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The European, Middle Eastern and African Arbitration Review 2016

Escalation Dispute Resolution Clauses

Parties to the vast majority of commercial contracts select methods for resolving the disputes arising out of or in connection with such agreements. In a cross-border context, disputes are often resolved by arbitration to ensure that the resulting decision is enforceable almost globally. While arbitration has many well-known advantages, it can be lengthy and expensive in terms of getting the final and binding award. And although it may be worth it when the entire transaction falls apart, often the disputes relate to various smaller issues, such as the quality of certain works, compliance of a certain consignment of goods to the agreement or a delay in delivery. Smaller issues frequently involve much smaller amounts at stake than initially anticipated when agreeing to arbitrate under the rules of a reputable but quite expensive arbitral institution.

What is an escalation clause?

To accommodate the variety of disputes under a contract not all of which might be worth fighting in arbitration, one sees more often these days ‘tiered’ or ‘escalation’ dispute resolution clauses.

Tiered dispute resolution clauses require the parties to engage in a series of steps where they generally explore more informal methods of dispute resolution before resorting to a final, usually adjudicative, dispute resolution forum. Typically, the parties agree first to embark upon a certain form of alternative dispute resolution (ADR) and, if the initial stage is unsuccessful, then commence litigation or arbitration proceedings.

ADR options available to the parties are fairly diverse and may include, among other things:

  • negotiations or structured negotiations;
  • mediation;
  • early neutral evaluation;
  • dispute review board;
  • expert determination; and
  • adjudication.

The variety of combinations of these methods allows sophisticated parties to tailor the dispute resolution to the needs of their specific transactions, but also gives room for an even greater number of mistakes if not dealt with properly at the drafting stage.

The practical and commercial benefits of such a clause are obvious: it requires the parties to attempt to reach a settlement at an early stage which, if successful, avoids having to launch more formal proceedings that will almost inevitably prove time consuming and costly, and also may enable the parties to restore and continue their business relationship.

Arguably, the negotiation stage may be the hardest to get right when drafting the clause. This may be because at the negotiation stage parties are left on their own, without any support or assistance from various institutions and the rules available for instance in mediation, expert determination or adjudication. Hence, the parties are essentially left with a variety of drafting options relying primarily on their own previous experience. This article will therefore focus primarily on negotiations as a tier preceding arbitration.

Indeed, parties may embark on negotiations at any time without a need for it to be provided in their contract. Yet the requirement to negotiate amicably, in good faith or at a certain management level, has a number of advantages, and for that reason is seen in an increasing number of commercial contracts.

First, it creates a certain psychological comfort for parties willing to negotiate but unwilling to suggest negotiations for fear of being seen as weak. If it is a requirement under the contract, none of the parties will give an impression of acknowledging its weaker position; rather, they would simply follow the provisions under the contract.

Second, in case of structured negotiations, it may be an effective tool to raise the awareness of more senior management within the company about the issue and allow people with decision-making powers to negotiate a solution. Thus, it is not unusual for project managers to be unwilling to settle for the fear of admitting their own earlier mistake or due to the absence of an authority to take certain decisions themselves. If their own mistake is involved, it is not unlikely for their reports of the problem to senior management to be tainted by a desire to cover themselves or others on the ground. However, if the clause requires that the dispute, not resolved by the project managers of the parties, be referred to negotiations by senior managers (eg, members of the board), it may well result in a better understanding of the situation by senior decision-makers in both companies and eventually in amicable and mutually beneficial settlement.

Is it enforceable?

While the advantages of tiered dispute resolution clauses are apparent, the question of their enforceability is rather uncertain. Unfortunately, the approaches differ from jurisdiction to jurisdiction. Arguably, the more formal a method of ADR the contract provides for, the higher the chances that the courts would consider it an enforceable condition precedent to arbitration. Thus, in two recent cases, the Swiss Supreme Court1 and the English High Court2 concluded that the requirement to refer disputes to the Dispute Adjudication Board under the FIDIC is indeed a condition precedent for commencing a formal dispute. In more informal ADR procedures, such as negotiations or mediation, the courts often take different approach.

For example, until very recently, English courts treated such clauses with hostility, and held that the purported agreement to engage in preliminary steps was unenforceable. Much of the courts’ reasoning stemmed from the general principle of English law that an agreement to agree is unenforceable as set out in Walford v Miles,3 although as pointed out by Longmore LJ in Petromec Inc v Petroleo Brasileiro SA Petrobas,4 in Walford there was no concluded contract at all (since it was ‘subject to contract’), whereas with an escalation clause, the agreement as to the initial step is one term of an otherwise concluded contract.

Nevertheless, applying this general principle to escalation clauses, in Wah v Grant Thornton,5 the court held that a clause which provides that any dispute should first be referred to a panel of three members of the board of the partnership and that no party shall commence arbitration until the earlier of such date as the panel determines that it cannot resolve the dispute and the date one month after the dispute has been referred, was too nebulous to be given legal effect. Accordingly, the challenge to the tribunal’s jurisdiction in that case failed.

Similarly, in Sul America v Enesa Engenharis,6 the Court of Appeal had to consider whether an undertaking by the parties that, ‘prior to a reference to arbitration, they will seek to have the Dispute resolved amicably by mediation’, was enforceable. Moore-Bick LJ held that although he was in no doubt that the parties intended for the clause to be unenforceable, in order for it to be enforceable it must define the parties’ rights with sufficient certainty to enable it to be enforced. He considered that, as the clause did not set out a defined mediation process or refer to the services of a specific mediation provider, it was not apt to create an enforceable obligation to commence or participate in a mediation process.

However, in the recent decision in Emirates Trading Agency LLC v Prime Mineral Exports Private Limited,7 Teare J considered the clause requiring negotiations a condition precedent for commencing arbitration. The contract in the Emirates Trading Agency case contained a clause providing that the parties shall first seek to resolve any dispute by ‘friendly discussion’, but that if no solution can be arrived at after a continuous period of four weeks, the non-defaulting party can commence arbitration.

The jurisdiction of the arbitral tribunal was challenged on the basis that the parties had not completed the required ‘friendly discussion’. Notwithstanding the authorities referred to above, Teare J took a very different approach to the question of whether the clause was enforceable. He considered the reasoning in Wah v Grant Thornton to be unpersuasive and felt able to distinguish the Court of Appeal’s decision in Sul America on the basis that the absence of a named mediator or an agreed mediation process left the agreement in that case incomplete.

Instead, he largely adopted the reasoning in the Australian decision in United Group Rail Services v Rail Corporation New South Wales8 and also cited favourably the Singaporean authority of International Research Corp PLC v Lufthansa Systems Asia Pacific Pte Ltd,9 as well as the approach of certain ICSID decisions to the enforceability of agreements to negotiate in good faith (including ICSID Case No. ARB/11/28). Interestingly, Teare J also considered that an obligation to seek to resolve disputes by friendly discussion must import a duty to do so in good faith.

In United Group Rail Services v Rail Corporation New South Wales, Aslopp P disagreed with Walford and provided some persuasive support to enforceability of the negotiations clauses:

An obligation to undertake discussions about a subject in an honest and genuine attempt to reach an identified result is not incomplete. It may be referable to a standard concerned with conduct assessed by subjective standards, but that does not make the standard or compliance with the standard impossible of assessment. Honesty is such a standard [...] Whether it is capable of assessment depends on whether there is a standard of behaviour that is capable of having legal content. Asserting its uncertainty does not answer the question. The assertion that each party has an unfettered right to have regard to any of its own interests on any basis begs the question as to what constraint the party may have imposed on itself by freely entering into a given contract. If what is required by the voluntarily assumed constraint is that a party negotiate honestly and genuinely with a view to resolution of a dispute with fidelity to the bargain, there is no inherent inconsistency with negotiation, so constrained. To say, as Lord Ackner did, that a party is entitled not to continue with, or withdraw from, negotiations at any time and for any reason assumes that there is no relevant constraint on the negotiation or the manner of its conduct by the bargain that has been freely entered into. Here, the restraint is a requirement to meet and engage in genuine and good faith negotiations. For the reasons expressed below that expression has, in the context of this contract, legal content.

Although in Emirates Trading Agency the challenge to the tribunal’s jurisdiction was dismissed with the court concluding that the requisite friendly discussions had indeed taken place, the judge held that the (time-limited) obligation in the present case was indeed enforceable and therefore a condition precedent to the right to arbitrate:

The agreement is not incomplete; no term is missing. Nor is it uncertain; an obligation to seek to resolve a dispute by friendly discussions in good faith has an identifiable standard, namely, fair, honest and genuine discussions aimed at resolving a dispute. Difficulty of proving a breach in some cases should not be confused with a suggestion that the clause lacks certainty [...] Enforcement of such an agreement when found as part of a dispute resolution clause is in the public interest, first, because commercial men expect the court to enforce obligations which they have freely undertaken and, second, because the object of the agreement is to avoid what might otherwise be an expensive and time consuming arbitration.

Even an enforceable clause to negotiate or mediate may not necessarily affect the jurisdiction of the tribunal. Thus, some courts would treat the compliance with procedural prerequisites in an arbitration context as substantive obligation and, therefore, as not preventing parties from commencing the arbitration.10 On this basis, the Russian Court refused to set aside an award rendered by the arbitration tribunal under the Rules of International Court of Commercial Arbitration at the Russian Chamber of Commerce and Industry (ICAC Rules) where the parties allegedly breached the pre-arbitration procedures. The court reasoned that this obligation would be a substantive one and thus would not form a part of an arbitration clause, the breach of which could result in setting aside the award.11

At the same time, other courts would consider that failure to comply with pre-arbitration procedures precluded the parties from commencing arbitration.12 In one reported case, the arbitral tribunal acting under the ICAC Rules terminated the proceedings having found that the parties failed to follow pre-arbitration procedures.13 Arguably, however, it may be an easier call for a Russian arbitrator to terminate the proceedings for the parties’ failure to comply with the pre-arbitration requirements as Russian procedural legislation has historically provided for a similar remedy to be used by the state courts in case the parties failed to follow whatever pre-litigation procedures they agreed in their contract.

Even willing parties may face significant difficulties in negotiating or mediating disputes with an obstructive or unwilling opposing party. Thus, in one ICC case the tribunal found that the attempts to negotiate were sufficient and fruitless negotiations should not prevent a party from commencement of arbitration:

The arbitrators are of the opinion that a clause calling for attempts to settle a dispute amicably are primarily expression of intention, and must be viewed in the light of the circumstances. They should not be applied to oblige the parties to engage in fruitless negotiations or to delay an orderly resolution of the dispute. Accordingly, the arbitrators have determined that there was not obligation on the claimant to carry out further efforts to find an amicable solution, and that the commencement of these arbitration proceedings was neither premature nor improper.14

In a US judgment a similar conclusion was made in relation to the clause requiring mediation: ‘surely a party may not be allowed to prolong resolution of a dispute by insisting on a term of the agreement that, reasonably construed, can only lead to further delay’.15

More recently, the English High Court issued another ruling on the clause requiring ‘friendly negotiations’. In Emirates Trading Agency LLC v Sociedade de Fomento Industrial Private Ltd,16 Popplewell J declined to decide whether the ‘friendly discussions’ requirement was an enforceable condition precedent to the tribunal’s jurisdiction as this was already decided in the partial award on jurisdiction, but made a few observations as to what kind of discussions might qualify under the provision, if it was enforceable. Thus, according to Popplewell J the discussions taking place before the claimant was able to put forward a quantified claim should suffice to satisfy the requirement as long as the dispute that was subsequently referred to arbitration had been subject of discussions. Furthermore, there is no need to show the discussion of each particular claim or indeed the defences subsequently raised by the defendant.

To conclude, the enforceability and effect of a tiered clause depends to large extent on the wording of the clause itself and the circumstances of a particular dispute. While such a clause may not always be interpreted as depriving the tribunal of the jurisdiction to hear the dispute, parties would most likely be expected to act reasonable and commercially, whereas the obstructive and uncooperative behaviour may not prevent the other party from protecting its rights in arbitration.

Some dos and don’ts when using escalation clauses

When deciding to implement an escalation clause, one must research its enforceability in all jurisdictions potentially involved, including at the place of arbitration and at the places of both parties incorporation. This will ensure that the clause takes into account requirements that may be imposed by laws or jurisprudence in each of the jurisdictions involved to avoid or minimise the risks of subsequent challenges to the tribunal’s jurisdiction or enforceability of an award.

Furthermore, parties considering such a clause must take care with the drafting to ensure that their particular agreement complies with the requirement of certainty. The clause shall clearly express which procedures parties are required to go through and the time frames for each step. In particular, parties must clearly specify if a particular step is going to be mandatory or optional, and make sure the timescale allows all of the preliminary steps to work together. If the parties have to go through such a preliminary step, the drafting must also ensure that it does not allow the defaulting party to delay commencement of litigation or reference to arbitration. This can be a particular problem if a limitation period is about to expire.

Sometimes complex dispute resolution provisions provide for different ADR procedures for different types of disputes. For example, clauses may provide for negotiations of the commercial differences by senior management and exert determination of the technical disputes. In such cases, there is always a risk that certain disputes fall between the gap, which means that the clause has to provide for a ‘catch-all’ provision that would ensure any dispute is resolved in some manner, even if it does not fall within the scope of a specific ADR clause. For example, the agreement may provide that disputes not falling within an expert determination clause be finally settled by arbitration.

Moreover, parties should not use a ‘standard’ or ‘boilerplate’ clause from earlier agreements. While this recommendation stands true for every dispute resolution clause, escalation clauses are a particularly sensitive area and only work when tailored to a particular transaction, bearing in mind potential disputes and the specifics of a particular trade. While structured multi-tier dispute resolution clauses calling for negotiations as well as adjudication and expert determination of certain disputes may be perfectly appropriate, it will most likely not fit a one-off sales contract. Likewise, the time frames for negotiating amicable settlement in a long-term ore supply agreement may not be appropriate in the shareholders agreement if it prevents the parties from taking urgent actions to protect their investments.

Even if drafted in the clearest and most certain terms, parties must always carefully consider whether they in fact want such a clause. While such an agreement provides the opportunity to resolve a dispute before embarking on a costly litigation or arbitration, inevitably such a clause will result in some degree of delay if no settlement is achieved, and while that can be minimised by careful drafting, any delay may have detrimental consequences depending of the facts of a particular case. For example, the time frames should not be unreasonably long as this may arguably damage a party requiring an instant protection of its rights (eg, in cases where the transfer of shares in a JV company may need to be prevented by immediate injunction from an emergency arbitrator tribunal or a state court).

A party anticipating a dispute arising out of a contract containing a tiered dispute resolution clause needs to ensure that it takes reasonable and commercial efforts to comply with pre-arbitration procedures, particularly if the case involves jurisdictions where such clauses are considered enforceable, let alone affecting the tribunal’s jurisdiction. While this does not mean that the obstructive opposing party may be allowed to delay the final resolution of the dispute, the party seeking to commence the formal dispute resolution process must ensure that the attempts to comply with the pre-arbitration procedures are appropriately documented. This would help if the opposing party later attempts to challenge the tribunal’s jurisdiction or the award on the basis of alleged non-compliance with agreed pre-arbitration procedures.

Finally, if the contract provides for use of certain ADR methods prior to commencing arbitration, it may be best to make good use of such methods. Indeed, while amicable resolution of disputes may not always be possible, it may nevertheless be worth attempting such resolution if the contract requires this anyway. Arguably, if parties treated pre-arbitration negotiations somewhat more seriously than just ticking the box, in many cases the appropriate solution could have been found and a lengthy and costly arbitration could have been avoided.

Notes

  1. Case No. 4A_124/2014.
  2. Peterborough City Council v Enterprise Managed Services Limited [2014] EWHC 3193 (TCC) QBD.
  3. [1992] 2 AC 128.
  4. [2005] All ER 209.
  5. [2013] 1 Lloyds Rep 11.
  6. [2012] 1 Lloyds Rep 671.
  7. [2014] EWHC 2104 (Comm).
  8. [2009] NSWCA 177 (3 July 2009).
  9. [2012] SGHC 226 (approved on appeal at [2013] SGCA 55).
  10. Judgment of 15 March 1999, 20 ASA Bull. 373, 374 (Kassationsgericht Zurich) (2002); Int’l Ass’n of Bridge, Structural v EFCO Corp, 359 F.3d 954, 956-57 (8th Cir. 2004).
  11. Resolution of the Federal Arbtirazh Court for the Moscow Circuit of 28 August 2007 No. KG-A 40/7548-07 (hearing appeal from the Ruling of the Moscow Arbitrazh Court in the case No. A40-15779/07-40-156). See also the Resolution of the Supreme Court of the Russian Federation dated 2 April 2002 in the case No. 5-G02-23 for similar reasoning.
  12. Judgment of 6 July 2000, 2001 Rev. arb. 749 (French Cour de cassation); HIM Portland, LLC v De-Vito Builders, Inc, 317 F.3d 41 (1st Cir. 2003); White v Kampner, 641 A.2d 1381, 1385 (Conn. 1994).
  13. Ruling dated 8 February 2008 in the ICAC case No. 18/2007.
  14. Final Award in ICC Case No. 8445, XXVI Y.B. Comm. Arb. 167 (2001).
  15. Cumberland and York Distributors v Coors Brewing Co, F.Supp.2d, WL 193323 (D.Me. 2002).
  16. [2015] EWHC 1452 (Comm).