply scuttle any right to arbitration by including injunctive relief amongst its claims, but it felt constrained to rule in this manner by the language that had been used in the clause. Given that arbitrators are capable of issuing injunctions, and that most arbitral rules permit parties to approach courts for preliminary or emergency injunctions without waiving their right to arbitrate, it is questionable whether a litigation “carve-out” for injunctive relief is useful [ix]. Nevertheless, if intent on doing so, parties should consider specifying that the only matter assigned to litigation would be the injunction, with all other claims submitted to arbitration [x].
4. Narrow arbitration clauses are subject to defeat by broad pleadings.
The general approach to using a “carve-out” is to pair it with a broadly framed arbitration provision. Nevertheless, where references to arbitration are themselves narrowly tailored, courts no longer assume that most claims should be arbitrated, and instead look to the pleadings to determine if the dispute fits within the limited arbitration provision or the equally specific “carve-out.” [xi] This scenario gives the party crafting the complaint significant influence over whether the dispute will ever go to arbitration, as strategic pleading can slant the characterization of the dispute towards litigation. Ultimately, what the court sees as the “central” issues in the case, or the “real” points of contention as per the pleadings will determine where the case is heard [xii]. Parties seeking to use narrow arbitration provisions should be concerned about their effectiveness if a dispute truly develops.
Ultimately, “carve-outs” may be a useful tool to resolve difficult negotiations over an arbitration clause. Nevertheless, those seeking to draft an arbitration provision containing a “carve-out” should be careful to include precise language to guard against unintended outcomes.
i Oracle Am., Inc. v. Myriad Grp. A.G., 724 F.3d 1069 (9th Cir. 2013).
ii Archer & White Sales, Inc. v. Henry Schein, Inc., 935 F.3d 274 (5th Cir. 2019). This case is now before the U.S. Supreme Court. The Court’s decision may help to clarify the rules of construction around this type of clause.
iii Id., at 283 et seq.
iv While it is often the case that the incorporation of arbitration rules that contain a delegation of authority to the arbitrator to decide matters of arbitrability will resolve any issues of “who decides,” both Oracle and Archer and White involved clauses that incorporated such rules, but the courts arrived at different results. As was the case in Archer and White, the language of the “carve-out” may be interpreted to defeat the effect of the rules. A better approach is to include an express delegation of this authority to the arbitrator within the clause itself to remove any doubt over “who” decides. See Archer & White Sales, Inc. v. Henry Schein, Inc., 935 F.3d 274, 281 (5th Cir. 2019) (“Defendants urge that Crawford controls and the only difference between that arbitration agreement and the one here is syntax—the ordering of words. But that is precisely the point—the placement of the carve-out here is dispositive.”).
v NASDAQ OMX Grp., Inc. v. UBS Sec., LLC, 770 F.3d 1010 (2d Cir. 2014).
vi Id., at 1016, 1032, and 1035.
vii Id., at 1035.
viii Archer & White Sales, Inc. v. Henry Schein, Inc., 935 F.3d 274, 282 (5th Cir. 2019) (“…the [‘carve-out’s’] plain language includes all actions seeking injunctive relief, not a more limited category of cases.”).
ix See, e.g., ICC Rules art. 28(2) and ICDR Rules art. 24(3).
x Even here, the potential for parallel litigation and other unanticipated outcomes should give reason to pause before including such a “carve-out.”
xi In Microsoft Corp. v. Samsung Elecs. Co., 60 F. Supp. 3d 525 (S.D.N.Y. 2014), the Southern District of New York was called upon to determine whether a dispute set out in Microsoft’s complaint fell within a narrowly tailored ICC arbitration clause, or within the clause’s reference to litigation. In making its determination, the Court carefully analyzed the claims and portions of the contract. Ultimately, the Court issued a decision on what constituted the “crux” of the dispute, or the “central” issues in dispute. This case illustrates both the process required and the somewhat subjective analysis of the matter. Id. at 531.
xii Microsoft Corp. v. Samsung Elecs. Co., 60 F. Supp. 3d 525, 530 (S.D.N.Y. 2014) (“…where, as here, the arbitration clause is a narrow one, the court ‘must be careful to carry out the specific and limited intent of the parties’ … [t]he court must order arbitration only if the question at issue is ‘on its face within the purview of the clause.’” [citations omitted]).