Financial Transactions

ARBITRATION IN BANKING AND FINANCE*

The human species, according to the best theory I can form of it, is composed of two distinct races: the men who borrow and the men who lend.

Charles Lamb¹

A. Introduction

The world’s bifurcation into debtors and creditors has created yet another class of people: those involved in resolving disputes between lenders and borrowers. To promote reliability in financial dispute resolution, credit agreements have generally provided that potential controversies will be submitted either to courts in the bank’s home jurisdiction,² or to courts of a major money center such as London or New York.³

In the alternative, parties to a financial transaction might agree to resolve disputes between them by arbitration, thus conferring adjudicatory competence on private rather than public decision-makers. Arbitration has long been common in settling commercial⁴ and insurance⁵ disputes, where its use tends to reduce litigation costs. In an international context, arbitration serves to level the playing field where there exists a particularly acute fear of the other side’s “home-town justice.”

In contrast to the commercial and insurance communities, bankers have traditionally preferred judges over arbitrators. This should not be surprising. A debtor’s default usually results from simple inability or unwillingness to pay, rather than any honest divergence in the interpretation of complex or ambiguous contract terms. Arbitration therefore may appear as an unnecessary invitation to a “split the difference” award, reminiscent of King Solomon’s famous threat to cut the baby in two.⁶ Moreover, financial institutions with a security interest over a debtor’s assets will usually find it easiest to bring a court action where the pledged property is located. Finally, going to court may also give the lender the benefit of summary procedures for the enforcement of promissory notes and other commercial paper obligations.⁷

Herd mentality and respect for custom provide other clues to the banker’s hesitation to embrace private adjudication. Not without good reason, the financial sector has tended to be conservative, wary of rapid change.⁸ If suing borrowers in court rather than before arbitrators has worked well enough in the past, few bankers will buck the trend.

Increasingly, however, the financial community is finding benefits to arbitration, particularly in connection with securities transactions, guarantees, documentary credits, consumer loans, and public sector lending. This chapter will examine how arbitration has developed in each of these selected areas. In addition, it will analyze the major elements in the efficiency calculus of financial arbitration: (i) the multilateral treaty network for the enforcement of arbitral awards; (ii) the arbitrator’s ability to ignore “Act of State” defenses arising from foreign exchange controls; and (iii) the risk of excessive American jury awards with respect to both punitive damages and “lender liability” claims. No dispute resolution clause will satisfy every segment of the financial services industry. Rather, the interaction of all elements of a given financial transaction will determine when and how arbitration may (or may not) be appropriate to the resolution of banking and securities controversies. This chapter suggests, however, that arbitration merits special consideration when the borrower’s assets are found in jurisdictions lacking judgment treaties with the probable litigation forum, when loans are subject to exchange controls, and when debtors might file punitive damage or “lender liability” actions. Arbitration may also be appropriate when there exists a need for special expertise, such as in the settlement of documentary credit disputes subject to the Uniform Customs and Practices of the International Chamber of Commerce (ICC).

To the extent that arbitration promotes respect for bargains between creditor and debtor, it commends itself not only to the bankers’ self-interest, but also as a matter of sound international economic policy. The greater the risk in loan recovery, the higher the interest rate. Because loans are loans, not gifts, untrustworthy enforcement mechanisms will tend to chill cross-border economic cooperation to the detriment of those countries that depend most on foreign capital for development.

B. Enforcing Loan Agreements

At the outset, arbitration should be distinguished from other non-judicial forms of alternative dispute resolution currently in vogue. Arbitration implies not only the consent of the parties to settle their dispute out of court, but also bindingness of result. On the strength of an arbitral award, assets can be attached and competing litigation precluded.⁹ By contrast, neither mediation nor conciliation is legally binding; both may end up being little more than foreplay to litigation.¹⁰

Treaties

Bankers sometimes must enforce court judgments in their favor against assets located outside the country where the judgment was rendered. For example, an American bank that obtained a judgment in New York against a foreign borrower might have to seek its enforcement against property in Europe, Asia, or Latin America.

Unfortunately, not all banks will benefit from an adequate treaty network for the recognition of foreign judgments. Although the Bruxelles¹¹ and Lugano¹² Conventions bless Western Europe with a sound mechanism to enforce each others’ court judgments, these treaties will be of no avail in recovering loans against assets in non-treaty countries. Moreover, no treaties at all exist for the enforcement of American judgments abroad.¹³ While some countries might as a matter of “comity” enforce a foreign judgment,¹⁴ not all legal systems will be so generous.¹⁵

In contrast, a worldwide network of bilateral¹⁶ and multilateral¹⁷ treaties provides for the enforcement of arbitral awards. The most important of these treaties is the New York Arbitration Convention,¹⁸ which requires courts of over one hundred contracting states to enforce written arbitration agreements¹⁹ and the resulting awards,²⁰ subject only to a limited litany of defenses related to procedural matters such as the validity of the arbitration agreement, the opportunity to be heard, and the limits of the arbitral jurisdiction.²¹

Many Latin American countries have adopted the Inter-American Arbitration Convention (often referred to as the Panama Convention),²² sometimes in addition to the New York Convention. The Inter-American Convention mirrors much of the New York Arbitration Convention, albeit with a more limited enforcement scheme.²³

In addition, the Washington Convention has established an arbitration procedure under the auspices of the World Bank’s International Centre for Settlement of Investment Disputes (ICSID),²⁴ covering disputes arising out of investment contracts between a host state and a foreign national.²⁵ Investment treaties frequently contain consent to ICSID jurisdiction, and many define investment to include “all categories of assets,” including claims to money.²⁶

Lender liability²⁷

Claims by debtors

A chameleon-like catch-word with several meanings, “lender liability” has been pressed into service by non-performing debtors in the United States seeking damages for a bank’s alleged failure to act in “good faith,”²⁸ whether under common law²⁹ or statute.³⁰ Analogous regimes have been imposed in some Continental legal systems.³¹

The “lender liability” label has been affixed to duties owed by a creditor to a debtor under theories of breach of contract, fraud and bad faith in pre-contractual negotiation. Such claims typically arise at termination of a line of credit, acceleration of payment under a note or foreclosure on collateral.³² Sometimes claims are made even when a bank exercises explicit powers under a credit agreement.³³ While bankers are most often criticized for being too closefisted,³⁴ some financial institutions have also been faulted for being overly generous with credit.³⁵

To avoid what they consider to be excessive and unpredictable awards by juries in such litigation, several American financial institutions now provide for arbitration in credit agreements.³⁶ These institutions presume that an arbitrator will be less swayed by solicitude for the borrower than will members of a civil jury, whose own credit problems may cause them to empathize with the debtor.

Claims by third parties

Another incarnation of lender liability relates to a banker’s duty toward the borrower’s other creditors. Bankers have sometimes been asked to pay their debtors’ bills, under the theory that the lenders were de facto partners in the borrowers’ ventures.³⁷ The plausibility of such claims usually turns on the amount of control exercised by the financier over the management of the borrower’s business.

Lenders will not always be able to impose arbitration of such third-party claims, simply because a borrower’s other creditors will not necessarily have agreed to arbitration. Nevertheless, arbitrators sometimes do hear third-party claims, and their commercial sophistication has often led to reasonable solutions.³⁸

Exchange controls

When a country freezes or restricts payment of foreign currency obligations,³⁹ borrowers sometimes invoke these exchange controls as defenses to loan recovery,⁴⁰ on the theory that such controls constitute a foreign “Act of State” to which courts must defer. Although principally an American obsession, the Act of State doctrine exercises an influence well beyond common law countries, given the large number of cross-border financial transactions routinely subjected to the law of New York or to the jurisdiction of New York courts.

The Act of State doctrine generally prohibits courts from questioning a foreign government’s behavior concerning assets within its territory.⁴¹ Sometimes explained as a limit on judicial interference with the conduct of foreign affairs,⁴² the doctrine might best be understood as a conflict-of-laws rule that imposes foreign law even if such law is contrary to the public policy of the forum.⁴³

Creditors sometimes avoid application of the Act of State doctrine by virtue of judicial manipulation of the situs of the debt in question. Courts may deem the debt to be located outside the territory of the country imposing the exchange controls.⁴⁴ Favorable characterization of the debt situs, however, may come only after years of costly litigation.⁴⁵

The United States has eliminated the Act of State defense in actions to enforce arbitration agreements and awards. The Federal Arbitration Act (FAA) provides:

The enforcement of arbitral agreements, and the confirmation of arbitral awards, shall not be refused on the basis of the act of state doctrine.⁴⁶

The scope of this remarkably succinct bit of legislation, however, has not been extended to court litigation. Thus, an arbitration clause in a cross-border loan agreement may enhance considerably a creditor’s prospect of loan recovery.

Sovereign immunity

To avoid repayment of loan obligations, government debtors often invoke principles of “sovereign immunity,” which operate to prevent one country from hauling another country into its courts. The modern rationale for sovereign immunity mirrors the justification sometimes given for the Act of State doctrine: judges should not interfere with the executive branch of government in its conduct of foreign relations.

Although most nations grant immunity to foreign governments and their agencies, immunity is subject to several exceptions. As a general rule, immunity covers “public” rather than “commercial” acts,⁴⁷ with the character of an act determined by its nature rather than its purpose.⁴⁸ Immunity from suit will be further restricted by an arbitration clause. Many national legal systems deny sovereign immunity in an action to enforce an arbitration agreement or to confirm an arbitral award.⁴⁹

Arbitration can be of special benefit to a lender when an award must be enforced against a sovereign debtor’s assets in the United States. Normally, a functional connection is required between the property to be attached and the activity that gave rise to the claim. A judgment against a foreign state can be executed only against property used in the same commercial activity upon which the claim is based.⁵⁰ In the case of a loan, this “same activity” requirement can limit attachment of assets to funds earmarked for debt reimbursement, which may be scarce when the debtor defaults.

The Foreign Sovereign Immunities Act,⁵¹ however, removes this requirement of a functional nexus with respect to arbitral awards. The statute provides that property of a foreign state used for a commercial activity in the United States shall not be immune from attachment in aid of execution if judgment is based on an order confirming an arbitral award.⁵²

An arbitration clause in a loan agreement can also be helpful when the borrower is an international organization. In Britain, a dispute between the International Tin Council (ITC) and its creditors ended up before the House of Lords, which interpreted the ITC Headquarters Agreement with the United Kingdom as granting the ITC sovereign immunity.⁵³ The same Headquarters Agreement, however, had also provided that the ITC would not