Escalation clauses

Introduction

A recent decision by the English Commercial Court provides support for the validity of escalation clauses which require discussions to take place before a dispute can proceed to arbitration.

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

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, not only avoids having to launch more formal proceedings which will almost inevitably prove time-consuming and costly, but also may enable the parties to restore and continue their business relationship.

Court hostility to the clauses

Until the decision in Emirates Trading Agency LLC v Prime Mineral Exports Private Limited [2014] EWHC 2104 (Comm), the English courts had in recent years treated such clauses with hostility, regularly holding that the purported agreement to engage in preliminary steps was unenforceable.

Much of the courts’ reasoning had stemmed from the general principle of English law that an agreement to agree is unenforceable, as set out in Walford v Miles [1992] 2 AC 128. However, as pointed out by Longmore LJ in Petromec Inc v Petroleo Brasileiro SA Petrobas [2005] All ER 209, 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. Moreover, writing extra-judicially in 1997, Lord Steyn considered that the decision in Walford v Miles was ripe for reconsideration as it failed to give effect to the expectations of honest men.

Nevertheless, applying this general principle to escalation clauses, in Wah v Grant Thornton [2013] 1 Lloyd’s Rep 11 the court held that a clause which provided 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 [2012] 1 Lloyd’s Rep 671, 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 that the clause should be enforceable, 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.

A change in attitude

The contract in the recent 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 Wales (2009) 127 Con LR 202, and also cited favourably the Singaporean authority of International Research Corp plc v Lufthansa Systems Asia Pacific Pte Ltd [2012] SGHC 226 (approved on appeal at [2013] SGCA 55) 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). 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.

Although 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.”

The principle that contractual provisions must be sufficiently certain to be enforceable remains firmly a part of the law. However, the application of that principle to escalation clauses has received radically different treatment by Teare J. The decision is clearly significant – in particular for contracts containing agreements to enter into “friendly discussions”, which are common.

Care in drafting

Despite the more favourable approach of Teare J, parties considering such a clause must still take care with the drafting to ensure that their particular agreement complies with the requirement of certainty. 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.

Even if drafted in the clearest and most certain terms, parties must always consider carefully whether they in fact want such a clause. While such an agreement provides the opportunity to resolve a dispute before embarking on 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 on the facts of a particular case.

Further reading

See also International arbitration report issue 2, “Escalation clauses: English courts set up stringent test”, pp22–24, on the need for careful drafting of tiered dispute resolution clauses.