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Don’t be a Midnight Cowboy: avoiding common pitfalls when drafting and negotiating arbitration clauses

There is no shortage of (mostly?) apocryphal stories about clauses that are put into draft agreements as a joke at an early stage of negotiations and, due to oversight, are never removed. My personal favourite is the so-called “End of the World” clause which goes something like this:

“Upon the occurrence of the end of the world, all loans will become immediately due and payable and the Lender may enforce its rights by any available procedure. For remedial purposes, the Lender will be deemed aligned with the forces of light, and the Borrower with the forces of darkness, unless and until Lender elects otherwise in writing.”

More troublesome, however, are the so-called “midnight clauses.” These are the clauses that are negotiated (or not) at the very last minute, when the parties are in a rush to close the transaction. All too often, perhaps because they are usually to be found towards the end of a contract, dispute resolution clauses (and particularly arbitration clauses) fall into this category. This is just one of the reasons why there is no shortage of examples of poorly drafted arbitration clauses. These clauses can result in confusion as to the actual intention of the parties, causing delay and additional expense if a dispute arises.

So, for the benefit of midnight cowboys everywhere, here’s a quick rundown of some of the most common pitfalls when drafting arbitration clauses and how to avoid them.

Inconsistency

It’s not uncommon to see an arbitration clause, recently inserted towards the back-end of an agreement, followed, a few clauses further on, by a boilerplate jurisdiction clause giving exclusive jurisdiction to the English courts. Nine times out of ten, when adding the arbitration clause, someone has simply forgotten to delete the boilerplate clause. Avoiding this pitfall is simple. Generally speaking, if you are agreeing to arbitrate, you should not in the same document be agreeing to submit to the jurisdiction of the courts. If you do want to retain the option to go to court, then that needs careful drafting and you should seek advice.

It is even more common to see this inconsistency across a suite of transactional documents. In some cases, this is a considered decision. For example, in complex financing transactions, the parties may have made a deliberate choice that disputes under one agreement should be referred to arbitration whilst disputes under another agreement should be referred to the court. If you don’t want consistency and do in fact want different jurisdiction clauses in different but related contracts, you need to spell that out and make it express. If you don’t spell it out, and there is a dispute as to which jurisdiction clause applies to a particular dispute, the court will have to decide whether the parties intended disputes to be resolved by the same tribunal, the so-called “one-stop” presumption from Fiona Trust & Holding Corp and others v Privalov and others or, as a matter of construction, whether the disputes are governed by different jurisdiction provisions (see, for example, UBS AG & UBS Securities LLC v HSH Nordbank AG and Sebastian Holdings Inc v Deutsche Bank AG).

However, it is not always a considered decision. Sometimes, it is simply inconsistency across the documents.

In an ideal world, the neatest and most comprehensive approach is to prepare a stand-alone umbrella arbitration agreement, which is signed by all of the various parties to the transaction. Unless provided for in any relevant institutional rules, the umbrella agreement should include a provision for the consolidation of proceedings in order to avoid multiple proceedings and potentially inconsistent awards.

At the very least, there should be a consistent arbitration clause in each related contract in the transaction, which provides a mechanism to join parties and consolidate proceedings.

Reference to the unknown

A significant number of defective arbitration clauses are those where the parties agree to submit their disputes to arbitral institutions that do not exist, to institutions that have no arbitration rules or to incorrectly identified institutions.

The problems this can cause is illustrated in the recent case A v B, where the court was called on to construe an arbitration clause providing for: “Arbitration proceedings – London international arbitration court, in accordance with the laws of Great Britain…”

It was claimed that the words “London international arbitration court” were ambiguous as to whether they referred to the London Court of International Arbitration (LCIA) or to an international arbitral body in London more generally. The court decided that the clause did not clearly indicate the LCIA. One of the reasons for this decision was that the court considered that more care would have been taken to ensure the wording specifically identified the LCIA, if the parties had intended to specify the LCIA, for example, by stating “LCIA” in brackets, so as to put the matter beyond doubt.

This case is a good reminder that it is relatively simple to avoid this pitfall. Don’t accept a reference to arbitration rules or to an arbitral institution unless you are 100% certain that they exist and, if in doubt, check.

The complex carve-out

In most cases, the arbitration agreement is intended to cover all disputes that may arise, so the general rule is to keep the scope as broad as possible. In that case, wide wording such as “any dispute arising out of or in connection with [the agreement] including any question as to its existence, validity or termination” should be used.

In some cases the parties may want to carve out specific disputes from the scope of the arbitration agreement. In hotel management agreements, for example, disputes relating to the operating budget are frequently carved out and decided by expert determination, with other disputes going to arbitration. Expert determination is often more suitable in those instances because it will likely be a financial rather than legal issue and the parties will need someone with in-depth knowledge of hotel accounting to be able to determine the dispute swiftly. However, carve-outs need careful drafting to ensure that the scope of disputes covered by the clause is as clear as possible, in order to avoid ambiguity as to whether a particular issue falls to be determined by expert determination or by arbitration.

It may seem very clear which types of dispute each method is intended to cover before a dispute has arisen, but often when a dispute arises the waters are muddied. For this reason, carve-outs are best avoided as they always carry this risk, no matter how carefully they are drafted.

Arbitrator qualifications

One of the advantages of arbitration is it gives the parties the opportunity to participate in the selection of arbitrators and it’s not uncommon to see arbitration clauses requiring arbitrators to have specific qualifications. Selection criteria give the parties confidence that disputes will be resolved by someone with the requisite skills and experience and, in some cases, arbitrator qualifications can be a good thing. However, requiring arbitrators to have specific qualifications can be a pitfall for the unwary.

For example, an arbitration clause requiring arbitrators to have “at least 10 years’ experience in the luxury hotel business” can mean very different things to different people and it is not always easy to ensure that the required qualifications are sufficiently clearly expressed and understood by both parties. Also, where industry experience is a requirement, it’s advisable to specify whether that includes experience from working with or on behalf of that industry (for example lawyers and professional advisers) or is limited to those working within the industry itself.

This problem was very clearly illustrated in Allianz Insurance Plc v Tonicstar Ltd. The arbitration clause in question included the following provision: “Unless the parties otherwise agree the arbitration tribunal shall consist of persons with not less than ten years’ experience of insurance or reinsurance.”

Allianz appointed a QC with more than ten years’ experience of insurance or reinsurance as their arbitrator. Tonicstar accepted that the QC had more than ten years’ experience of insurance or reinsurance law, but argued that the phrase “experience of insurance or reinsurance” required an arbitrator to have experience in the business of insurance or reinsurance itself. Tonicstar sought (and obtained) an order that the QC be removed as an arbitrator on the grounds that he was not qualified to act as an arbitrator.

To avoid the pitfalls, first consider whether the qualifications are really necessary. In the commercial context, it may be better to preserve flexibility on this front as it’s often difficult to predict the precise nature of the disputes that might arise at the time the arbitration clause is drafted. For example, at the drafting stage of a complex IT contract, the parties may feel that expertise in IT systems is an essential qualification for an arbitrator. However, in practice, IT disputes often centre around the application and interpretation of key contractual provisions rendering legal qualifications at least, if not more, useful than IT expertise. If selection criteria are included, make sure that they are clear, appropriate and not overly restrictive.

The mandatory reference

Finally, and perhaps most importantly, make sure that your arbitration clause includes a mandatory reference to arbitration.

Staged or tiered dispute resolution clauses have become increasingly common, particularly in international contracts. These clauses provide for several stages of one or more non-binding form of dispute resolution (commonly negotiation or mediation) followed by a binding process (litigation or arbitration) as a fallback. The advantage of a tiered dispute resolution clause is that it allows the parties to initiate negotiations to settle a dispute without appearing weak. However there are a couple of common pitfalls.

First there is a confusion over the term ADR (alternative dispute resolution). The term covers a number of techniques for resolving disputes (including structured negotiation and mediation), all of which are consensual and non-binding. However, the term is sometimes taken to include arbitration. This is a mistake. Arbitration is a binding process and an alternative to litigation in the courts. A common problem with tiered clauses is to confuse arbitration with other forms of ADR or to fail to include a mandatory reference to arbitration to take effect if the ADR process fails.

This problem is illustrated in the case of Kruppa v Benedetti, where the clause in question provided: “in the event of any dispute between the parties pursuant to this Agreement the parties will endeavour to first resolve the matter through Swiss arbitration. Should a resolution not be forthcoming the English courts shall have non-exclusive jurisdiction.” The court found that the clause did not constitute an effective arbitration agreement because it did not contain a clear and mandatory reference to arbitration, but rather an agreement to agree a form of arbitration.

Conclusion

These may all seem to be rather elementary points to make about drafting arbitration clauses, but it remains the case that relatively little attention is paid to drafting the dispute resolution clauses in otherwise heavily negotiated agreements and, as a result, they are points that continue to arise practice. Hopefully, by getting the basics right, some of the main pitfalls can be avoided.

Bryan Cave Leighton Paisner Jane Parsons

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