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Beware of the monster lurking at midnight

2023-04-25

Beware of the monster lurking at midnight

Avoid pathological clauses in arbitration

Introduction  

Arbitration has gained popularity, especially in commercial and construction disputes, local and international. Indeed Article 159(2) of the Constitution of Kenya has expressly recognized arbitration as one of the alternative modes of dispute resolution. By choosing arbitration, parties forfeit their right to refer the dispute to publicly funded ordinary courts and opt for a private judge. The main motivation is efficiency, expediency expertise, and evenhanded enforceability, the 5 “Es”. 

Yet, more often than one would expect, many arbitration agreements are defectively drafted. The main reason is that the arbitration agreement, which is normally part of the main contract, is included in the contract almost as an afterthought or none. Parties negotiate to take time to negotiate everything else, and only when they are about to toss the champagne, someone points out that there is no arbitration clause. It is at that point that someone rummages through earlier, sometimes unrelated contracts, “cuts and pastes’ or calls a colleague to share a boilerplate arbitration clause and Eureka!   The parties then sign off and the party begins. Hence the term “midnight” or “champagne” clauses. 

Reality dawns on parties when the dispute arises. By then the respective parties’ positions have hardened. They realize that the arbitration clause is defective thereby making referring the dispute to arbitration either difficult or out of question. One party takes advantage of the defect!

It is Frédéric Eisemann, the then Secretary General of the ICC Court of Arbitration. (later renamed the International Court of Arbitration), who, Zin 1974, coined the term “pathological clauses” i.e. a defective arbitration clause. In the worst-case scenario, the clause might be so defective that it cannot be enforced as an arbitration clause at all. 

The law

Section 6 of the Arbitration Act empowers the High Court to stay proceedings and refer the parties to arbitration unless it finds that the arbitration agreement is null and void, inoperative or incapable of being performed. In other words, it is defective beyond cure. This means some defects in arbitration can be cured while others are terminal. Whether courts are inclined to save the clause will depend on the extent of the defect and whether the country is arbitration-friendly. 

How to draft a valid arbitration agreement

The arbitral process is anchored in the consent of the parties. It is the arbitration agreement which grants the arbitral tribunal jurisdiction to entertain the dispute. If the arbitrator proceeds to hear a matter under a defectively incurable agreement, a party dissatisfied with the award can successfully apply to have it set aside. 

It is therefore critical that parties consider the arbitration clause as important as any other fundamental clause. The first thing to consider is whether, given the value of the contract, it would be viable to have an arbitrator appointed in the first place and if so, how many. It may not be value for money for an arbitrator to be paid KES 1.5 Million to determine a dispute of KES 6 million. Or to pay KES 10 Million to a tribunal of three arbitrators to hear a dispute of KES 50 Million.   

The second thing is the terms of the arbitration agreement, which should be simple and clear. Parties can, with little or no modification, adopt one of the model clauses by arbitration institutions. That way they will not need to reinvent the wheel.  

For instance, the UNCITRAL,  model clause states: 

Any dispute, controversy, or claim arising out of or relating to this contract, or the breach, termination or invalidity thereof, shall be settled by arbitration under the UNCITRAL Arbitration Rules as at present in force. 

UNCITRAL model law is domesticated in our Arbitration Act 1995.

On its part, the Nairobi Centre for International Arbitration model clause states:

Any dispute, controversy or claim arising out of or in connection to this contract, or breach, termination or invalidity thereof shall be settled by arbitration in accordance with the NCIA Arbitration Rules.”

While the Chartered Institute of Arbitrators (Kenya Branch) model clause states.

Any dispute arising out of or in connection with this Contract, including any question regarding its existence, validity, interpretation or termination, shall be determined by arbitration following the rules of the Chartered Institute of Arbitrators (Kenya branch) that are applicable at the commencement of the arbitration.

Two points are critical in any properly drawn arbitration agreement, that is the scope of the arbitration and the finality of the ensuing award. 

The scope is captured by the words, “any dispute arising out of or in connection with this contract ….” Arbitration clauses may refer either specific or general disputes, arising out of a contractual or other legal relationship, to arbitration. It is advisable to draw such clauses as widely as possible to limit possible conflicts as to whether a matter falls under the arbitration clause. Broadly worded arbitration clauses may prevent the fragmentation of disputes between different fora.

Arbitration agreements covering “all disputes out of a contract” apply to claims for damages out of the breach of contractual obligations, unjust enrichment, and tort if the contractual violation and the harmful action are connected in a way that they must be seen as forming a unity with the contractual obligations. The scope of such arbitral agreements does not, however, include noncontractual obligations that are only very loosely connected to the contract.

Indeed, section 3 of the Arbitration Act 1995 defines “arbitration agreement” as 

“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”. 

Parties can also add to the arbitration agreement the number of arbitrators, the expertise and experience of the arbitrator(s), the venue of the arbitration etc. 

The second point is the finality of the award. This is encapsulated in the words, “shall be settled”. Not “will”, or “may”. It should be stated in mandatory but not optional terms.  

Conclusion

In subsequent posts, we will explore how courts in various jurisdictions, civil and common law, have handled this persistent problem of pathological arbitration clauses. Parties and contract drafters are well-advised not to gamble with such an important term of the commercial contract as the arbitration clauses by giving it as much attention as the other clauses of the contract. Otherwise…always remember the monster!

Daniel Musyoka