Escalation Clauses: no longer a tripping hazard for arbitrations with seat in Germany?

Escalation clauses need careful drafting to be enforceable and commercially useful. There is uncertainty as to the consequences of the parties’ non-compliance with escalation clauses providing for ‘final’ dispute resolution by means of arbitration. Will it affect the jurisdiction of the arbitral tribunal or the merits of the claim and can an arbitral award even be set aside? In two recent decisions, the German Federal Court of Justice (Bundesgerichtshof) clarified that, in arbitral proceedings seated in Germany, an arbitral tribunal is entitled to assume jurisdiction irrespective of whether the parties complied with the escalation clause.

The cases before the Bundesgerichtshof

Both cases were brought before the Bundesgerichtshof by means of a complaint on points of law (Rechtsbeschwerde) concerning interim arbitral awards on jurisdiction pursuant to Sec. 1040 (3) sentence 1 of the German Code of Civil Procedure (ZPO) where the defendants argued lack of compliance with an escalation clause.

In the first ruling, a shipbuilding contract provided for arbitration according to the rules of the German Maritime Arbitrators Association (GMAA) with seat in Hamburg. In addition, the parties stipulated that the opinion of an expert shall be final and binding regarding technical disputes. The Higher Regional Court of Hamburg (OLG Hamburg, case no. 6 Sch 3/15) rejected a challenge of the arbitral tribunal´s interim award on jurisdiction with decision of 27 May 2015.  The court held that compliance with such an escalation clause was irrelevant for the question of jurisdiction of the arbitral tribunal as the latter is rather required to dismiss the claim as ‘currently unfounded’. Upon a complaint on points of law, the Bundes­gerichtshof confirmed this ruling with its decision of 14 January 2016, while explicitly leaving open whether to dismiss the claim as either ‘currently inadmissible’ or ‘currently unfounded’ (case no. I ZB 50/15, available in German here).

With its ruling of 9 August 2016, the Bundesgerichtshof confirmed and substantiated this view concerning an ICC arbitration proceeding seated in Frankfurt stating that the question of whether or not the parties had complied with an escalation clause is not a question of jurisdiction, but of the admissibility of the claim (case no. I ZB 1/15, available in German here).

Welcome clarification of consequences of lack of compliance with escalation clauses

In consequence, arbitral tribunals with seat in Germany may accept jurisdiction even if the parties have failed to comply with previous steps set out in an escalation clause. The clarification is especially valuable in an international context since it provides certainty in an area that is handled strikingly differently by national courts and arbitral tribunals depending on the jurisdiction and the exact wording of the escalation clause. If the escalation clause is considered to be enforceable at all, compliance with the preceding dispute resolution settlement procedure is qualified either as a matter of jurisdiction, in particular a condition precedent to arbitration, or as a matter of admissibility or a substantive obligation. At the same time, there are different answers to the question of whether non-compliance precludes the proper initiation of arbitration proceedings or whether the requirements can be satisfied subsequently, and regarding the allocation of competence over disputes regarding escalation clauses.

The Bundesgerichtshof’s approach can thus only be welcomed, since it provides for certainty for arbitrations with seat in Germany. Arbitral tribunals can assume jurisdiction and are thus competent to decide on those disputes and to grant injunctive relief, while parties will no longer be inclined to initiate time-consuming and costly challenge proceedings concerning interim awards on jurisdiction. At the same time, compliance with the escalation clause is ensured since the arbitral tribunal is not entitled to decide on the merits if the parties have not acted in accordance with the particular escalation clause. Furthermore, the decisions should have reduced the prospects of successfully applying for a setting aside of the final award by not qualifying compliance with the escalation clause as a matter of jurisdiction. The jurisprudence is thus in line with the arbitration-friendly approach taken by the German courts.

Stay of the arbitration proceedings as expedient alternative

However, it would have been helpful had the Bundesgerichtshof pointed out that, just as in German litigation, it must be possible for an arbitral tribunal to direct the parties to comply with the dispute resolution settlement process stipulated in the escalation clause by staying the proceedings and setting a deadline for the parties to comply with the relevant process, and to resume the proceedings subsequently.

Such approach is preferable from an arbitration user’s perspective, since a preceding dispute resolution settlement process will usually not lead to a happy ending if  the dispute has already been brought to arbitration. Dismissal will only cause recommencement of the arbitration and the appointment of a new arbitral tribunal, which will result in a waste of precious time and additional costs.

Although the Bundesgerichtshof did not expressly refer to this alternative, one can expect that a stay of the arbitration proceedings will be the preferred solution in practice. In addition, the parties’ respective behaviour regarding non-compliance with the escalation clause may be reflected in the cost decision of the arbitral tribunal.

Implications for setting aside and enforcement proceedings

Irrespective of the aforesaid, contracting parties are strongly urged to draft their escalation clause clearly and to strictly follow the established procedure when enforcing their claims to achieve certainty in the long run. Although the Bundesgerichtshof reduced the prospects of successfully applying for a setting aside of the final award, there remains a risk so that a party’s (alleged) failure to comply with an escalation clause or the tribunal’s failure to deal with this situation properly will be put on the table in setting aside and enforcement proceedings, especially if such proceedings are taking place in a country where compliance with escalation clauses is considered to be a matter of jurisdiction and non-compliance precludes the proper initiation of the arbitration.

This article was first published on Kluwer Arbitration Blog.

* Gordon Kardos assisted in preparing this blog post.