Escalation clauses

Introduction

Escalation clauses (tiered dispute resolution clauses) need careful drafting so that the wording is both enforceable and commercially useful – as recent decisions show.

In escalation clauses, parties engage in a series of steps, usually in the form of one or more alternative dispute resolution procedures – such as structured negotiations, mediation, adjudication, neutral or expert determination – before resorting to the ‘final’ dispute resolution mechanisms of litigation or arbitration. Each subsequent step in the process is engaged if the parties cannot resolve the dispute during the previous step.

The pitfalls of poor drafting

Parties often consider that these clauses provide a more commercial mechanism by which to resolve disputes without resorting to the final, adjudicative resolution.

If a valid escalation clause requires the parties to engage in one or more forms of structured negotiation or other ADR as a precondition to arbitration, the arbitral tribunal will not have jurisdiction to hear the dispute until the parties have done so. As a result, a poorly drafted escalation clause may allow one party to delay reference to arbitration, particularly where no time limit is specified for completing the preliminary ADR process.

In these circumstances, it would be risky for the other party to attempt to commence an arbitration, or for the arbitrators to accept jurisdiction to hear the dispute, as the resulting award may be subject to challenge on the grounds of lack of jurisdiction or subject to challenges to enforcement. Even if the issue of the validity or otherwise of the escalation clause is resolved by an early reference to the court (as permitted by the English Arbitration Act), significant time and costs may already have been expended.

Conversely, a party which expects to be able to rely on the escalation clause may find that it is unable to compel the other to engage in the negotiation/ADR processes envisaged because the escalation clause is deemed insufficiently certain for it to be enforceable.

Requirements for escalation clauses under English law

What, then, should an escalation clause say to avoid such consequences? English case law does not set out minimum requirements for validity, but does lay down general requirements which are subject to the interpretation of the court in each particular set of circumstances.

The Tang Chung Wah v Grant Thornton case

These general guidelines were recently refined in the case of Tang Chung Wah (Aka Alan Tang) and anor v Grant Thornton International Limited and ors [2012] EWHC 3198 (Ch).

An agreement setting out the terms of membership of accountancy firm Grant Thornton’s international network included the following provisions:

Section 14.3

• Any dispute or difference … shall in the first instance be referred to the Chief Executive in an attempt to settle such dispute or difference by amicable conciliation or [sic] an informal nature ...
• The Chief Executive shall attempt to resolve the dispute or difference in an amicable fashion… and… shall have up to one (1) month after receipt of such request to attempt to resolve it.
• If the dispute or difference shall not have been resolved within one (1) month following submissions to the Chief Executive, it shall be referred to a Panel of three (3) members of the Board to be selected by the Board, none of whom shall be associated with or in any other way related to the Member Firm or Member Firms who are parties to the dispute or difference. The Panel shall have up to one (1) month to attempt to resolve the dispute or difference.
• Until the earlier of (i) such date as the Panel shall determine that it cannot resolve the dispute or difference, or (ii) the date one (1) month after the request for conciliation of the dispute or difference has been referred to it, no party may commence any arbitration procedures in accordance with this Agreement.

This was followed (section 14.4) by a standard LCIA arbitration agreement with London as the seat.

A dispute arose between Grant Thornton and minority partners (the Hong Kong entity). Grant Thornton’s chief executive was forced to recuse himself given his involvement in the decision to expel the Hong Kong entity from the network and the three-member panel contemplated in clause 14.3(c) was never constituted, as no governors put themselves forward to serve.

Grant Thornton commenced arbitration proceedings, but the Hong Kong entity challenged the tribunal’s jurisdiction, on the basis that the steps prescribed at clause 14 had not been followed.

The tribunal determined that the steps prescribed in the agreement did not constitute a detailed process which was sufficiently certain to be enforceable. The conciliation provisions were more akin to an agreement to agree, given that the provision required the complaining party to deal with Grant Thornton’s CEO, and thereafter with members of Grant Thornton’s executive body, with no third party involvement.

The Hong Kong entity challenged the award on the ground that the tribunal did not have substantive jurisdiction (section 67, English Arbitration Act 1996). Mr Justice Hildyard made three key points.

1. The provisions of clause 14.3 lacked sufficient definition and certainty to constitute enforceable conditions prior to the arbitration. There was no detail as to what form the process of conciliation should take, who would be involved or what their obligations would be.
2. Clause 14.3(d) did not prevent any party to the agreement from commencing arbitration two months or more after the first reference of a request for conciliation. Neither (if the arbitration commenced earlier) did it disallow the failure of the conciliation process whether because it was not possible to establish a panel – if no members of the board were willing to serve – or because the members of the board took the view that the dispute could not be resolved by such a panel.
   
   The arbitration in this case had been commenced well after any such time frame had expired and after it was clear that no panel could be established.
3. On either approach, the tribunal, as it itself concluded, did have jurisdiction.

In his analysis of the principles laid down by case law, Mr Justice Hildyard stated that the overarching test of enforceability is ‘whether the obligations and/or negative injunctions it imposes are sufficiently clear and certain to be given legal effect’. There must be:

a sufficiently certain and unequivocal commitment to commence a process (b) from which may be discerned what steps each party is required to take to put the process in place and which is (c) sufficiently clearly defined to enable the Court to determine objectively (i) what under that process is the minimum required of the parties to the dispute in terms of their participation in it and (ii) when or how the process will be exhausted or properly terminable without breach.

Commercial parties may find it surprising that the relatively detailed escalation clause in this case still failed the test. However, the judge thought the clause too equivocal in terms of process required and too nebulous in terms of the content of the parties’ obligations to be given legal effect.

Commercial parties may find it surprising that the relatively detailed escalation clause in this case still failed the test. However, the judge thought the clause too equivocal in terms of process required and too nebulous in terms of the content of the parties’ obligations to be given legal effect.

This case highlights the need for particular care when drafting escalation clauses. Even where the parties adopt sample clauses drafted by arbitration institutions such as LCIA, CEDR or ICDR, they should still check their wording against recent case law. Then, if challenged, the clauses are more likely to be upheld. Legal construction can and often does affect outcome.

So too does the composition of the tribunal. Different tribunals – depending on whether they comprise civil or common law lawyers – may view the enforceability of, and parties’ compliance with, escalation clauses quite differently.