Rise of alternative OTC dispute venues

Author: | Published: 24 Mar 2015
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

Counterparties in the region are increasingly resorting to alternative venues to resolve disputes over complex financial products

Traditionally litigation has been the preferred form of dispute resolution in international finance. For a long time, the default option in derivatives contracts – even involving counterparties in Asia – either the London or New York courts. That changed in September 2013 when the International Swaps and Derivatives Association (ISDA) published the 2013 ISDA Arbitration Guide. The 2013 Guide set out an overview of the key features of arbitration.

It included a number of model arbitration clauses for many of the main arbitral institutions, designed to be used in the 1992 and 2002 ISDA Master Agreements. This was a heralded development, lending credibility and reassurance to the idea that arbitration could be used to resolve derivatives disputes.

"China’s courts can, and do, enforce foreign arbitral awards"

It is important to understand the reasons for the traditional reluctance, particularly among the large financial institutions, to embrace arbitration. There is confidence in the litigation system, particularly in London and New York, where there are judges capable of understanding complex financial instruments. The court procedure in London and New York also allows unmeritorious claims to be struck out or dismissed at an early stage.

The common law legal system is also precedent-based, which brings with it a level of certainty. Banks are astute litigators and will generally fight only the cases they expect to win, which means that the relevant case law is relatively bank-friendly.

Why arbitration?

The principal driver for arbitration has been the increasing involvement of parties from emerging markets, particularly in Asia, in international finance. This is relevant because parties based in emerging markets may be unwilling to agree to London or New York jurisdiction, while the international banks are unlikely to be willing to agree to the jurisdiction of the counterparty's home court.

Arbitration offers a neutral venue. For Asian counterparties, Hong Kong and Singapore – and increasingly Seoul – are established commercial and arbitral hubs. Further, it is, as a rule, more straightforward to enforce an arbitral award than a court judgment.

China is the ideal example; its courts will not enforce a judgment of the significant majority of foreign courts, including English and US court judgments. It is, however, a signatory to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards, commonly known as the 'New York Convention. China's courts can, and do, enforce foreign arbitral awards.

"There is a sufficient amount of anecdotal evidence of use of the 2013 Guide to indicate that it has had a meaningful impact"

It is also fair to say that arbitration as a practice has itself developed in recent years. The number of individuals who sit as arbitrators with relevant experience of complex financial products and related disputes has increased significantly. A body named PRIME Finance was established in 2012 with the specific purpose of bringing together a pool of arbitrators experienced in this area.

The major arbitral bodies have also recognisedthe advantages of the court procedure. The Singapore International Arbitration Centre (SIAC) introduced an expedited procedure in its 2010 rules, which requires awards to be issued within six months of the tribunal being appointed. While not exactly equivalent to summary judgment, these measures are designed to address the concern of being stuck in lengthy unmeritorious proceedings. Similarly, in 2013, the Hong Kong International Arbitration Centre (HKIAC) introduced updated rules for interim relief and extended the scope for expedited procedures.

It was against this backdrop that ISDA published the 2013 Guide. Its publication followed a two-year consultation on the use of arbitration to resolve disputes under the ISDA Master Agreements.

The 2013 Guide included a number of model clauses that were designed to address concerns raised regarding poorly drafted arbitration agreements (sometimes known as pathological arbitration clauses) and the problems that they cause. Those model clauses are designed principally for use with the 2002 version of the Master Agreement, but additional wording is included for adaptation to the 1992 version. The model clauses provide for arbitration under a range of arbitral institutions and their rules, including the HKIAC and SIAC.

Market reactions

The ISDA Arbitration Committee met towards the end of 2014 to discuss its reception and also to consider proposals for amendment and expansion. Broadly, the feedback from market participants and their advisers was that the 2013 Guide has been well received.

The proposals for amendments were principally focussed on providing additional information in the guide, including the differences between rules and procedures of relevant arbitral bodies. It was also suggested that the seats available under the 2013 Guide be extended to include, for example, the Dubai International Finance Centre. ISDA certainly appears committed to the 2013 Guide and seeking to work with its members and the wider market, in ensuring that it is both used and usable.

The difficulty in discerning the take up of arbitration in derivatives contracts is that arbitration is a confidential process. No hard figures are available. Further, even if arbitration clauses are being included in ISDA Master Agreements, those agreements are unlikely to be the subject of dispute for some time, if at all.

"There will be an increased trust in arbitration as more derivatives disputes are resolved satisfactorily"

There is, however, a sufficient amount of anecdotal evidence of use of the 2013 Guide to indicate that it has had a meaningful impact and is being adopted. This is particularly the case in Asia where there remains a significant amount of activity in the derivatives markets, but where concerns around local courts and enforceability of judgments are perhaps most relevant. For example, one of the international investment banks is now understood to use arbitration clauses in its private client agreements in Asia almost exclusively.

The use of arbitration in derivatives contracts and other financial agreements, is only expected to increase as large financial institutions and other market participants become more familiar and comfortable with this form of dispute resolution. As with any development, it will take time and a certain recalibration of approach and practice in the market.

As ISDA noted during the consultation process before the publication of the 2013 Guide, it expects the number of arbitrators with derivatives experience to grow naturally as more derivatives disputes are referred to arbitration. Similarly, there will be an increased trust in arbitration as more derivatives disputes are resolved satisfactorily by that process.

This is important in Asia where (possibly historical) concerns around the resolution of any disputes and enforcement have impacted on large financial institutions' willingness to enter into agreements with counterparties in certain jurisdictions in the region. Of course, those jurisdictions also have a role to play in ensuring that their courts give effect both to arbitration agreements and to arbitral awards.

There remain circumstances in which the English or New York court is the sensible jurisdiction for the resolution of disputes under the ISDA Master Agreement. However, we have arrived at the position where arbitration is now, at least, a viable alternative and one that should be thoroughly explored.

By Jonathan Cary, partner, and Robert Rhoda, senior associate, at Smyth & Co in association with RPC in Hong Kong.