By Howard Rosen

As business grows increasingly global and companies from more developed countries conduct business in less developed countries, arbitration clauses are routinely entered into as a means of defining a dispute resolution process that is not subject to local rule of law and local courts.

It is imperative that businesses understand the implications of the arbitration clauses that they have entered into, both from a legal and damages perspective. As well, once a dispute arises there is a choice between initiating arbitration and attempting to settle outside of the arbitration clause. Business leaders would be well advised to examine the potential size and identifiable risks associated with their claim, before initiating proceedings.

While a legal analysis is outside of my expertise, from this perspective there are at least two issues to be aware of in drafting arbitration clauses. The first deals with the governing law clause in the contract. This will determine the laws of which country will be applied in the arbitration. The second issue deals with the seat of arbitration, which will be specified in the arbitration clause in the contract.

The governing law clause in a contract will define the laws of which country that will apply to disputes governed by the contract. A detailed knowledge of the laws of particular countries is therefore essential before agreeing to be bound by the laws of a country other than your own.

The seat of arbitration chosen in the arbitration clause can also have a dramatic impact on the outcome of the arbitration. A desirable location chosen for logistics, shopping, restaurants, etc., may have an adverse impact on the outcome of arbitration proceedings. Before, during, or after an arbitration the seat of arbitration provides the arena for potential intervention. Local Courts can be used to attack the proceedings by seeking injunctions prior to the hearings commencing (or in some circumstances, while the proceedings have commenced). As well, an award can be attacked in the local courts through an annulment proceeding after it has been rendered.

In general, a “pro” arbitration seat should be sought out to provide a properly neutral venue for the arbitration. In searching out a pro arbitration seat, a careful review of any interventions made by local Courts in past arbitration cases should be sought out to ensure that there has not been any untoward interference. In one recent case in 2009, the hearing was interrupted by the Respondent who had obtained an ex parte injunction to halt the arbitration proceedings. This was an example of the seat of arbitration being in a country where the local Courts were willing to intervene.

From a damages analysis point of view, arbitration clauses should spell out, as best they can, the type and measurement of damages that are envisaged for a breach or non-performance of the agreement at the outset.

Depending on the nature of the business relationship, this may be quite straightforward, and be calculated as a loss of profits. In these types of cases typically damages are calculated based on the profits that would have been earned by the business enterprise but for the breach.

Profits, however, have many different definitions and interpretations. Economic and accounting concepts such as: marginal cost, direct cost, incremental cost, etc., may impact greatly on the calculation of damages. Differences in the customary way in which lost profits is calculated can differ in different geographies around the world as well as in different industries. The recent introduction of international accounting standards (IFRS) may result in more comparable financial statements worldwide, but gaps can and will still continue to exist in the methods and precision of the calculation of damages. It is best to define what is intended to compensate an aggrieved party in these circumstances as far as you can.

In the case of a catastrophic loss or expropriation, which leads to the loss of a business or the entire opportunity, the measurement of fair market value may be the appropriate measurement of loss. Again, it is best to define what is intended in these circumstances, and how fair market value should be determined (valuation date, discount rate). The various components that go into a determination of fair market value are not always determinable by formula, so some broader guidelines may need to be employed.

In essence, what you should be trying to achieve is some enhanced degree of certainty in entering into contracts in countries other than your own. In a recent construction dispute, there was a termination clause that called for “fair compensation of an amount no less than the value of the project at the time of termination in addition to a sum representing not less than half of the anticipated net profits for the period remaining in the contract period”. Without discussing the merit of the contract or circumstances of the case, this is an example of contract language that does not achieve the goal of removing uncertainty in the calculation of damages.

This leads to the last area of discussion: how to evaluate and decide if settlement is a better option to initiating or conducting the arbitration. As with most business decisions, there is uncertainty and risk associated with this process.

It is important to understand not only the financial merits of the case you are presenting or defending, but also to ensure you have a good understanding of the arbitration risks. The decision to settle or arbitrate should be based on a thorough understanding and quantification of the amounts at dispute, the risks in the legal arguments being presented, likely size of any award of damages, and an appreciation of the time and cost associated with the arbitration proceedings.

For the purposes of this discussion, let us assume that the decision to settle or arbitrate is purely a financial one. For some disputes this is not the case; there is some intangible value to carrying through with the arbitration. That can be an important consideration, for example, when a company is engaged in arbitration disputes in a number of venues around the globe and needs to demonstrate the seriousness of its resolve to take disputes to a conclusion. If a company is not known to be willing to take a dispute all the way through an arbitration, companies involved in other disputes with them may not negotiate as readily.

Once legal counsel has reached a level of comfort about the merits of the legal argument, you should be able to quantify this risk with some approximate probability. Your financial expert should be able to quantify the amount of damages, taking into account all of the relevant business risks. A combination of these two analyses, together with the knowledge of what arbitration panels have considered as appropriate damages on similar cases, should provide a good benchmark as to a probable outcome.

On top of this, there will be a requirement to devote corporate resources to bringing or answering a claim in an arbitration. The resources required will depend on the complexity of the claim. A further consideration, depending on the forum of the arbitration, is the magnitude of the costs associated with the proceedings.

Business leaders and decision makers must take into consideration all of these points (and any others that are relevant to their specific case) in order to make rational business decisions about entering into arbitration proceedings before exhausting settlement opportunities.