Herbert Smith Freehills has secured an important judgment from the Hong Kong Court of Appeal, C v D  HKCA 729, regarding escalation clauses – contractual provisions which require negotiation or mediation before either party can begin formal proceedings.
These clauses are intended to promote the efficient resolution of disputes, but often lead to costly litigation. In particular, where the dispute is ultimately referred to arbitration, an argument about compliance with the escalation mechanism can derail proceedings, leaving any decision of the arbitrators vulnerable to challenge in the courts.
The Court of Appeal has now resolved this issue by finding that any dispute about escalation clauses should generally be resolved by the arbitrators chosen by the parties, not the courts. Findings made by the arbitral tribunal on these issues should be final and binding, and cannot be used as a basis to challenge the final award save for in exceptional circumstances.
We provided a brief summary of the outcome and our three key take-away points here. Set out below is a more detailed overview of the background and reasoning from the team who successfully argued these points in court.
The contract in issue stipulated that, if a dispute arose between the parties, they should “attempt in good faith promptly to resolve such dispute by negotiation”. The contract went on to say that “either Party may, by written notice to the other, have such dispute referred to the Chief Executive Officers of the Parties for resolution” and that, if the parties could not resolve the dispute amicably within 60 business days “of the date of the Party’s request in writing for such negotiation”, they could refer the matter to arbitration.
It was common ground that these provisions required both sides to negotiate their dispute in good faith. The parties disagreed, however, as to whether it was mandatory to refer any dispute to the CEOs before commencing arbitration.
When the issue was raised before the arbitral tribunal, it held that the general requirement to negotiate in good faith was compulsory, but the reference of any dispute to the CEOs was optional. On that basis, the tribunal concluded that the provisions had been complied with, there was no issue as to its jurisdiction to hear the case, and it proceeded to issue a number of awards dealing with the merits.
The first instance decision
C, who had lost the arbitration, applied to the Hong Kong Court of First Instance to set aside the arbitral award on jurisdictional grounds under section 81 of the Arbitration Ordinance (Cap 609), which adopts Article 34 of the UNCITRAL Model Law.
C argued that the counterparty, D, had not complied with the escalation mechanism, such that the tribunal lacked jurisdiction. D argued in response that the contract had been complied with in full, but in any event this question concerned the admissibility of the claims, rather than the jurisdiction of the tribunal. There was no doubt that the parties had agreed ultimately to resolve their disputes by arbitration. The only issue in dispute was whether the claims were ‘ripe’ for determination – in other words, had they been filed prematurely. This issue did not engage Art. 34 of the Model Law.
The court agreed with D, holding that the “generally held view of international tribunals and national courts” is that non-compliance with a pre-condition to arbitration is a question of admissibility, not jurisdiction. The award therefore could not be set aside under Hong Kong law. Our blog post with a detailed analysis of the first instance decision, can be found here.
Issues in dispute on appeal
C was granted permission to appeal, as the Court of First Instance recognised that the issue in dispute was of “some general significance to arbitration law in Hong Kong”.
The appeal was advanced on three grounds:
- First, C argued that the award should be set aside under Article 34(2)(a)(iii) Model Law, because the failure to comply with the pre-conditions meant that “the award deal[t] with a dispute not contemplated by or falling within the terms of the submission to arbitration”. In particular, C argued that the distinction between admissibility and jurisdiction was irrelevant as this did not reflect the text of Article 34(2)(iii), but in any event, even if the distinction existed, the objection was jurisdictional in nature.
- Second, C contended that Article 34(2)(a)(iv) allows an award to be set aside where: “the arbitral procedural was not in accordance with the agreement of the parties”, and in this case the phrase “arbitral procedure” encompassed pre-conditions to arbitration. Since the preconditions had not been fulfilled, the arbitration was not conducted in accordance with the agreement of the parties.
- Third, C maintained that, on a proper construction of the contractual provisions, D was required to refer the dispute for a determination by the CEOs, such that the pre-conditions to arbitration had not been fulfilled.
Decision on appeal
The Court of Appeal rejected all three grounds of appeal, upholding the judgment at first instance.
As to the first ground, the Court observed that the distinction between admissibility and jurisdiction “is well recognised in both case law and academic writings”, including in England & Wales, Singapore, Australia and the United States. The distinction is not drawn on the specific wording of the Ordinance but “is a concept rooted in the nature of arbitration itself” and necessarily informs “the construction and application of [section] 81 even though the Ordinance does not in terms draw such distinction”.
Against that background, a dispute which goes to the admissibility of the claim, rather than the jurisdiction of the tribunal, should be regarded as a dispute “falling within the terms of the submission to arbitration” under Article 34(2)(a)(iii). This approach, the Court said, would be in line with the general trend of minimising judicial interference in arbitration.
The Court rejected C’s argument that the challenge was, in any event, jurisdictional in nature. C had argued that, where a contractual obligation is subject to a condition precedent, there is, prior to the occurrence of the condition, no duty to render performance of that obligation. In other words, until the occurrence of a condition precedent to arbitration, there is no consent and no duty to arbitrate.
The Court felt this was an “over-simplification” of the matter. As arbitration is a consensual process, the true and proper question should be to ask whether the parties intended that any doubt about the fulfilment of a condition precedent would be determined by the arbitral tribunal. If they did, the matter falls “within the terms of submission to arbitration”.
C’s objection was not that the substantive claim advanced by D could never be referred to arbitration. Rather, C contended that the reference to arbitration was premature. Viewed in this light, the Court held that the challenge was targeted at the claim, not the tribunal. Absent any agreement of the parties to the contrary, C’s objection addressed the admissibility of the claim, not the jurisdiction of the Tribunal, such that the award was not susceptible to review under Article 34(2)(a)(iii).
The Court of Appeal in fact went one step further on this issue, finding that they would have reached this conclusion regardless of the distinction between admissibility and jurisdiction. Citing the “one-stop shop” principle in the well-known UK House of Lords decision in Fiona Trust & Holding Corporation v Privalov  Bus LR 1719, the Court held that there was a presumption that commercial parties intended to refer all disputes arising from their agreement to a single decision-maker. In this case, there was no reason to confine the scope of arbitral disputes to only the substantive disputes arising out of the contract, and to exclude from it disputes on whether the pre-conditions had been complied with.
The second ground of appeal was also rejected. The Court disagreed that D had failed to comply with the “arbitration procedure”. Even if it were correct to say that Article 34(2)(a)(iv) could be extended to cover pre-arbitration requirements, the parties clearly intended in this case that questions regarding compliance with pre-conditions to arbitration should be determined by the arbitrators. It followed that the parties had not intended that any failure to comply would bar arbitration altogether. It was therefore clear that the “arbitration procedure” had been followed.
In light of these findings, the Court held that it was unnecessary to consider C’s third ground for appeal, which was based on the correctness of the tribunal’s original findings on contractual construction.
This is an important case of international significance. It reflects a growing trend in the international case law to minimise judicial interference in the arbitral process by categorising disputes regarding pre-conditions to arbitration as matters of admissibility rather than jurisdiction. Although this issue has been addressed by other national courts, the decision of the Hong Kong Court of Appeal is the highest authority on this specific question from a Model Law jurisdiction. It therefore provides much welcome certainty on this point and should carry significant weight outside of Hong Kong.
What is also apparent from the case is the very pro-arbitration stance of the Hong Kong judiciary. As the Court of Appeal made clear, whether a party has complied with a pre-condition to arbitration: “is a question intrinsically suitable for determination by an arbitral tribunal, and is best decided by an arbitral tribunal in order to give effect to the parties’ presumed intention to achieve a quick, efficient and private adjudication of their dispute by arbitrators chosen by them on account of their neutrality and expertise”.
This does not, of course, mean that escalation clauses are unimportant or unenforceable. As the Court of First Instance made clear, arbitral tribunals have many tools at their disposal to police compliance with these provisions. They can, for example, decline to hear a dispute until the parties have complied with the contract, or adjourn proceedings to allow negotiation or mediation to take place. They can impose cost sanctions on the party that has breached the escalation provision, or they can decide ultimately to take no action at all on the basis that compliance with the provision would have been futile. The key point is that these are questions for the arbitrators to decide, and whatever decision they make should not lead to further review by the courts.
Fundamentally, and as the Court of Appeal was careful to emphasise, these are all questions of what the parties intended when they drafted the particular arbitration agreement. As such, there may be extreme circumstances where the contract makes clear that failure to follow the escalation mechanism will have jurisdictional consequences. For example, a contract could in theory stipulate that, before any dispute is to be referred to arbitration, the parties must negotiate in good faith for a period of 30 days, and that any subsequent arbitral tribunal will lack jurisdiction to hear the case unless these provisions are strictly met. Such drafting is exceptionally rare and would not be recommended. Indeed, it would create a recipe for precisely the sort of costly litigation that the ruling is intended to prevent.
For more information, please feel free to get in touch with any of the contacts below, or your usual Herbert Smith Freehills contact.