Insolvency and Arbitration

The relationship between insolvency and arbitration is often characterised as “a conflict between near polar extremes.”

This phrase aptly encapsulates the inherent tension between the two regimes.

In a nutshell, that is because: insolvency is a centralised and transparent court-regulated procedure, governed by mandatory national laws and resulting in an outcome that affects multiple parties; whereas arbitration is an autonomous, private (sometimes confidential) and procedurally-flexible dispute resolution mechanism, created by a simple contract between commercial parties and resulting in an award that is only binding on them

The conflict that arises when insolvency and arbitration collide boils down to the following question: When commercial parties have agreed by contract that certain disputes between them will be resolved privately by arbitration, but a later change in circumstances finds one of them unable to pay its debts, so that the state itself is obliged to intervene to preserve public order, what will happen to the insolvent party’s original and binding commitment to have its disputes settled by arbitration?

What Are the Issues that Arise When Insolvency and Arbitration Intersect?

To begin with, various factors must be taken into account when considering the practical implications of an insolvency on arbitration, which include: the stage of the insolvency proceedings; the stage of the arbitration proceedings (pre-arbitration, ongoing, post-award phase); whether the insolvency concerns the claimant or the respondent; and whether the insolvency is mandatory or the distressed company is undergoing a voluntary winding up.

Moreover, insolvency proceedings can impact:

• the validity of the arbitration agreement;
• the insolvent party’s capacity to arbitrate its disputes;
• the arbitrability of the subject matter in dispute;
• the conduct of the arbitral proceedings;
• the content of the award; as well as
• the subsequent recognition and enforcement of the award by national courts.

Prior to examining how these issues are addressed by arbitrators and domestic courts, it is important to provide an overview of the regulatory framework governing insolvency proceedings.

National Insolvency Laws: Common Objectives and Territorial Scope

Each country has its own set of insolvency laws, which have different names and are mandatory in nature, since public policy interests are at stake and multiple private parties are usually affected when a business becomes unable to pay its debts. It is important to keep in mind, however, that the effect of such laws is usually limited to the jurisdiction in question (the territorial scope of the national insolvency laws).

Despite the existing differences between various domestic insolvency regimes, certain common objectives can be identified, which include:

• rescuing viable businesses through reorganisation;
• distributing a liquidated estate in such manner so as to maximise payment to creditors;
• ensuring that same-class creditors are treated equally.

These objectives are attained via mandatory domestic laws, which usually alter general contract law principles by temporarily limiting the contractual freedom of the debtor for the public good, to the effect that:

• the debtor is normally deprived of its right to manage and dispose of its insolvent estate, as well as of its right to sue and be sued in arbitration;
• a neutral trustee is usually appointed to act on behalf of the bankruptcy estate, who can potentially initiate arbitration in order to manage the estate;
• all “core” bankruptcy issues (for example, the nomination of the trustee, the verification of creditors’ claims, etc.) are non-arbitrable and entrusted solely to national courts;
• all domestic legal proceedings, including domestic arbitrations, are usually brought to a halt against the insolvent entity (so, if pending, they are suspended or stayed and, if new, they cannot begin), unless specific leave is granted by the competent court and/or consent is given by the trustee.

How Arbitrators and Courts Handle the Insolvency of a Party to an International Arbitration

There is, unfortunately, no consistency in terms of how arbitrators and courts handle (nor consensus in terms of how they should handle) the various issues that arise when insolvency and international arbitration clash.

The first point to be made is that in the context of an international arbitration, several complex conflict-of-laws issues also usually arise and decision-makers are called to make important policy considerations in order to render an enforceable award. That is because arbitrators are not attached to any forum (in legal terms, they have no lex fori, as national courts do) thus, all national laws, including the mandatory national insolvency laws discussed herein, are considered, at least conceptually, foreign to them. In reality, however, in order to ensure that an enforceable award will be rendered, arbitrators do need to respect the mandatory rules of the seat of the arbitration, especially when the distressed party is (or it is about to be) declared insolvent there. Otherwise, they risk that the award will be set aside and refused recognition and enforcement at the seat of the arbitration on public policy grounds.

Under the 1958 United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards (the “NYC”), which is the primary reference guide for ensuring the success of any international arbitration, there are two limbs of public policy grounds that can be raised to block recognition and enforcement of an award rendered in violation of insolvency laws, i.e.:

1. 1. that the subject matter in dispute is not capable to be resolved by arbitration (Article V(2)(a) of the NYC); and
2. 2. that actual enforcement of the award would contradict with the public policy of the state addressed (Article V(2)(b) of the NYC).

The overall pro-enforcement bias flowing from the NYC, however, mandates that these two provisions are interpreted restrictively, and domestic courts should bear that in mind when making a decision to recognise and enforce an arbitral award rendered in the context of an international arbitration which clashes with a foreign insolvency.

Further, practice shows that international tribunals generally acknowledge parallel insolvency proceedings and do try to integrate them into the arbitral process. This means that the opening of insolvency proceedings does not necessarily frustrate the parties’ agreement to arbitrate their disputes. Nor does it make the subject matter in dispute necessarily non-arbitrable, considering that usually only very “core” issues, such as the insolvency proceedings themselves, are excluded from the arbitration realm and entrusted purely to domestic courts. The content of the award might also be modified (from monetary to declaratory) to make sure that the purpose of an insolvency (for example, the protection of the equality of creditors) is not defeated.

To reconcile both regimes, certain modifications to the conduct of the proceedings are normally necessary, such as granting reasonable extensions of time, taking into account that every decision made by the insolvent party may be subject to a series of authorisations. While some delays may be warranted to respect due process, there is also a very thin line between a genuine difficulty of the insolvent party to participate in the arbitration proceedings and dilatory tactics intended to frustrate them.

Further, if the insolvency proceedings are still ongoing, the distressed party is arguably not deprived of its capacity to appear before tribunals (and courts). Instead, its capacity to do so is merely transferred to and upheld by the trustee. Only entities that, upon liquidation and distribution of their estate, cease to exist (and are deleted from commercial registries) arguably lose their legal capacity entirely.

Last but not least, while there are several streams of arguments put forward herein showing that insolvency and arbitration proceedings can (and shall) be reconciled, it is true that businesses are often reluctant to pursue arbitration, when it is expected that the insolvent party will be left with few assets, especially when the claimant would be a low-priority creditor under the relevant insolvency framework. Bankruptcy trustees may have greater incentives to commence arbitration proceedings against the bankruptcy estate’s debtors, assuming that the bankruptcy estates can in fact pay for the arbitration proceedings or secure third-party funding to fund legitimate claims.