By Tom Hals

WILMINGTON, Del., Sept 10 (Reuters) - Advocates of a novel private arbitration system in Delaware that was shot down by a federal court aren't giving up. They are mounting an appeal while also looking at ways to revamp the program so it passes constitutional muster.

Delaware enacted the system, believed to be the only arbitration program in the nation in which sitting judges act as private arbitrators, to bring more legal business to the state. But U.S. District Judge Mary McLaughlin in Philadelphia put a stop to the arbitrations, ruling on Aug. 30 that the proceedings were essentially civil trials and that conducting them behind closed doors violated the First Amendment guarantee of public access to government proceedings.

Many Delaware lawyers saw the arbitrations as a potential source of new business as well as a way for the state's legal industry to head off competition from alternate dispute forums in New York and overseas. Arbitrating big disputes such as joint venture disagreements has become particularly popular with non-U.S. businesses because it can resolve them quickly and out of the public eye.

Members of Delaware's bar argued that their system adopted the best features of existing arbitration programs -- quick hearings with customized procedures -- along with a big local advantage: the Court of Chancery's five judges would act as arbitrators.

The litigation challenging the arbitrations was brought by the Delaware Coalition for Open Government, which argued that the public has a right to access proceedings that are overseen by judges on the public payroll. Judge McLaughlin agreed, writing that "the judiciary as a whole is strengthened by the public knowledge that its courthouses are open and judicial officers are not adjudicating in secret."

An attorney for the Chancery judges -- the defendants in the case -- said they will seek to overturn McLaughlin's decision at the 3rd U.S. Circuit Court of Appeals. So me Delaware lawyers said McLaughlin's opinion provided an opening for the appeal: The judge suggested the Chancery proceedings might pass muster if they could more clearly be seen as exercises in commercial arbitration rather than as civil trials, and if advocates could demonstrate that secrecy benefited the parties.

The appeal could try to distinguish the Chancery arbitration from civil trials by emphasizing the customized nature of proceedings, which allow the parties to craft their own rules regarding discovery and other procedures.

The appeal notwithstanding, Delaware lawyers are already contemplating ways to recast the law, and one lawmaker said there would be support in the Delaware General Assembly.

"We want to stay competitive. We want Chancery Court to have the best tools possible," said Lincoln Willis, a Republican member of the state's House Judiciary committee. "It's really important for employment and it is a significant generator of revenue."

Among the changes under review: To answer the concern over secrecy, the final hearings in the arbitrations could be made public. Also, the system could rely on retired Chancery Court judges, instead of sitting ones.

"At worst, there are a few tweaks there that make it free from a constitutional claim," said Mike Kelly, of McCarter & English in Wilmington. "The general principle of arbitration has got to be favored. There's too much litigation in this country."

However, some of the retired Chancery judges already act as private arbitrators. T hat might make it hard to distinguish Delaware's program from what is now available through organizations such as the American Arbitration Association.

Since Delaware launched its arbitration program in 2010, there have been an estimated seven arbitration cases filed. Some have settled and at least one is thought to have led to a ruling, although it is hard to know for sure, given the system's secrecy.

The arbitrations gained prominence last year when semiconductor maker Advanced Analogic Technologies Inc disclosed that it took a disputed merger with rival Skyworks Solutions Inc into the process. The two settled.

GROWING COMPETITION

For Delaware, law is big business. Two-thirds of the companies in the S&P 500 call Delaware home, in part thanks to its corporate law, which gives corporate directors wide latitude so long as they maintain their fiduciary duties to shareholders. The Chancery Court is the keeper of that law, making it one of the most prominent business courts in the country.

But the court's boosters fear that role might be slipping away, and Chancery arbitration was aimed at bringing it back.

"If certain businesses are not offered the opportunity to use the Delaware Court of Chancery to resolve their disputes confidentially," stated an amicus brief filed by the Nasdaq and New York Stock Exchange, "they may choose other dispute resolution venues, which may be outside the United States."

The legal team of the two exchanges included William Chandler, who until last year was the chief judge, or chancellor, on the Chancery Court.

The Chancery arbitration system had promised to bring in money for the state. Filing a case cost $12,000 compared to less than $1,000 for filing a public civil lawsuit.

The Chancery arbitration could be used by two consenting businesses with a dispute worth at least $1 million and could get a final hearing in 90 days in front of one of the sitting judges.

The law also required at least one party be incorporated in the state, potentially expanding a rich source of fees for Delaware. Corporations and other entities paid $759.7 million last year for the right to base themselves in Delaware, amounting to 21 percent of the state's general budget revenues.

Attorneys said they have been recommending that clients write into contracts that disputes must be resolved in Chancery arbitration.

For example, data analysis firm Teradata Corp's agreement last year to acquire Aster Data Systems for $263 million included a clause that any legal proceeding stemming from the agreement would go to binding arbitration in the Chancery Court, according to a regulatory filing.

Supporters said that despite the legal setback, they expect that Delaware Chancery arbitrations, in some form, will likely take root in the coming years.

"In five years, we could see substantial growth in the number of these cases, said Gregory Varallo, of Richards, Layton & Finger in Wilmington, "It could even rival the number of public business cases."

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