By William Perry and Reka Koerner

This article discusses why arbitration — as opposed to other means – is usually the preferred method for settling disputes in cross-border transactions. It also suggests some basic rules of thumb when drafting arbitration clauses in contracts to avoid common pitfalls.

Arbitration is widely regarded as a preferred method of resolving international commercial disputes. Among other advantages, it provides security against being forced into another party’s local courts where there may be a “home field” advantage. Arbitration can be confidential, is generally more flexible than litigation, and is frequently less expensive and less time-consuming as well. Moreover, in many countries a foreign arbitration award — that is, an arbitration decision rendered in another country — is easier to enforce than a foreign court judgment.

However, in order to receive the advantages of arbitration, the arbitration clause in the contract must be properly drafted. A “standard” arbitration clause or one that does not adequately take into account international arbitration law and treaties can be a serious problem and can lead to a situation where the arbitration never moves forward or the award is unenforceable. While drafting an arbitration clause is usually one of the last things on a business person’s mind when negotiating a transaction, it warrants attention; it may well prove to be the most important provision in the contract if the business relationship sours.

Importance of Treaties

Arbitration awards are easier to enforce than court judgments in foreign countries due to several international treaties. However, there is no single arbitration treaty that applies to all countries. Therefore, it is important to match up the parties to a contract, and their major assets, to an international arbitration treaty that provides for the enforcement of arbitral awards. An arbitration clause is of little use if the prevailing party in arbitration is unable to enforce the award against the assets of the losing party.

The most important international arbitration treaty is the “New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards”— a 1958 treaty that is referred to simply as the “New York Convention.” It has been ratified by more than 120 countries and territories, and an arbitration award issued in one of those countries can generally be enforced in any other country that has ratified this convention.

The New York Convention recognizes certain limited defenses to enforcement of an arbitral award. These include the following. First, an award cannot be enforced if the arbitration clause was void under the law selected by the parties in the contract or the law of the country where the award was rendered. Second, it cannot be enforced if the parties were not given proper notice of the arbitration. Third, another defense to enforcement is the arbitration tribunal ruling on matters beyond the scope of the arbitration clause. Fourth, enforcement of the award can be blocked if it would violate the public policy of the enforcing country. If the New York Convention is properly implemented, these defenses will typically be construed and applied very narrowly (although the “public policy” defense has occasionally been a problem in some countries).

If a deal involves a Latin American party, consideration should be given to whether the relevant country has ratified the “Inter-American Convention on International Commercial Arbitration,” a 1975 treaty called the “Panama Convention.” There is substantial overlap between countries that have ratified the Panama and New York conventions and the two treaties have similar provisions. However, some countries, like Brazil, have ratified the Panama Convention but not the New York Convention.

There are various other international arbitration treaties or conventions that may apply to a given transaction, some with a regional or subject-matter specialization. If a governmental entity and an “investment dispute” are involved, then the “International Center for Settlement of Investment Disputes between States and Nationals of Other States” — called the “ICSID” or “Washington Convention” — may apply. Additionally, the World International Property Organization in Geneva, Switzerland established an arbitration center in 1994 for intellectual property disputes. Bilateral treaties on the recognition of arbitral awards also exist between many individual countries.

What Rules to Choose

An arbitration clause should indicate whether the arbitration will proceed under the supervision of an international arbitration institution or without the supervision of an institution but under pre-existing arbitration rules. The experts call this a choice between an “institutional” arbitration and an “ad hoc” arbitration. Depending on the type of arbitration selected, the parties will need to give thought to which institution they wish to select — in the case of an institutional arbitration — or the rules they want to govern — in the case of an ad hoc arbitration.

Among the most prominent of the international arbitration organizations are the International Chamber of Commerce, or “ICC,” the London Court of International Arbitration, or “LCIA,” and the American Arbitration Association, or “AAA.” Each of these institutions has its own rules for conducting the arbitration. Each also supervises such matters as the appointment of and challenges to arbitrators. Each can help overcome procedural obstacles, particularly in the early stages of the arbitration, before the tribunal is fully constituted.

In an ad hoc arbitration, the parties and arbitration tribunal manage the arbitration themselves, but typically incorporate by reference an agreed set of procedural rules, such as the rules drafted by the United Nations Commission on International Trade Law, known as the “UNCITRAL rules.” The UNCITRAL rules are specifically designed for ad hoc international arbitrations. If procedural disputes arise before the tribunal is fully constituted and able to act on its own, the UNCITRAL rules provide for an “appointing authority” to decide such disputes as disagreements on the selection and disqualification of arbitrators. The parties should identify an appointing authority in the arbitration clause to avoid problems in reaching such agreement after a dispute arises. Many institutions that typically administer their own arbitrations – such as the ICC or the LCIA – are willing to be named as the appointing authority for an UNCITRAL arbitration. If the parties cannot agree on an appointing authority, then the UNCITRAL rules provide for the Permanent Court of Arbitration at The Hague to designate the appointing authority.

There are advantages and disadvantages to both institutional and ad hoc arbitration. Institutional arbitration tends to be more expensive because of the administrative fees involved, but it is often preferred because of the stabilizing, neutral role institutional oversight can play in a proceeding. An established institution can provide the parties with a clear set of rules, a history as to how the rules are implemented, and a readily accessible forum for resolving procedural disputes. Institutional arbitration is a particularly good choice where one of the parties has not had any prior experience with international arbitrations or is from a country that has not been arbitration-friendly. On the other hand, the single most important factor in a successful arbitration is not whether it is “institutional” or “ad hoc”; it is the quality, experience and competence of the arbitrators. For this reason, an ad hoc UNCITRAL arbitration can be just as effective in the hands of a good arbitration tribunal and a competent appointing authority. A proactive ad hoc tribunal can handle many of the procedural matters that are addressed by institutional rules and provide the parties with more autonomy.

When choosing an international arbitration institution to administer the arbitration or to act as the appointing authority in an ad hoc UNCITRAL arbitration, there are several factors to take into account, including the institution’s reputation, access to qualified arbitrators, stability, and cost. First, the institution’s reputation and whether it is perceived as neutral may be important to the ability to enforce the award. If the institution is well respected internationally and is perceived as geographically neutral (not “pro-Western”), then there will be less opportunity for the losing party to claim that the arbitration process was biased or manipulated. Second, the more specific the contract is about the backgrounds of the arbitrator to be chosen, the more important it is that the selected institution be able to draw from a broad pool of potential arbitrators. Third, institutional stability and longevity are vital since the arbitration clause may fail if the institution no longer exists when a dispute arises.

Each of the three international arbitration institutions noted above — the ICC, LCIA, and AAA —has an international reputation, and at the end of the day it will not matter greatly which one is selected. Their rules are more alike than different, and the outcome of an arbitration is not likely to differ simply because one institution is chosen over another. In the past, parties in certain regions — such as Asia — have been reluctant to use the ICC, viewing it as a Western institution that solves problems on Western terms, although the ICC has been working to overcome this perception. The AAA in the United States has suffered from the same perception problems.

Of these three institutions, the ICC probably will provide the most administrative oversight, but it also charges the most for administrative services. The LCIA charges less for less oversight. On balance, however, the relative difference in administrative fees among these institutions – which can be driven by such things as the amount in controversy, the complexity of the dispute, and the amount of oversight actually required – tends to be overshadowed by the fees and expenses of the arbitrators themselves, which will be much more significant and can easily exceed a combined total of $100,000 (in some cases, much more) in a multimillion dollar case of moderate complexity.

Good Arbitration Clauses

Structuring an effective arbitration clause is more complicated in the international than the domestic realm. Matters such as designating the place of arbitration may seem simple, but are full of traps for the unwary.

There are at least five issues that a well-drafted international arbitration clause should address. They are the scope of the arbitration, the place of arbitration, the number of arbitrators and any essential qualifications, the language of the arbitration, and the applicable substantive law. While there are many other considerations that can make arbitration more efficient and may affect the outcome, they are beyond the scope of this article.

First, the arbitration clause should define the scope of the matters that the parties intend to refer to arbitration. Unless the parties have a good reason for carving out a specific issue that they do not wish to resolve through arbitration, the arbitration clause should be broad. Broad clauses typically define the scope of the arbitration as “any controversy or claim arising out of or related to” the contract or “all disputes, controversies or claims arising in connection with this contract.” If the arbitration clause lists specific issues that are subject to arbitration instead of using broad, general wording, the other party may claim that anything not specifically listed is not subject to arbitration.

Second, the parties should give careful thought to the place of arbitration and designate the city and country in the arbitration clause that will be considered to be the “seat” or “situs” of the arbitration. This is an important legal concept: although the hearings may be held elsewhere, the “seat” of the arbitration is where the award is deemed to have been issued. In selecting the “seat” of arbitration, the parties must consider whether the host country has ratified one of the international treaties regarding arbitration awards. If it has not, then the arbitration award may not be enforceable in other countries. An additional consideration in selecting a “seat” of arbitration is whether the country’s laws and legal culture favor or tend to obstruct the arbitral process, since recourse may be necessary to the host country’s courts to resolve issues that arise during the course of the arbitration proceedings. Even if a country’s laws favor arbitration, caution is warranted before arbitrating in a country where one of the parties is connected to the government (or is the government itself), although as a practical matter this may be difficult to avoid in negotiating some transactions.

Third, the arbitration clause should specify the number of arbitrators that will sit on the parties’ tribunal and any essential arbitrator qualifications.

An arbitration tribunal typically will consist of either a single arbitrator or three arbitrators. There are several issues that should be taken into account in deciding whether to opt for a single- or a three-member tribunal.

A single-member tribunal is less likely to result in delays once the arbitration is underway since it will not be necessary to coordinate three tribunal members’ conflicting schedules. However, delays may occur before the tribunal is constituted if the arbitration clause or rules require the parties to agree on the single arbitrator or there are arbitrator qualifications specified in the arbitration clause. The parties will inevitably disagree on the other side’s proposed arbitrator and whether an individual meets the qualifications of the arbitration clause. There is more at stake if there is just one arbitrator.

Three-member tribunals are favored in major disputes because many parties are not comfortable entrusting a significant decision to a single arbitrator. A three-member tribunal allows for the selection of arbitrators of different nationalities and with different areas of expertise. It is difficult to find a single arbitrator who will bring as much experience to the process as a well-selected three-member tribunal. However, in addition to the disadvantage of having to coordinate the schedules of three arbitrators, a three-member tribunal may be more prone to allegations of bias. If the parties decide they want a three arbitrator tribunal, then the applicable rules will typically provide that each party will nominate one arbitrator and the third arbitrator — the chairperson — can be appointed by the two party-nominated arbitrators, the institution, or the “appointing authority.” Although all of the tribunal members are required to be neutral (and most arbitrators are), in some cases there can be a lingering perception that a party-nominated arbitrator is biased in favor of the appointing party.

Regardless of whether the parties decide that a single-or three-member tribunal best suits their needs, they should specify the number of arbitrators in the arbitration clause. Failure to do so will lead to a default decision. The default rules of the ICC, LCIA and AAA provide for a single arbitrator unless the institution decides that three are warranted. The UNCITRAL rules provide for a default three-member tribunal.

In addition to the number of arbitrators, the parties can also require in the contract that the arbitrators have certain qualifications, such as fluency in a language or expertise in a particular area. However, only truly essential qualifications, if any, should be included, because they will limit the pool of available qualified arbitrators. Significant problems may arise if there are no available arbitrators that meet the arbitration clause criteria.

Fourth, the arbitration clause should specify the language for conducting the arbitration. If the parties do not select a language in advance, then the arbitrators will make the selection after the tribunal is constituted. Until then, uncertainty about which language will govern may make it difficult to nominate an appropriate arbitrator and, in the case of a three-arbitrator tribunal, for the party nominated arbitrators to select a chairperson. While the chairperson of a three-arbitrator tribunal is usually not supposed to be a national of any country involved in the arbitration, he or she should be familiar with the language of the arbitration. Finally, once the tribunal is constituted, it could potentially select a language that causes significant inconvenience to one of the parties.

Fifth, the arbitration clause should designate the substantive law that will govern the parties’ dispute. If the parties do not agree to a choice-of-law provision, they may face uncertainty as to how to perform under the contract in ambiguous situations, and the arbitrators will be left to determine the governing law after the fact. The choice-of-law provision should clearly state that it applies only to the substantive law governing the dispute. If the parties do not distinguish between substantive and procedural law, then the choice of law provision may be read to conflict with the procedural portions of the arbitration clause.

Most institutions, as well as UNCITRAL, have suggested “model” arbitration clauses. These suggested arbitration clauses should be used as a starting point. The parties can then add additional provisions or specifications that fit their needs.

Avoid “Pathology”

Frederic Eisemann, while secretary general of the ICC in 1974, described arbitration clauses that were unenforceable as written or were certain to lead to disagreement over their interpretation as “pathological.” To avoid the pathology of a poorly drafted arbitration clause from infecting the well-being of your business transaction, keep it simple and clear, think ahead, consult the basic guidelines described in this article and obtain advice on international arbitration law.