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Pandemic-Related Insolvencies Reveal International Arbitration Issues

April 2, 2021, 8:01 AM

The global pandemic has devastated companies large and small, particularly in sectors such as travel, hospitality, and entertainment, but also in the blue-chip domains of manufacturing, retail, and energy. For many businesses, a sharp decline in revenue led to a liquidity crunch severe enough to threaten debt service and raise the specter of bankruptcy.

Some of the earliest emergency measures adopted by many governments in 2020 were designed to stave off a tsunami of insolvencies. While interim lending, tax breaks, and similar steps will be enough to bridge the gap for some businesses, corporate insolvencies are expected to rise significantly around the world this year. In the U.S., for example, bankruptcies are projected to increase 57% from 2019 to 2021.

This kind of disruption has not been seen in years, probably at least since the financial crisis of 2008. As it did then, the mass failure of businesses raises the question as to how troubled companies and their creditors will deal with the largely untested interaction between insolvency and arbitration.

Arbitration Is Preferred in Cross-Border Disputes

International arbitration is the preferred method of dispute resolution for cross-border transactions—whether it be for sales of goods and services, debt instruments, equity acquisitions, IP licensing, or oil and gas production-sharing arrangements.

Arbitration offers contracting parties a neutral, private, and confidential forum for the resolution of disputes outside the realm of national courts, with unparalleled enforcement of resulting awards around the world through the New York Convention of 1958, a treaty to which almost all of the countries of the world are party.

But arbitration is a creature of contract, and while most countries have adopted laws favoring the parties’ autonomy to craft their own means to solve conflicts between them, that “hands-off” approach can change where public policy is perceived to come to the forefront. The need to protect the existing creditors of a bankrupt company can throw otherwise predictable contractual relations and dispute outcomes into disarray.

In some jurisdictions, local bankruptcy regulations take precedence over arbitration laws, potentially blocking enforcement of arbitral awards against an insolvent judgment debtor.

Insolvency Is a National Event

When a company declares itself insolvent, this is a deeply national (as opposed to international) event. A court, normally at the place of the bankrupt’s incorporation, declares the company insolvent under local law—imposing a range of limiting measures to conserve assets and protect creditors.

The court’s order will rein in its legal relationships— including the conduct of litigation and arbitration—both pending and prospective. International insolvency laws are divers, and insolvency impacts arbitration from start to finish.

Arbitration agreements concluded prior to insolvency generally remain binding on a bankrupt party. But in some countries (such as the U.S., U.K., and in Hong Kong) an ongoing arbitration can be forcibly paused (or “stayed”) when insolvency is triggered. Permission from a court is needed to re-start the arbitration process.

In the U.S., courts will normally lift the stay unless the arbitrators are asked to decide questions at the heart of the insolvency, such as how the insolvent party’s trustee should distribute assets. By contrast, in the U.K., the burden is on a creditor to convince the court that restarting arbitration would not complicate the fair and efficient administration of the bankruptcy estate.

The bankruptcy administrator is often accorded the power to step into the shoes of the insolvent party to conduct the arbitration and will continue with the dispute resolution process.

In most countries, arbitration awards (particularly of the international variety) are not subject to appeal and can be challenged only for very limited reasons. The insolvency of a party may undermine certainty in this regard, since an award can be set aside in most countries where there is a violation of public policy.

In Germany, an award may be vulnerable if the insolvency administrator did not replace the debtor to conduct the arbitration. In France and the U.S., courts may find a breach of public policy where the tribunal pushed forward to issue an award instead of staying the case when one of the parties became insolvent.

Even where an arbitral award can be obtained against a bankrupt party and it survives challenge, most insolvency legislation around the world requires that enforcement take place only within the framework of court-managed bankruptcy proceedings.

National Insolvency Laws Can Have Global Effects

International arbitration is frequently chosen to take disputes to ‘neutral ground,’ beyond the reach of judges in either side’s home country. This works because arbitration laws around the world restrict national courts’ interference where arbitration is ‘seated’ elsewhere.

But national insolvency laws often have global effects, as legislators centralize the administration of local companies’ bankruptcies under their own courts’ jurisdiction. Indeed, it is not uncommon for the shareholders of a defendant corporation to force the company into bankruptcy—through the enforcement of previously dormant shareholder loans, for example— to disrupt and delay an arbitration they know the company will lose.

In short, with a wave of business failures on the horizon, international litigation strategy will need to assimilate the potential for insolvency and its possible impact the case and on the enforcement of an eventual award.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

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Noah Rubins is head of the international arbitration group at Freshfields Bruckhaus Deringer’s Paris office and leads the firm’s CIS/Russia Dispute Resolution Group. He specializes in investment arbitration and has practiced law in New York, Washington, Houston, and Istanbul, and served as arbitrator in more than 40 cases.