Escalation clauses: what are they and how do they affect arbitral awards

July 2023 | EXPERT BRIEFING | LITIGATION & DISPUTE RESOLUTION

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Escalation clauses, also known as multi-tiered clauses, are commonly written into commercial agreements. These clauses often contain mandatory language that requires parties to make a good faith attempt at negotiating or mediating their disagreements before formal proceedings are commenced. Often, a ‘cooling off’ period is written into the escalation clause so that parties are required to take time out to reassess and evaluate their respective positions.

Their purpose is to provide the parties with a structured, or step by step, process to resolve their commercial disputes. These types of clauses also encourage dispute resolution at an early stage by encouraging parties to settle any misunderstandings, or otherwise forge consensus and compromise.

Nevertheless, in recent years, the meaning and effect of multi-tier or escalation clauses has generated substantial debate. This is especially in the scenario where one party has allegedly complied (or refuses to comply) with the steps laid out in the multi-tier clause before arbitral proceedings begin. In turn, arbitral tribunals and national courts have had to determine whether the failure to comply with pre-arbitral steps constitutes a question of ‘admissibility’ or ‘jurisdiction’.

Admissibility versus jurisdiction

Described in simple terms, ‘admissibility’ is about whether it is appropriate for the tribunal to hear a particular claim, or whether a claim has been properly brought. On the other hand, ‘jurisdiction’ refers to whether the tribunal has the power or legal authority to hear the dispute.

The distinction between the two concepts is well-recognised in Hong Kong, Singapore and the UK – all popular jurisdictions to arbitrate disputes in. For instance, in PAO Tatneft v Ukraine (2018), the English High Court characterised the difference between the two as follows: (i) issues of jurisdiction go to the existence or otherwise of a tribunal’s power to judge the merits of the dispute; and (ii) issues of admissibility go to whether the tribunal will exercise that power in relation to the claims submitted to it.

The distinction between the two matters greatly, especially at the enforcement stage of an award. The most important implication (at least in common law jurisdictions) is that questions of admissibility are usually considered not to provide a challenge to the general authority of the parties’ agreement to arbitrate. A tribunal’s decision that certain claims are admissible is generally not subject to de novo review by the courts at the seat of the arbitration. On the other hand, a tribunal’s decision that it has jurisdiction to hear a claim may be subject to review by the courts at the seat of the arbitration. Where it is found that a tribunal lacked jurisdiction, its award is at risk of being set aside.

Although international arbitration practitioners have traditionally considered the issue of whether escalation clauses have been complied with to be an issue of admissibility, case law in England, Hong Kong and Singapore has historically been less certain. However, unless the approach of national courts aligns with accepted arbitration principles, arbitral awards that deal with escalation clauses remain vulnerable to challenge if there is a dispute over compliance.

Thus, the renewed debate over the distinction between admissibility and jurisdiction (and what this means in the context of escalation clauses) has been welcomed by arbitration practitioners globally.

The Hong Kong case of C v. D

In C v. D, parties entered into an agreement for the development and building of satellites. The dispute resolution clause contained an escalation clause: it stipulated that where a dispute arose, parties were required to first attempt good faith negotiations prior to arbitration. Specifically, the relevant clause required that either party must provide written notice to the counterparty’s chief executive and the chief executives (or their authorised representatives) would then need to meet and attempt resolution through negotiation. If this procedure failed, then either party could file an arbitration with the Hong Kong International Arbitration Centre to kickstart formal proceedings.

When differences arose, the chief executive of Company D issued a letter to the chairman of the board of directors of Company C (who also provided a copy to Company’s C chief executive). When arbitration commenced, the parties disputed whether the letter provided to Company C’s chairman qualified as written notice under the agreement, and accordingly, whether the tribunal had jurisdiction to hear the claim.

In a partial award, the tribunal held that it had jurisdiction to hear the dispute, and that the conditions to arbitrate had been duly complied with. Thus, it refused Company C’s objections. Shortly thereafter, Company C filed an application in the Hong Kong courts to set aside the partial award on the basis that the tribunal lacked jurisdiction to hear the dispute. Counsel D’s lawyers submitted that, properly framed, these were questions of admissibility and not jurisdiction. Accordingly, the tribunal’s decision on the matter should not be subject to review by Hong Kong courts under the Hong Kong Arbitration Ordinance.

The Hong Kong Court of First Instance agreed with Company D. In his decision, the judge reaffirmed the pro-arbitration stance that Hong Kong courts have consistently adopted, and noted in particular that the court’s approach to set aside applications had to be confined to “true questions of jurisdiction”. The court found that the “generally held view of international tribunals and national courts is that non‑compliance with procedural pre‑arbitration conditions such as a requirement to engage in prior negotiations goes to admissibility of the claim rather than the tribunal’s jurisdiction”.

In reaching this conclusion, the Hong Kong Court of First Instance also considered the ‘tribunal versus claim’ test that had been discussed by other courts in common law jurisdictions.

Steps toward international consensus

In C v. D, the Hong Kong Court of First Instance also held that the academic works and international authorities submitted before him demonstrated that the distinction between admissibility and jurisdiction is also a concept rooted in the nature of arbitration itself.

Notably, the judge quoted passages from the ‘International Arbitration Practice Guideline on Jurisdictional Challenges’ issued by the Chartered Institute of Arbitrators. This note observed that challenges based on time-bar, or preconditions that had to be satisfied before arbitration, were challenges to the admissibility of such claims. They were not challenges to the arbitrators’ jurisdiction to decide those claims.

The distinction between jurisdiction and admissibility was also recognised by the US Supreme Court in an investor-state case, BG Group plc v Republic of Argentina (2014). The relevant treaty stipulated that a party needed to first submit its dispute to the national court of the other party. Arbitration was permitted if there was no final court decision after 18 months had passed from the date the dispute was submitted to the national courts. Eventually, an award was rendered against Argentina, which then sought to set aside the award in the US courts by arguing that the investor had not complied with the domestic litigation requirement.

However, the US Supreme Court held (by a majority) that the courts presume that the parties intend arbitrators, and not courts, to decide questions concerning the meaning and application of preconditions to arbitrate. Thus, the US Supreme Court observed that the requirement in the relevant treaty concerned whether the contractual duty to arbitrate arises, but not whether there was a contractual duty to arbitrate at all. Consequently, whether the preconditions were satisfied was for the arbitrators and not the courts to interpret and apply.

The ‘tribunal versus claim’ test was notably considered in BA & others v BAZ (2020). This Singaporean case, in turn, referenced academic works cited by leading international arbitration that supported this approach. Ultimately, this test asks whether the objection is targeted at the tribunal (i.e., the claim should not be arbitrated due to a defect in or omission to consent to arbitrate) or at the claim (i.e., the claim itself is defective and should not be raised at all). The Singapore court has previously concluded that issues about whether certain claims are time-barred or subject to res judicata are matters that go to admissibility and not jurisdiction.

English courts have also adopted a similar approach. In The Republic of Sierra Leone v SL Mining Ltd (2021), the court held that a key factor was whether an issue was arbitrable. Further, the question of whether or not a claim is arbitrable (e.g., whether it has been presented prematurely) is a matter of admissibility. The court thus concluded that this was best left to the arbitral tribunal to decide this issue.

The decision in The Republic of Sierra Leonne was affirmed in NWA v NVF (2021), another English case that concerned the failure by one party to comply with a term in the arbitration agreement that it should first seek to mediate its dispute before resorting to arbitration. In concluding that this issue went to admissibility and not jurisdiction, the English court found that “if a dispute is not settled in the arbitration procedure, it remains the same dispute”. Thus, non-compliance with the pre-arbitration steps is generally an issue of timing: it generally does not affect whether the dispute was of a kind that the parties agreed to submit to arbitration.

The current status of C v. D

In June 2022, the Hong Kong Court of Appeal handed down its judgment in C v D (2022) In this, the Court of Appeal affirmed the judgment of the Court of First Instance. However, it also held that parties remained free, in their arbitration agreements, to agree that pre-arbitral procedural requirements should go to the tribunal’s jurisdiction. Such an agreement though, would require clear and unequivocal language.

In December 2022, the Hong Kong Court of Final Appeal gave leave to appeal: the top court found that the question it had certified was not only one of general importance, but also the first case in which it has fallen to be considered in Hong Kong.

In late April 2023, a hearing was held in the Court of Final Appeal, and it is expected that its judgment will be handed down in the coming weeks. While it is not the first court to have considered this subject, the Hong Kong Court of Final Appeal’s judgement will be one of the first to be rendered by a supreme court in a commercial context. As such, its decision is anticipated to have wide-reaching implications for companies, arbitrators and arbitration practitioners globally.

John Rhie is a partner and Lillian Li is an associate at Quinn Emanuel Urquhart & Sullivan LLP. Mr Rhie can be contacted on +852 3464 5602 or by email: johnrhie@quinnemanuel.com. Ms Li can be contacted on +852 3464 5619 or by email: lillianli@quinnemanuel.com.

John Rhie and Lillian Li

Quinn Emanuel Urquhart & Sullivan LLP