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The growth of arbitration in the finance sector

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Freeman James
James Freeman

Partner

London

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02 February 2012

Banks have traditionally preferred litigation to arbitration.

That is now changing in emerging markets transactions because of the enforcement advantage offered by arbitration.

In some markets outside Europe and North America, arbitration is now becoming the market standard. This makes it more important for banks to understand this area of the law. This article draws attention to some of the key issues, including in particular drafting pitfalls to avoid, and recent developments in the field of which banks should be aware.

Traditionally, banks have preferred litigation over arbitration to resolve their disputes. Two factors tended to influence their preference.

Commercially-minded judges in leading jurisdictions would reliably deliver robust judgments which enforced the letter of the banks’ contractual documentation and followed earlier precedents. By contrast, no system of precedent binds arbitrators, and there was a perception that tribunals of three arbitrators tend to produce a compromise decision that offers some reward to both sides.

Many courts offer a summary procedure which, it was felt, would avoid protracted litigation for simple processes like debt collection. It was thought that arbitration did not offer a similar expedited process.

There remains some truth in these distinctions, although both can be overstated.

As to the first distinction, if a bank wants robust decision-making from an arbitral tribunal, it can nominate its own arbitrator with the right profile, and may also have some influence over the choice of the tribunal’s chairman. For example, there is a growing body of awards in which the ISDA Master Agreement has been interpreted in accordance with its terms by tribunals featuring arbitrators chosen by banks with that purpose in mind.

As to the second distinction, summary judgment can be difficult to obtain. For instance, recent litigation arising out of the financial crisis has shown defendants succeeding in avoiding summary judgment by raising mis-selling allegations which require a trial to determine. It is also incorrect to assume that a summary process is not available in arbitration. There are few limits to the parties’ ability to decide their own process in an arbitration; among other things, their arbitration agreement can set out an expedited process resembling summary judgment.

Nevertheless, historically arbitration was little used by banks until the last few years, when substantial growth has been seen in the use of arbitration by banks. The article from Slovakia earlier in this Review reports on the popularity of arbitration in finance disputes.

The growing popularity of arbitration

There are a number of factors driving the growing popularity of arbitration. Among these are:

  • that arbitration offers a neutral forum where the alternative would be unreliable local courts;
  • that arbitral proceedings tend to be confidential (although specific drafting may be required); and
  • that an arbitral award is a final decision that cannot usually be appealed.

However, one advantage stands out above all: the ease of enforcement. Within the EU, the Brussels Regulation enables court judgments to be enforced across borders with relative ease. However, enforcing a court judgment in another state becomes considerably harder outside Europe. By contrast, arbitration benefits from the 1958 New York Convention (NYC), which has been called “perhaps the most ef fective instance of international legislation in the history of commercial law”. It enables an arbitral award rendered in one NYC contracting state to be enforced in any of the other 144 contracting states, simply by presenting the award and the arbitration agreement.

Unsurprisingly, the practice of enforcement is not always as easy as it looks on paper. India, for example, has ratified the New York Convention, but will only enforce the arbitral awards of countries that have “registered” with it, despite this not being a requirement of the NYC. And there are no known cases of an arbitral award being enforced in Saudi Arabia, despite it being a party to the NYC.

Nevertheless, as banks, like other global businesses, look increasingly to emerging markets for investment and growth, arbitration can substantially reduce the enforcement risk associated with a transaction. Arbitration is fast becoming the market standard in financial transactions in Asia, for example, because of the unreliability of the courts in a number of jurisdictions. As a result, we are seeing growing interest in arbitration from banks and other market participants. Reflecting this interest, ISDA is currently consulting on a number of services that it might offer its members as a result of their increasing use of arbitration, including the provision of standard arbitration clauses for use with the ISDA Master Agreement.

Whilst confidentiality in arbitrations can be an advantage, it can also operate as a disadvantage. The awards are generally not made public and they have no “precedent” value, ie they do not have to be followed in subsequent disputes involving the same or similar legal issues. In disputes involving commonly argued points (for example, recently there have been a number of cases where municipalities have put forward lack of capacity arguments to try and evade contractual liability) this lack of precedent could mean that banks end up having to arbitrate or litigate disputes on legal points which have already been determined in a previous arbitration

Drafting considerations

Arbitration may offer advantages, but it also involves more work at the drafting stage. Arbitration is based on the parties’ consent. It is critical, therefore, to ensure that the arbitration agreement meet the parties’ needs. Banking transactions typically involve complex suites of contractual documentation. Two particular difficulties arise. The first is joinder: ie joining an extra party to an existing arbitration. The second is consolidation: ie joining two existing arbitrations into a single proceeding. National courts have innate joinder and consolidation powers, but arbitral tribunals need the prior consent of all relevant parties. This can be achieved in the arbitration agreement, but requires careful drafting.

A strong trend in the market practice of European banks (less so in Asia) has been to use “optional” arbitration clauses. These clauses provide that a dispute will be resolved by arbitration, unless a party exercises an option to litigate the dispute (or vice versa). Generally, the option is open only to the banks, rather than the debtor.

These clauses reflect banks’ customary wish to have flexibility over where they can sue for the debt. However, they are not free from risk. While their validity in some jurisdictions like England and France has been established, there are real doubts as to whether an award would be enforceable in other jurisdictions if the underlying arbitration agreement was optional. These clauses are particularly popular in Russian deals. A recent trickle of Russian cases have upheld their validity but the current advice remains that Russian law in this area is not yet settled. The current position in China is that optional arbitration clauses are not valid there.

This uncertainty means that while an optional arbitration clause offers obvious advantages to a bank in the right case, it should not be regarded as boilerplate. Rather, banks should consider for each specific transaction whether an optional arbitration clause should be included.

Recent developments

Three recent developments are worth noting for the use of arbitration in financial transactions.

Reforms to institutional rules

First, we are in the middle of a round of revisions to leading institutional rules. Banks need to be aware of these revisions to ensure that their existing standard clauses remain fully effective under the amended rules. Some of the amendments are designed to make the rules work more easily for multi-agreement transactions like syndicated loans. For example, the new ICC Rules, which came into force on 1 January 2012, contain joinder and consolidation provisions which go a good way towards addressing the issues described above. A revised version of the LCIA Rules is due to be published this year. Banks will need to ensure that their standard clauses continue to work properly under the new rules. Having studied the new ICC Rules, our view is that standard-form joinder and consolidation wording may well require revision.

P.R.I.M.E. Finance

A second development relates to the establishment of P.R.I.M.E. Finance (Panel of Recognised Market Experts in Finance). This body was established with the professed aim of facilitating the resolution of disputes in global financial markets by bringing together a panel of experts from different market disciplines. It appears to be envisaged that members of the panel will have a number of roles, including as expert witnesses and mediators for complex financial disputes. It is also expected that they will act as arbitrators, while P.R.I.M.E. Finance itself is expected to act as an arbitration institution, administering arbitrations and publishing its own arbitration rules, which are due imminently. P.R.I.M.E. Finance has established some traction. There are undoubtedly some eminent experts on its panel, both in finance and arbitration. ISDA’s consultation exercise contemplates that it might be one form of arbitration offered in a suite of standard ISDA arbitration clauses, alongside well-established institutional rules like those of the ICC and the LCIA. It is therefore worth keeping track of P.R.I.M.E. Finance’s progress. However, it is very early days – too early to say whether it will take off.

Arbitration of financial disputes under investment treaties

A third development of note is the use of investment treaty arbitration in financial disputes. This is a different creature to the commercial arbitration of largely contractual disputes. Under a bilateral investment treaty (or BIT), a state (the “host state”) offers certain protections, under international law, to the investments of investors of the other contracting state (the “home state”). The home state investors are able to bring an arbitration claim against the host state if those protections are not met. Historically, investment treaty arbitrations have concerned what might be regarded as “traditional” investments, like major infrastructure projects. However, we are now seeing arbitrations arising from financial transactions. There is growing acceptance that financial products can constitute “investments” for the purpose of these BITs. For example, holders of Argentinean sovereign debt at the time of the financial crisis there have established that their bond holdings amounted to investments under the relevant BIT, and that therefore a tribunal has jurisdiction to hear their claims that Argentina did not meet its international law obligations to protect the value of the bonds. Given the sovereign debt concerns currently being seen, it is worth bearing in mind that this is one option on the table – although it is an option not to be chosen lightly.

Comment: With the rise in the use of arbitration clauses in the contractual documentation for emerging market transactions, banks are likely to find themselves involved in a growing number of arbitrations. Both banks and arbitration practitioners have work to do, to ensure that arbitration results in disputes in the financial sector are being resolved successfully. Banks need to check that their arbitration agreements meet their needs, and that they keep abreast of developments in an area of law and legal practice on which traditionally they have not had to focus. Arbitration practitioners need to ensure that arbitration meets the needs and expectations of the financial sector.

Further Information

The European Finance Litigation Review is a quarterly publication on recent developments in the finance litigation and regulatory sector in key European jurisdictions.  For more information please contact Amy Edwards amy.edwards@alleovery.com.