To Arbitrate or Litigate
The Validity of Arbitration Clauses

Overview

Arbitration clauses have become a cornerstone in commercial contracts, offering an attractive alternative to traditional litigation for resolving disputes. Businesses often prefer arbitration for its privacy, efficiency, and the opportunity to select arbitrators with specific expertise.

However, when a dispute arises, it is very common to see one party attempts to litigate while the other party resists litigation by relying on the arbitration clause. There are numerous factors affecting the validity of an arbitration clause which in turn affect the parties’ way to resolve the dispute in litigation or arbitration. This article delves into the intricacies of arbitration clauses and discusses some of the potential issues which might cause conflicts in honouring or not honouring the arbitration clause.

Definition of an Arbitration Agreement

Article 7 of UNCITRAL Model Law which is equivalent to Section 19 of Arbitration Ordinance governs the definition and form of arbitration agreement. According to this section, an arbitration agreement is an agreement by the parties to submit to arbitration all or certain disputes which have arisen or which may arise between them in respect of a defined legal relationship, whether contractual or not. An arbitration agreement may be in the form of an arbitration clause in a contract or in the form of a separate agreement.

The arbitration agreement shall also be in writing and it is regarded as being in writing if its content is recorded in any form, whether or not the arbitration agreement has been concluded orally, by conduct or by any other means, such as electronic communication.

Common Issues in Arbitration Clause

An effective arbitration agreement is paramount to ensuring a smooth dispute resolution process. Potential issues in validating or invalidating an arbitration clause include:

Unequivocal Agreement to Arbitrate

The most problematic element which can result in disputes over the interpretation of the arbitration clause would be whether an arbitration clause has unequivocally expressed the parties' intention to arbitrate any or certain disputes arising from the contract. Ambiguities as to whether arbitration is the exclusive means of resolving disputes can lead to the question of whether an arbitration agreement exists at all. A landmark judgment in Hong Kong given by Former Chief Justice Geoffrey Ma when he was then sitting as the Chief Judge of the High Court at the time of him giving this judgment, set down a further interpretation of Article 7 of UNCITRAL Model Law and held that an agreement which does not compel the parties to have disputes or differences resolved by arbitration is not an arbitration agreement and there must be its element of compulsion in the agreement between the parties that any disputes or differences must be resolved by arbitration.

In this regard, there are queries if permissive language is used rather than “shall”, such as “may” or “can”, whether an arbitration clause satisfies the element of compulsion.

After this High Court ruling, the word “shall” was held to be a valid arbitration agreement. The clause in this case goes as follows:

“All disputes at any time arising between Buying Agent [the 1st Defendant] and Vendor [FDL], or Buyer [the 2nd to 7th Defendants as the case may be] and Vendor, as to the performance of the Contract or as to any matter or thing arising out of the Contract or in any way connected herewith shall be referred to the arbitration as a single arbitrator who shall be agreed between Buying Agent and Vendor, or Buyer and Vendor, within 14 days of the dispute arising. Failing such agreement, the single arbitrator shall be appointed at the request of either party by the President for the time being of the Law Society of Hong Kong. The arbitration shall be conducted in accordance with the Arbitration Ordinance for the time being in force in Hong Kong…”

The Court was of the view that it is difficult to construe the above clause as somehow giving an option to the parties whether or not to have their disputes resolved by arbitration, nothing in the above clause mentions such an option. In another case, Kaplan J at the Court of First Instance held that the clause “in case of any incompleteness of the contract both parties shall reach settlement through friendly consultations. If settlement cannot be reached through consultations, the matter may be submitted for arbitration to China International arbitration body”. The Court was of the view that although “may” is a permissive expression, in this context it essentially means once one of the parties chooses to commence arbitration proceedings, the other party is bound to comply, hence, under this context, the word ‘may’ in effect equals to ‘shall’.

Similarly, in another case in the UK, the Privy Council stayed proceedings in favour of arbitration concerning disputes under a shareholders’ agreement which provided that “any party may submit the dispute to binding arbitration”. The Privy Council held that it is open for a party to commence litigation, but when one party chooses to invoke the arbitration clause, both parties must enter arbitration. In other words, even the arbitration clause may appear to be purely permissive, it becomes mandatory for both parties when one party chooses to invoke the arbitration clause.

The reasoning in the UK case is later relied on by Hong Kong Court for both, showing a similar judicial position Hong Kong and the UK on the interpretation of “may” in an arbitration clause. The Court of First Instance of Hong Kong dealt with the interpretation of an arbitration clause that used the term “may” instead of “shall” or “must.” The arbitration clause stated that “both parties may in accordance with the relevant arbitration laws of Hong Kong submit the dispute or controversy to the relevant arbitral institution for resolution…”. The ambiguity led to litigation as one party argued that arbitration was optional. The court eventually upheld the effectiveness of the arbitration clause, on the basis that an arbitration clause will not normally be construed as giving a choice to the parties between arbitration and litigation unless there is unambiguous language providing for such.

According to these High Court rulings, as long as parties express a mutual intention to resolve the dispute by arbitration ONLY and invoke the arbitration clause, the Court will tend to rule that the arbitration clause is unambiguous and liable to be complied with by the parties.

Dispute Covered by the Arbitration Clause

Another common litigation issue is whether the arbitration clause effectively covers the dispute.

In a Hong Kong case, the Court of First Instance navigated through inconsistencies in the arbitration clauses within the bonus scheme letters to determine whether the disputes could be covered by arbitration. There were several bonus letters between a company and an employee. There were 3 bonus letters:

• The first bonus letter was silent on arbitration, lacking any clause that would mandate disputes to be arbitrated.

• The second bonus letter included a specific arbitration clause requiring any disputes arising from that letter to be referred to arbitration in Hong Kong, with a sole arbitrator chosen by the company.

• The third bonus tetter mirrored the 2017 clause, but this letter was not signed by the employee.

Despite these inconsistencies, the court took a pro-arbitration approach, interpreting the clauses in a manner that made commercial sense and aligned with the presumed intentions of the parties. Following the principle established in a well-known UK case, the Court presumed that the parties, as rational businessmen, intended for any disputes arising from their relationship to be resolved by the chosen arbitral tribunal. Despite the inconsistency between the bonus letter, the Court upheld the effectiveness of the arbitration clause and stayed the proceeding in favour of arbitration. The decision underscores Hong Kong court’s pro-arbitration stance when determining whether a dispute is covered by an arbitration clause.

However, this pro-arbitration stance may not always apply, especially when the arbitration clause is governed by different legal systems. In another Hong Kong case, the Hong Kong court dismissed the defendant’s application for a stay of action in favor of arbitration because the PRC law-governed arbitration clause did not cover tortious disputes. The arbitration clause, governed by PRC law reads as follows:

“Any dispute arising from the performance of this agreement shall be resolved by amicable negotiation, failing which either party has the right to refer the dispute to the Hong Kong International Arbitration Centre for arbitration pursuant to the arbitration rules in force at the time of the signing of this agreement.”

The clause was found to be limited to disputes arising from the performance of the agreement, thereby excluding tortious claims. The court relied on a PRC legal expert’s opinion that under PRC law, the judicial authority would interpret such term narrowly to exclude tortious claims. This case has highlighted that the common law’s pro-arbitration approach may not always be applicable under different legal frameworks.

Precondition Procedures to Arbitration

Arbitration clauses sometimes require the parties to seek to resolve their dispute amicably by negotiation before entering into a formal arbitration. A question that arises in this context is whether a failure to meet such a pre-condition can provide a basis for resisting arbitration.

In a recent Hong Kong case, one party contested an arbitral tribunal's jurisdiction by arguing that the other party had not followed the escalation procedure outlined in the contract. The clauses in question stated:

Clause 14.2 – Dispute Resolution

“The Parties agree that if any controversy, dispute or claim arises …, the Parties shall attempt in good faith promptly to resolve such dispute by negotiation. Either Party may, by written notice to the other, have such dispute referred to the Chief Executive Officers of the Parties for resolution …” [emphasis added)

Clause 14.3 – Arbitration

“If any dispute cannot be resolved amicably within sixty (60) business days of the date of a Party’s request in writing for such negotiation, or such other time period as may be agreed, then such dispute shall be referred by either Party for settlement exclusively and finally by arbitration in Hong Kong at the Hong Kong International Arbitration Centre (‘HKIAC’) in accordance with the UNCITRAL Arbitration Rules in force at the time of commencement of the arbitration (the ‘Rules’) …” [emphasis added]

The court eventually held that non-compliance with a pre-condition to arbitration generally concerns the admissibility of the arbitration by the arbitral tribunal, but not the jurisdiction of the arbitral tribunal. It means that it is a question for the arbitral tribunal to decide whether or not to accept the parties to resolve the dispute by arbitration, rather than an issue for the court to intervene. Therefore, the plaintiff's attempt to seek a declaration from the court to set aside the arbitration awards failed.

Similarly, in another UK case, the relevant dispute resolution clause provided that:

“[t]he parties shall in good faith endeavour to reach an amicable settlement of all differences of opinions or dispute which may arise between them in respect of the execution performance interpretation or termination of the agreement”, and that “[i]n the event that the parties shall be unable to reach an amicable settlement within a period of 3 (three) months from a written notice by one party to the other specifying the nature of the dispute and seeking an amicable settlement, either party may submit the matter to the exclusive jurisdiction of a Board of 3 (three) Arbitrators …”.

An arbitral award was challenged on the ground that the 3-month negotiation period had not yet expired by the time of the request for arbitration, and thus the arbitrators were without jurisdiction. The Court similarly held that an objection based on the alleged prematurity of a request for arbitration concerns the admissibility of the claim rather than the jurisdiction of the tribunal. Therefore, the attempt to set aside the arbitral award failed.

In other words, in theory, non-compliance to pre-conditions of an arbitration clause will not preclude the party who wants to invoke the arbitration clause from submitting the dispute to an arbitral tribunal and this is not a ground to be relied on by a party who wishes to litigate in court.

Selection of Governing Law

When enforcing an arbitration clause, it is crucial to consider three sets of laws: 1) the law governing the contract, 2) the law governing the arbitration agreement, and 3) the law of the seat of arbitration. Controversy surrounding the arbitration clause may arise if the contract is silent on the governing laws, or if there are contradictory governing law clauses.

An English Court of Appeal case established a three-stage test for determining the governing law of an arbitration agreement:

• Whether the parties expressly chose the law of the arbitration agreement;

• Whether the parties made an implied choice of the law of the arbitration agreement; and

• In the absence of an express or implied choice, the system of law with which the arbitration agreement has the “closest and most real connection”.

This three-stage test has been approved by the Court of Final Appeal in Hong Kong and applied in the UK Supreme Court case. The UK Supreme Court in Enka set out that the law applicable to the arbitration agreement will be (a) the law chosen by the parties to govern it; or (b) in the absence of such a choice, the system of law with which the arbitration agreement is most closely connected. Where the law applicable to the arbitration agreement is not specified, a choice of governing law of the contract will generally apply to an arbitration agreement that forms part of the contract.

In a recent Hong Kong case, the Court observed that the starting point for determining the applicable law of an arbitration agreement was the terms of the arbitration clause and the relevant contract. The court found that the contract, including the arbitration clause, must be reviewed to ascertain whether there was any express or implied agreement by the parties as to the law of the arbitration agreement. Only if such an agreement could not be found would the implication arise from the choice of the seat, that the law of the seat would likely govern the arbitration agreement. In the case, although the contract specified German law as the governing law and the arbitration was to be held in Shanghai, the court held that the governing law of the arbitration agreement was German law. This was due to the explicit language in the contract and the requirement for one arbitrator to be a German lawyer, indicating an intention for German law to apply in arbitration.

Thus, this case underscores the importance of clearly specifying the governing law for the arbitration agreement to avoid legal uncertainties and potential invalidation, highlighting the intricate relationship between the laws of the contract, the arbitration agreement, and the seat of arbitration.

Conclusion

This article illustrates the common litigation issues for validating or invalidating an effective arbitration clause. For legal assistance in enforcing arbitration clauses, or for more information on how recent legal developments may impact your business, please contact our legal team.