David Foster, Simon Walsh

O'Melveny & Myers LLP

During a recent LCIA symposium in Dublin, one of the topics discussed was the problem of identifying the proper law to determine the effect of insolvency proceedings upon an ongoing international arbitration. If, for example, one of the parties to an arbitration becomes bankrupt, or enters into some form of administration or chapter 11 process in its own country, should one look to the law of the contract, the law of the insolvency proceedings or the law of the seat of the arbitration to determine the impact, if any, upon the arbitration proceedings? This prompted a number of responses from delegates, most acknowledging that it was a very interesting but rather tricky issue. However, nobody was able to cite any clear authority indicating the correct approach to the problem.

This kind of question, raising a combination of conflicts of law, insolvency law and arbitration law issues, seems likely to arise with increasing regularity in the current economic climate. However, when looking for guidance on the interplay between insolvency and arbitration, one finds that most arbitration text books give little or no attention to what happens to arbitration proceedings when one of the parties becomes bankrupt. When they do consider the issue, their analysis tends to be from a purely domestic perspective, assuming that the insolvency rules of the seat of the arbitration will apply. Few practitioner guides address the conflicts of law problems that occur when the insolvency proceedings are in one country and the seat of the arbitration is in another.

In order to illustrate the complexity of the issues that arise, and the important impact they can have on the outcome of an arbitration, this article examines a recent case arising from an arbitration in London. The case involves a challenge to jurisdiction under section 67 of the Arbitration Act 1996 that has recently been decided by the English Commercial Court.

Vivendi v Elektrim

Background

The challenge to jurisdiction was made in an arbitration which has already given rise to a number of reported decisions by the English Court. The dispute is the ongoing LCIA arbitration, seated in London, between (among others) Vivendi Universal SA (Vivendi) and Elektrim SA (Elektrim). The background to this arbitration has been described in various court judgments (see, eg, Elektrim SA v Vivendi Universal SA (No. 2) [2007] 2 LLR 8) and is briefly summarised below.

Elektrim is a Polish company, which was previously the owner of a substantial shareholding in PTC, a large Polish mobile telephone company. Vivendi is a French company that, together with an affiliate, Vivendi Telecom International SA, entered into a contract with Elektrim known as the third investment agreement (TIA). The TIA was one of a series of agreements through which it was intended that Vivendi would acquire an interest in PTC. The TIA contained an arbitration agreement providing for disputes to be resolved by LCIA arbitration in London. By the time of the hearing before the Commercial Court, it was common ground that the arbitration agreement was governed by English law, although the rest of the TIA was governed by Polish law.

A dispute between Vivendi and Elektrim arose under the TIA, and Vivendi commenced LCIA arbitration proceedings in August 2003. Essentially, Vivendi claimed that Elektrim had breached its contractual obligations under the TIA by interfering with, or failing to secure, the interest in PTC that Vivendi was intended to obtain. The value of Vivendi's claim was approximately €1.9 billion. A tribunal was appointed consisting of Dr Wolfgang Peter (chairman), Alan Redfern and Professor Jerzy Rajski (the tribunal), and a one-week hearing on liability issues was fixed to take place in October 2007. In August 2007, however, before the hearing could take place but some four years after the start of the arbitration, Elektrim became bankrupt by order of the Polish court.

Elektrim asserted that because of its own bankruptcy, and as a matter of Polish bankruptcy law, the arbitration agreement between Elektrim and Vivendi had been terminated. As a consequence, Elektrim contended that the tribunal no longer had jurisdiction to determine the dispute. However, despite Elektrim's objections, the hearing scheduled to take place in London in October 2007 went ahead, and the tribunal heard from both parties on the question of its own jurisdiction as well as on the substantive issues of liability. The tribunal subsequently rendered an award dated 19 March 2008 rejecting Elektrim's challenge to jurisdiction and finding in favour of Vivendi on liability.

In response to the unfavourable award, Elektrim issued an application in the Commercial Court in London challenging the award, under section 67 of the Arbitration Act 1996, on the grounds that the tribunal lacked substantive jurisdiction over the disputes referred to it as a result of Elektrim's bankruptcy. A one-day hearing took place to determine the application on 2 July 2008.

The first-instance decision of the Commercial Court (Mr Justice Christopher Clarke) arising from this application has only very recently been handed down (the judgment was made public on 22 September 2008 under the case title Josef Syska acting as the Administrator of Elektrim SA (in Bankruptcy) & Elektrim SA (in Bankruptcy) v Vivendi Universal SA & Others [2008]). It is an important judgment for arbitration practitioners in Europe, and is likely to be a leading authority on the relationship between arbitration and insolvency proceedings, and in particular the impact upon an ongoing arbitration of Council Regulation (EC) No. 1346/2000 (the Insolvency Regulation).

Grounds for the section 67 challenge

Elektrim's challenge to the jurisdiction of the LCIA tribunal was based upon article 142 of the Polish Bankruptcy and Reorganisation Law, which provides as follows:

Any arbitration clause concluded by the bankrupt shall lose its legal effect as at the date bankruptcy is declared and any pending arbitration proceedings shall be discontinued.

Accordingly, it was common ground that, as a matter of Polish law, Elektrim's bankruptcy had the effect of terminating the arbitration agreement in the TIA and depriving the tribunal in any pending arbitration of jurisdiction.

Elektrim argued that this rule of Polish bankruptcy law should be applied by the tribunal to determine the effects of the bankruptcy upon the LCIA arbitration in London. Since by applying Polish law the arbitration agreement would end and the pending arbitration proceedings would be discontinued, Elektrim contended that the tribunal should have declared that it no longer had any jurisdiction as soon as Elektrim had been declared bankrupt. However, although the effect of Elektrim's bankruptcy upon arbitration proceedings was clear as a matter of Polish law, there was a big issue between the parties (and between Elektrim and the tribunal) as to whether Polish law was the correct law to apply to determine the impact of the bankruptcy upon an arbitration taking place in another EU member state.

The EU Insolvency Regulation

The critical question raised by Elektrim's challenge to jurisdiction was: what is the correct law to apply when seeking to determine the effects (if any) of the Polish bankruptcy order upon the arbitration proceedings? Elektrim's case was that it should be the law of Poland, and that as soon as the bankruptcy order was made the tribunal ceased to have jurisdiction. Vivendi, on the other hand, contended that the applicable law was that of England and Wales, as the seat of the ongoing arbitration, and that the application of English law meant that the arbitrators retained their jurisdiction.

The key to resolving the question was the Insolvency Regulation. This is a piece of subordinate EU legislation which is directly applicable and forms part of the law in all EU member states. The Insolvency Regulation was designed to promote the proper functioning of the European internal market by ensuring that cross-border insolvency proceedings could operate more efficiently, and to discourage forum shopping by opportunistic debtors and creditors. The general objective behind the Insolvency Regulation is set out in its preamble: in summary, it is intended to establish mandatory rules for choice of law, jurisdiction, recognition, enforcement and cooperation applicable to cross-border insolvencies anywhere within the European Union.

The Insolvency Regulation imposes a number of general rules or principles, one of which is the principle of universality. This means that a bankruptcy in any particular EU member state has an effect not only in that member state, but in all other EU member states as well. A closely related principle is the general rule that the law of the member state of the opening of the insolvency proceedings (lex concursus) should be applied to determine the effects of those insolvency proceedings across the European Union. This general rule, emphasising the importance of the lex concursus, is contained in article 4.1 of the Insolvency Regulation (entitled 'Law Applicable'), which provides:

Save as otherwise provided in this Regulation, the law applicable to insolvency proceedings and their effects shall be that of the Member State within the territory of which such proceedings are opened, hereafter referred to as the "State of the opening of proceedings".

In the situation involving Elektrim, the member state where the insolvency proceedings had been opened was clearly Poland, and a simple application of article 4.1 would lead to the law of Poland being used to determine the effects of the insolvency. However, article 4.1 also allows for exceptions to the general rule by opening with the words "save as otherwise provided". One of these exceptions is identified in article 4.2(f), which provides that the law of the state of the opening of proceedings should determine:

the effects of the insolvency proceedings on proceedings brought by individual creditors, with the exception of lawsuits pending [emphasis added.]

The applicable law for determining the effects of the insolvency proceedings upon 'lawsuits pending' is therefore not necessarily the law of the state of the opening. The law to apply for these purposes is identified by article 15 of the Insolvency Regulation, which reads:

The effects of insolvency proceedings on a lawsuit pending concerning an asset or a right of which the debtor has been divested shall be governed solely by the law of the Member State in which that lawsuit is pending.

Vivendi argued that it was articles 4.2(f) and 15 of the Insolvency Regulation that were relevant in this case, since the LCIA arbitration was a 'lawsuit pending'. The result of this would be that the effect of the Polish insolvency proceedings would be governed by the law of the EU member state in which the lawsuit was pending, which for a London-seated arbitration could only be English law. Under English law, the tribunal retained its jurisdiction over the dispute. At the hearing in October 2007, the tribunal had generally accepted Vivendi's approach and upheld its own jurisdiction, applying English law to determine the effect of Elektrim's insolvency.

First issue

In Elektrim's subsequent application under section 67, there were two key issues of interpretation of the Insolvency Regulation for the court to determine. The first issue concerned the meaning of the term 'lawsuit pending'. Elektrim contended that the phrase was limited to execution proceedings against a debtor's assets in which the assistance of a court was required, and that it could not extend to arbitration proceedings because arbitration was not a form of execution.

The judge held that he could see no good reason why 'lawsuit' should be regarded as excluding a reference to arbitration. If the draughtsman had intended to refer only to lawsuits pending before a court, he could easily have used language which was clear and unambiguous. There also appeared to be no good reason to treat arbitrations differently from civil litigation proceedings before a court of a member state. The Insolvency Regulation was part of the legal framework of the European Union designed to establish a common internal market, and thousands of commercial transactions within that market would be the subject of arbitration agreements. The judge commented that it 'would border on the irrational' to protect the legitimate expectations of parties who had commenced an action in court, but not those who had initiated a reference to arbitration. The judge therefore held that Vivendi was correct on this point, and that the reference to 'lawsuit pending' in articles 4.2(f) and 15 of the Insolvency Regulation led to the application of English law to determine the effects of Elektrim's bankruptcy upon the London arbitration.

Second issue

As a secondary argument, Elektrim also relied upon article 4.2(e) of the Insolvency Regulation., which provides that the law of the state of the opening of proceedings shall determine:

the effects of insolvency proceedings on current contracts to which the debtor is party [emphasis added.]

Elektrim argued that the arbitration agreement contained in the TIA was a 'current contract' within the meaning of article 4.2(e), since it imposed continuing obligations on both parties. For instance, it imposed a continuing obligation to comply with the tribunal's award and also an obligation not to sue in a national court. If Elektrim was correct and the arbitration agreement was a 'current contract', then Polish law (as the lex concursus) should apply to determine the effects of the insolvency proceedings upon it.

Under Polish law, the arbitration agreement became ineffective as soon as the bankruptcy order was made. Elektrim argued that because a valid arbitration agreement was a necessary condition of the tribunal's continuing jurisdiction during the reference, the annulment of the arbitration agreement had a consequential impact upon the reference and the indirect effect of bringing the arbitration proceedings to an end.

Vivendi's position was that an arbitration agreement was not a 'current contract' within the meaning of article 4.2(e), which, Vivendi submitted, was concerned only with substantive contracts and not procedural ones. Where arbitration proceedings had already been commenced, articles 4.2(f) and 15 governed the position and the law of the arbitral seat applied (lex arbitri), not the law of the member state of the opening of insolvency proceedings (lex concursus). The judge accepted Vivendi's (and the tribunal's) approach to interpretation of the Insolvency Regulation, and rejected Elektrim's argument, and consequently he declined to set aside or vary the tribunal's award.

Significance of the judgment

The Commercial Court's recent judgment in this case is important for arbitration practitioners for a number of reasons. Subject to any appeal, it has determined that an arbitration agreement is not a 'current contract' within the meaning of the Insolvency Regulation. Second, and perhaps more importantly, the English court has also ruled that ongoing arbitration proceedings fall within the meaning of 'lawsuits pending' as that phrase is used in articles 4.2(f) and 15 of the Insolvency Regulation.

The judge also made a number of significant comments in relation to this second issue that were strongly supportive of international arbitration. For instance, Elektrim had argued that when construing 'lawsuits pending', a distinction could be drawn between arbitration and litigation, since it would be an unacceptable infringement of the sovereignty of member states if the Insolvency Regulation were to require actions before the courts to cease. The judge dismissed this proposition robustly:

The expectation of those who agree to have their disputes resolved by arbitration that the dispute will be resolved by the arbitral tribunal to which they have agreed under the supervision of the relevant court is no less legitimate than that of those who expect their disputes to be resolved in and by a court....

Arbitration is not to be regarded as the poor relation for which no saving provision need be made, whereas the court, because it exercises the judicial power of the State, should enjoy a privileged position.

Finally, the decision gives the law of the seat of the arbitration a more prominent role when it comes to determining the effects of the insolvency of one of the parties. This should also be welcomed, as it circumscribes the potential for another system of law to be imported into the arbitration proceedings, with consequent conflicts of law and jurisdictional complications. Had the decision been otherwise, a party who had participated in arbitration proceedings for four years and obtained a favourable award on liability would have been frustrated because of an unusual provision in the bankruptcy legislation of one particular EU member state. This, it is submitted, could not have been within the contemplation of the parties when they agreed to refer their disputes to arbitration, and such a result would not have been a good advertisement for arbitration in Europe.

Overlap between insolvency and arbitration

The Elektrim case illustrates the increasing overlap between arbitration law and other specialised areas of law, such as insolvency law. The Insolvency Regulation dealing with cross-border insolvencies within the European Union cannot be ignored, and is likely to be an important factor whenever a party to arbitration proceedings is based, or has business interests in, an EU member state. In particular, article 4.2(e) of the Insolvency Regulation, relating to 'current contracts', can have a dramatic effect upon the substantive rights of the parties to a contract.

For example, the authors' firm recently advised in a case involving a contractual dispute between two parties, one of which was a construction company based in France. The parties had entered into a major construction contract governed by English law and providing for London arbitration. As is customary, the construction contract contained a long list of termination events entitling either party to bring the contract to an end. One of those termination rights arose upon the insolvency of one of the contracting parties. The increasingly difficult cash flow position of the construction company raised the possibility of the counterparty becoming entitled to terminate the contract as a result of an insolvency event. However, because the construction company was incorporated in France and any insolvency proceedings were likely to be commenced in France, article 4.2(e) of the Insolvency Regulation would have come into play. Applying article 4.2(e), the law of the place of the opening of insolvency proceedings (France) would have been the proper law to determine the effect of bankruptcy upon 'current contracts', and under French law, contractual terms providing for automatic termination rights upon insolvency were unenforceable, regardless of whether they were effective under the governing law of the contract (English).

The clear lesson to be drawn, both from this example and from the Elektrim case, is that arbitration lawyers need to be alert to the implications of a bankruptcy upon an ongoing arbitration. The effect of the insolvency of one of the parties upon arbitration proceedings can vary considerably depending upon the applicable system of law, and the identification of the correct system of law for these purposes can raise its own complex problems and uncertainties. In this context, practitioners in Europe also need to understand the critical importance of the Insolvency Regulation. In a year that has seen some of the world's leading investment banks collapse or teeter on the brink of insolvency, with economic experts predicting a deep global recession, now might well be a good time for arbitration lawyers, particularly those practising in Europe, to familiarise themselves with the key European legislative instrument designed to resolve the conflicts of law issues arising out of any cross-border insolvency.