How to Secede in Business Without Really Leaving: Evidence of the Substitution of Arbitration for Litigation

0:00The evidence increasingly suggests that business is turning to private arbitration away from litigation to solve their disputes. Arbitration is faster, it's cheaper, it's less formal, it's less adversarial, so you can end up being friends after you arbitrate, but it's pretty hard to end up being friends after you litigate. Lawyers can be selected for their expertise on the matters that they're judging. Public judges certainly can't be. Privacy can be maintained. And perhaps more importantly from the context of this conference, businessmen that wish to avoid the application of state-made laws by agreeing to something else in a contract can avoid the public courts who would overturn the contract if it violates somehow state-made laws by going to an arbitrator who will look to the contract instead of statutes.

1:04So arbitration would appear to be a pretty attractive alternative to business or for business disputes. But it is frequently contended that arbitration clauses in contracts are effective and or More arbitration rules are accepted primarily because the state courts back arbitration. The states sanction arbitration, throw the power of the state to coerce behind arbitration rulings. Otherwise, so the argument goes, no one would live up to their arbitration agreements. No one would accept arbitration rules.

1:50This contention is typically based on the assumption then that without a threat, a coercive threat by the state, people who breach contracts to arbitrate couldn't be, or people would have incentives to breach contracts to arbitrate. And this contention is backed by, quote, evidence that the passage of modern arbitration statutes Statutes that commanded our common law courts to enforce arbitration agreements really is what set the development of arbitration in motion in the United States and that business groups actually demanded these statutes so that they could establish arbitration.

2:37Well, both of these pieces of evidence are false as it turns out. So this leads me to think about an alternative hypothesis, and there is one, that is that arbitration is a substitute for litigation, and in fact arbitration is a way for business to escape the control of the state, at least on some dimensions. The state courts or legislatures propagate rules regarding business behavior and the and the business prefer to follow rules that they create themselves in their contracts and therefore when they have a dispute they choose arbitration rather than state courts.

3:25Arbitration is a way for business to secede without really leaving. I think this, even though it is a departure from what we've been talking about, it is an important issue to think about in the context of a conference on secession because has at least three reasons. One, it suggests that there are many ways to withdraw from the control of the state, short perhaps of actually physically separating. And it also suggests that secession is going on all the time on many dimensions besides arbitration. Arbitration is one way that people are pulling themselves out from under the thumb of the state and this discussion should illustrate that.

4:19The third point to make is that one of the strong arguments often made in support of a stable centralized state is that you need the state to enforce contracts in order to have free markets. And what I'm suggesting here is, in fact, that's a fallacious argument as well. You don't need the state to enforce contracts. People will do it themselves if the state doesn't do it well. So in my paper, I try to illustrate that the assumption of state backing is false, that The evidence listed or cited to support that is false and that in fact the evidence is more consistent with the alternative.

5:13In my paper, which is a lot longer than my talk, I do present a theoretical argument as to why people might voluntarily accept arbitration, might voluntarily accept a loss in Arbitration and live up to the arbitration ruling without the coercion of the state. It's essentially an argument that Mises made. He pointed out in his book on human action that there are at least two sources of cooperation, if you want to think of it in that way. One is threat. You can make people cooperate.

6:00Coercion can be a source of cooperation. But Mises also explained that contractual coordination based on symmetric expectations of long-term gains can be a source of cooperation and a willingness to settle disputes. So essentially then there are two alternative hypotheses to think about. Actually, there are a number of theoretical reasons to expect that business would voluntarily arbitrate and voluntarily accept arbitration rulings without the threats imposed by state sanctions. I don't want to go into a lot of detail on the theory, but I think I can summarize it and illustrate it fairly easily.

6:46The essential idea, one that Mises makes, is that people often voluntarily create incentives for themselves to do things that may appear undesirable in the short run because they expect to benefit in the long run. And to illustrate this, I thought I'd, maybe I need to pause and set it up a little bit. I got my PhD from Texas A&M, which makes me an Aggie, I guess, and in Texas they tell Aggie jokes, and in fact the last time I spoke at a Mises conference was the 10th anniversary conference in New York, and I based my whole presentation on an Aggie joke.

7:36I hesitated to do that again, but then I remembered when I did that that Murray sat in the audience and Chuckle the whole time I was talking suggesting either he thought it was pretty funny or he thought I was ridiculous but out reminding me of that I decided to go ahead and do it again and so I'm going to illustrate my argument with an an Aggie Joke. I'm not trying to push an alternative paradigm to the Austrian School. I'm not suggesting there's an Aggie Joke School of Economics, although it probably would generate more insight than a lot of what passes for economics today. But I thought I'd try another Aggie Joke on this Mises I know that the Mises Institute is very concerned about maintaining its political correctness image, but I did check with the PC police and they tell me that white males can tell jokes about other white males.

8:49I am an Aggie, so I think this will be alright that I can tell an Aggie joke as well. The joke goes something like this. An Aggie walked into the men's room at Texas A&M in one of the buildings on campus. Saw another Aggie standing over the toilet, staring down into the toilet. So he walked over and looked into the toilet to see what was laying at the bottom. Well, there was a nickel laying in there. Both Aggies stood staring down into this bowl for a while and then the first one reached into his pocket and he pulled out a quarter. He dropped it in the toilet. The second one said, why in the world did you drop a quarter in the toilet? And the first one said, you don't think I'm going to reach in there for a nickel, do you? Well, I don't know if that illustrates much about arbitration but it It does suggest that people will create incentives for themselves to do things they may not necessarily

9:54like to do. And in the world of business, businessmen do that all the time. Businessmen, for instance, invest in building reputations for honesty, for fairness, for ethical behavior. investment becomes valuable and then they become bound by it and forced at times to do things they don't want to do in order to maintain the value of that investment. So, for instance, if you have a reputation for honesty, it means you have to live up to your promises. If you promise to accept an arbitration ruling and it goes against you, you accept it anyway. Just like the Aggie might reach So the point then is that people voluntarily can create incentives to do things they don't necessarily want to do in the short run because they expect to be better off in the long run.

11:02The question then I guess in this talk is are businessmen more like Aggies or more like the people that suggest that they have to be forced to live up to their promises and in that regard we need to look at or there are certainly different ways to test these alternative hypotheses but one is to look at history and see what businessmen have done the conventional wisdom seems to be that arbitration in the United States started in 1920, with the passage of the arbitration statute in New York, and then subsequent passages in New Jersey, the federal government, Oregon, Massachusetts, all before 1925, and a series of additional state statutes, which essentially ordered common law courts to accept arbitration rulings as binding.

12:10I guess the evidence supporting this contention is that there weren't very many cases brought to court about arbitration. And so before 1920, suggesting to some historians that there must not have been very much arbitration. But looking at public court records is not a very good indicator of the amount of arbitration. Similarly, with the passage of arbitration statutes, I'm going to suggest that the propensity to litigate, to appeal to the public courts, increase dramatically. And so what we see is with the passage of the statutes is not an increase in arbitration, but an increase in litigation about arbitration.

13:03So we need to look at all other sources of evidence about arbitration. The historians have done so. Their work has simply been ignored, I think, in this debate. For instance, Jones, in an important article, I think, published in 1956, used newspapers, Merchant Letters, records from the New York Chamber of Commerce, legal records, and he found arbitration was in constant and widespread use in New York, going back into the 1600s, 1624 to 1664 under the Dutch, and then again under the British after that. Others have looked at New York as well and found similar evidence, wide-scale use of arbitration among the business communities.

14:07Others have looked at all of the other states or colonies and found widespread use of arbitration among businessmen in those places. Arbitration between businessmen in New York and Philadelphia was common in the 17th century. So commercial arbitration was widespread even before the United States was a nation. An example, the New York Chamber of Commerce at its first organizational meeting in April 1768 established an arbitration committee. It was appointed on June 7th of that year and was in business continuously until 1776 when it disband for a while, but then even during the war it was revitalized.

15:10During the British occupation, the British forces sent all civil cases to the Chamber of Commerce, because it was the only court in town. So arbitration by businessmen has a long history in the United States. The assumption that it started in 1920 is simply false. Not only did it have a long history, but the evidence suggests that it was growing continuously through this history, despite a very contentious view of arbitration by the public courts, by the common law courts. The common law courts didn't like arbitration, and if a case was appealed from arbitration, they found lots of ways to overturn the arbitration ruling.

16:03So these arbitrators and their courts were not taking their authority from the common law courts during this time. The relevant precedent comes from England in 1609, which essentially says the common law courts are, they know the law, arbitrators don't, so we can overturn anything that arbitrators do. So this was arbitration based, gaining its authority from someplace else. Well, I would suggest it was gaining its authority from the business community itself. Businessmen were willing to arbitrate and willing to accept arbitration because it was in their self-interest to do so. Even if they lose, they recognize that in the long run, they gain by behaving honestly, by living up to their promises to accept arbitration and so on.

17:00The fact is that every commercial group that organized, that I've seen evidence about through the 1800s established some sort of arbitration mechanism, not just between businessmen but also between businessmen and their customers. The New York Stock Exchange established its arbitration arrangements in 1817, I think, to arbitrate disputes between the stock industry and their customers and it's been going ever since so the evidence of widespread use of arbitration is quite strong and the the reasons are also I think fairly apparent the one interview of a businessman in New York back in The early 1800s asked why they didn't use the public courts. He responded not only did courts, according to expensive endless law, they were slow to develop legal doctrines that facilitated commercial development. In other words, they were slow, they were costly, they didn't enforce the law that the that the businessmen wanted, so the businessmen simply ignored them, by and large.

18:37The growth of arbitration is particularly strong during the last third, roughly, of the 1800s. And I think there's a couple of reasons for that. Essentially, the cost of litigation was increasing. Court delay was becoming increasingly important during this period and of course as it takes longer to get a case tried, that's expensive for businessmen and so even those who might prefer litigation over arbitration for some reason would tend to shift towards arbitration. And the other factor of course is the growth of the regulatory state which we can start start seeing in the last part of the 1800s as commercial autonomy became increasingly an issue and businessmen were trying to shield themselves from government more and more with the increasing effort of government to control business activity.

19:42So in other words, businessmen were seceding from the control of government long before the passage of the arbitration statutes. By World War I, arbitration, I mean the courts were completely irrelevant in many areas of business as business trade associations had their own arbitration tribunals and that's where disputes were handled. Well this brings up another question. If arbitration is so great and the businessmen were using it anyway, why were the statutes passed? What motivated the passage of these statutes? The typical argument is the business community demanded them because they felt like they needed the backing of the state in order to avail themselves to this more efficient litigation or dispute resolution process.

20:38Without state sanction, they couldn't pull it off. Well, I've looked at the history of the passage of the statutes as well then. And it turns out that the political pressure that started to build during the second decade of the 20th century for legislation of these arbitration statutes came primarily from the legal profession. not from the business community. Trial lawyers, for instance, were seeing business disputes shifted increasingly into arbitration tribunals. The trade associations don't like lawyers and they never have.

21:26In fact, one survey 40 years after the passage of these statutes in the late 1950s found that 40 years later, 40% of the trade associations still explicitly forbade lawyers representing parties in arbitration, and the other 60% discouraged them. So there was a forum for dispute resolution that was developing and very viable that wasn't using lawyers and lawyers then were looking for a way to get themselves into the arbitration process. At least that's my hypothesis. They, of course, they might have preferred, some of them even explicitly said they would have preferred to eliminate arbitration, make it illegal so that they could force disputes into the public courts. But I think they recognized that that wasn't possible, at least many of them did.

22:31So what might we do then as lawyers to get some arbitration business? Well, maybe we can pass some laws that allow for arbitration to be appealed to the public courts and tell the public courts to recognize arbitration rulings. But then with the prospect of appeal to the public courts, the parties in the arbitration disputes might need to consult with lawyers about that potential.

23:12Now, one critic of my argument here pointed out that most lawyers never go to trial, that most lawyers wouldn't be worried about this particular issue. But my response was that the lawyers who specialize in contract writing also would be threatened by arbitration because if you've got a good, cheap way to resolve disputes, you don't have to spend nearly as much time worrying about what the contract says. So contract writing lawyers were also threatened by arbitration and its growth. So the Bar Association started pushing for arbitration statutes. and they were successful first in New York and then in some other states and they got the Federal Statute passed.

24:00The impetus came from the Bar Associations. The Bar Associations drafted the statutes. They did create some other organizations sort of as fronts in this lobbying effort. The Arbitration Society of America was a big pusher, but it turns out that it was a spinoff of the American and New York Bar Associations. The American Arbitration Association, as well, was early on dominated by the Bar Association and active in the political process. and I have a lot of detail in my paper about that process for those of you who might be interested.

24:50What's the consequence? Well, as one observer noted shortly after the New York Arbitration Act was passed, the legal machinery for protecting and safeguarding and supervising arbitration was established, but instead of narrowing the jurisdiction of the Supreme Court, it broadened it. Instead of being ousted of jurisdiction over arbitration, the courts are given jurisdiction over them. The parties aggrieved have ready recourse to the courts. There was an explosion of litigation, not about arbitration rulings, but about the arbitration process itself. What was the court going to accept as appropriate procedures in arbitration? Do lawyers have to be present to all of those sorts of issues?

25:38And so, to a substantial degree, it appears that the bar associations were successful. For instance, in American Arbitration Association arbitration, the use of counsel rose from 36% in 1927 to 70% in 1938 to 84% in 1942 to 91% in 1947. So, start out with no lawyers and end up with lots of lawyers. I'm running out of time here. In conclusion, then, let me suggest that there's a literature in economics and law that says that common law rules evolve efficiently.

26:30And I certainly don't agree with that, but in the area of commercial law, there might be a little bit to it because of competition. There is competition from arbitration tribunals for the common law courts. So common law courts want business, dispute resolution business. They are going to have to develop law or enforce laws that the business community in general Supports, assuming the competition is fair, assuming we have a level playing field. Unfortunately, that's not the case. Since 1930, for instance, a Supreme Court case, Paramount Lasky Corporation v. the United States, an agreement to boycott, designed to back an arbitration system was struck down by the Supreme Court.

27:26A group of motion picture producers had agreed to place an arbitration clause in their contracts with motion picture exhibitors to boycott any exhibitor who refused to arbitrate or refused to accept arbitration rulings. The boycott agreement was declared illegal. So the mechanisms that private groups might develop to support their arbitration can be be undermined by coercive public, by the coercive state. Maybe a more significant threat to arbitration is the indirect one of limiting the scope of contracting. For instance, under the common law up until 1916, product liability issues were contract issues.

28:15You had to have a contractual relationship with someone before product liability issue could be tried. But then in 1916, the courts started expanding the product liability to people who were not in a contractual relationship. And that tidal wave, of course, has led to the explosion in product liability torque that we see today. Taking product liability issues out of contract means that it makes it much more difficult to Arbitrate Them and creates a booming business for the public courts, of course. So with these kinds of changes, it may be increasingly difficult for businessmen to secede without really leaving.

29:07They may have to actually leave if they want to avoid the public common law courts. The sheriff might come in and tell the Aggie that he can't throw his quarter in the toilet in order to get the nickel out, but the Aggie can always flush the toilet and head for the sewer plant, I guess. And maybe that's what businessmen will have to do as well.