Insolvency and international arbitration

Introduction

The COVID-19 pandemic has caused significant economic disruption and is expected to cause a deep global recession. The only uncertainty seems to be the length and depth of the recession. Even prior to COVID-19 there was talk of an economic downturn in the five major economies and worrying levels of corporate debt in certain key markets (including the US), so the disruptions of COVID-19 are being felt particularly hard with seemingly worse to come. In some sectors the effects are further compounded by other factors, such as in the oil and gas sector which has also been hit by a recent significant drop in the oil price, disruptions caused by the energy transition and greater restrictions on the availability of financing and insurance.

There is little question that there will be a significant increase in the number of corporate insolvencies across most sectors, possibly rivalling the numbers seen in 2009 during the global financial crisis. It will also likely lead to an increase in the number of international commercial disputes. Accordingly, in the coming months, many parties will find themselves in dispute with or contemplating claims against insolvent or soon to be insolvent entities. This article discusses the tension that arises between the competing public policy interests of international arbitration and national insolvency legislation.

Inherent tension between insolvency and arbitration policy

It is not always easy to reconcile the nature and aims of international arbitration and insolvency law and policy. An often used quote of the US courts neatly describes the tension: “a conflict of near polar extremes: bankruptcy policy exerts an inexorable pull towards centralization while arbitration policy advocates a decentralised approach towards dispute resolution.” The very essence of international arbitration is its consensual nature; the process flows from the agreement of the parties and the award is only binding on the parties to the arbitration. It is also a private, sometimes confidential, process. Arbitration laws in general aim to recognise and uphold agreements to arbitrate regardless of the position the parties find themselves in. By contrast, in insolvency proceedings the aim is generally to maximise the value of the insolvent party’s assets and appropriately distribute those between third party creditors, by way of a structured, centralised and transparent process. Insolvency policy also generally presumes that the state may step in when there is a change in one of the parties’ circumstances such that it cannot meet all of its obligations, thereby overriding any such earlier agreement in respect of dispute resolution. In many jurisdictions, upon insolvency or bankruptcy proceedings being commenced, a moratorium on other dispute resolution processes is implemented, including in respect of arbitral proceedings.

The English example

Article V(2)(a) of the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards 1958 (New York Convention) provides that the recognition and enforcement of an arbitral award may be refused if “the subject matter of the difference is not capable of settlement by arbitration under the law of that country.” National legislators are able to and do restrict a party’s ability to arbitrate in certain circumstances and many, including England and Wales, do so in the context of insolvency. The purpose of imposing a moratorium on other dispute resolution proceedings is to ensure a level playing field amongst creditors (subject only to any formal hierarchy of payment) and a centralised and transparent insolvency process. 

In England and Wales, there are a number of relevant mechanisms at play: the English Insolvency Act 1986 (the 1986 Act); the Regulation (EU) 2015/848 on Insolvency Proceedings (Recast Regulation); and the UNCITRAL Model Law on Cross-Border Insolvency (Model Law on Insolvency).

The English Insolvency Act 1986

Under the 1986 Act, the capacity of the administrator or liquidator to bring and defend proceedings in the name of the insolvent party by reference to the type of insolvency proceeding envisaged will determine the arbitrability of a dispute. Once a company enters administration, arbitration may not be commenced or continued against the company without the consent of the administrator or the permission of the court. The leave of the court is not required to pursue proceedings against a company which is undergoing a voluntary winding up. However, no proceedings may be commenced against a company in a compulsory winding up scenario without leave being granted.

In either case, the courts will carry out a balancing exercise between the legitimate interests of the applicant and those of the other creditors. The burden is on the creditor to show that it would be unjust for it to be denied the right to commence legal proceedings. Ultimately, if the proceedings are unlikely to impede the achievement of the purpose of the administration, leave may be granted.

Insolvency laws and procedural rules vary significantly across jurisdictions and the approach to arbitrability can therefore vary.

A full comparative analysis is beyond the scope of this article, however by way of example of the different approaches:

• In the US, the Federal Bankruptcy Code provides a general rule that any proceedings (including arbitrations) brought against an insolvent party or the property of the estate shall be stayed, with leave for a party to apply for relief from a stay. Where a party has petitioned for relief from the stay, the question is whether “cause” exists to lift the stay to allow the arbitration to go forward despite the potential impact on property of the estate. Courts have held that, where a valid arbitration agreement exists, the courts generally do not have discretion to continue to stay the arbitration unless the arbitration proceedings are “core” proceedings. “Core” proceedings are proceedings by or against the debtor in which the Federal Bankruptcy Code is the source of the claimant’s right or remedy, or that stem from the bankruptcy itself or would necessarily be resolved in claims allowance process.
• In France, the arbitrability of a claim is determined by the nature of the dispute. For example, only ‘pure’ bankruptcy issues, which concern the application and exercise of the bankruptcy procedures themselves, are deemed non-arbitrable whereas contractual matters remain arbitrable. However, even if an arbitral tribunal is found to have jurisdiction to rule on a contractual dispute after the commencement of bankruptcy proceedings, it must respect the public policy underpinning bankruptcy law. For instance, while a tribunal can rule that a debt exists and determine its amount, it cannot order the debtor to pay the debt. The reason for this is that such a ruling may violate the rule of equality between the creditors, which is a matter for the state to determine.
• In Germany, insolvency administrators remain bound to any arbitration clause previously entered into by the insolvent company, while the opening of insolvency proceedings does not affect the arbitrability of a dispute. This is pursuant to section 1030, paragraph 1, sentence 1 of the German Civil Code, which provides simply that pecuniary claims can be subject to arbitration. Nor are arbitration proceedings stayed following the commencement of an insolvency. However, in order to provide for a fair hearing and to comply with the procedural ordre public the tribunal is required to ensure that the insolvency administrator is granted sufficient time to assume the pending matter.

European Union Legislation as currently applicable to the UK

The UK left the EU on January 31, 2020 but under the European Union Withdrawal Act 2018 and European Union (Withdrawal Agreement) Act 2020 it will be treated as if it were still a Member State until the Brexit transition period ends on December 31, 2020 (unless extended). EU law on insolvency therefore continues to apply in the UK, for the time being. It is an important piece of the statutory puzzle as it determines conflicts of laws issues in cross-border insolvencies involving EU Member States.

The Recast Regulation replaced and superseded the Council Regulation EC 1346/2000 and applies to insolvencies beginning on or after June 26, 2017. It provides that where the ‘centre of main interests’ of a debtor is found in a EU Member State, insolvency proceedings brought in that state are known as the ‘main proceedings’ and are to be recognised as such throughout the EU. It also sets out mandatory choice of law rules such that the law of the EU Member State in which insolvency proceedings were commenced is applicable to determining the effects of insolvency proceedings “on current contracts to which the debtor is party” and other proceedings brought by individual creditors. Further, it states that if an arbitration has already commenced, the law of the seat of the arbitration, rather than the law of the EU Member State in which insolvency proceedings were commenced, shall determine arbitrability.

The question of which law governs the effect of one party’s insolvency upon ongoing arbitration proceedings was the subject of the well-known Elektrim/Vivendi cases, which dramatically highlighted the tension between arbitration and insolvency law. Elektrim SA was a Polish company that entered into an agreement in 2001 with Vivendi Universal SA and Vivendi Telecom International SA (together “Vivendi”) whereby Vivendi was to purchase PTC, a Polish mobile telephone company which Elektrim was previously a substantial shareholder in. Vivendi commenced multiple arbitrations against Elektrim under different but related agreements in 2003 in London and in 2006 in Geneva. However, in 2007, Elektrim was declared bankrupt by the Warsaw District Court, and as a matter of Polish law, Elektrim’s bankruptcy operated to cancel any arbitration agreement it had entered into. Elektrim raised objections to the jurisdictions of the tribunal in each of the London and Geneva seated arbitrations.

In determining this question with respect to the London seated arbitration, the English courts applied EU law (as it was then) and determined whether the dispute was arbitrable by reference solely to English law, being the law of the EU Member State in which the arbitration was pending. Under English law, the dispute referred to arbitration in London was arbitrable. In determining the same question with respect to the Geneva seated arbitration, the Swiss courts, which were not subject to EU law, took the opposite approach.

The Swiss courts deferred to Polish law, being the law of the state where the bankrupt party was incorporated. Under Polish law, the arbitration agreement was deemed ineffective upon the commencement of bankruptcy proceedings, therefore the Swiss Supreme Court held that the tribunal in the Geneva seated arbitration had no jurisdiction. The issue was later re-litigated yet again before the Polish courts when an application was made in Poland to enforce the arbitration award rendered in the English arbitration. It was reported at the time that the Polish appeal courts rejected the challenge to enforcement notwithstanding that pursuant to Polish Bankruptcy Law the dispute was not arbitrable. Reflecting a reluctance to use the exceptions to enforcement contained in the New York Convention as a means of unnecessarily interfering with the arbitral process, the Polish courts accepted that the English courts were correct to apply English law to the question. (As an aside, Polish law has since changed and a declaration of bankruptcy will no longer automatically render arbitration agreements ineffective.) These multiple and related challenges highlight the complications that can arise in a cross-border insolvency/arbitration situation.

Model law on insolvency

The Model Law on Insolvency was implemented in the UK pursuant to the English Cross-Border Insolvency Regulations 2006. Article 20 of the Model Law, as reflected in the 2006 Regulations, provides for a stay of arbitration where foreign insolvency proceedings have been recognised.

The purpose of the Model Law is to fairly distribute an insolvent company’s assets when those assets are found in more than one jurisdiction. Other countries that have adopted the Model Law include the US, Australia, Japan, South Korea and Singapore. The expectation is that as more countries ratify the Model Law, a common approach to this issue will apply around the world. Given that EU insolvency proceedings will no longer be automatically recognised in the UK (and vice versa) after the Brexit transition period ends, the Model Law is likely to take on increased importance in the UK.

Conclusion

In the face of a global recession and a consequent increase in cross-border insolvencies and disputes, the tension between insolvency and arbitration will be increasingly the subject of analysis and even litigation. When concluding arbitration agreements, and determining a dispute resolution strategy, close attention should be given to (i) the laws of the state in which insolvency proceedings may be commenced; (ii) the seat of the arbitration; and (iii) the lex arbitri and substantive governing law of the dispute likely to be applied by the tribunal. 

The authors would like to thank Majdie Hajjar, trainee, for his contribution to this article.