Managing Evolving Financial Risk in Arbitration
Arbitration is often chosen for its confidentiality, procedural flexibility, specialist tribunals and enforceability across international borders. Those advantages do not, however, make arbitration financially predictable.
The financial risks associated with arbitration can be difficult to assess, variable and, in some cases, unforeseeable. The most significant risk for a respondent is having to pay a substantial award. Both parties also face uncertainty about how long the arbitration will take, how much it will cost, how much of their legal spend will be recoverable if successful and what they may have to pay towards the other side’s costs if they lose.
Assessment and management of these financial risks is critical to businesses involved in arbitration in order to manage budgets and cash flow.
Award Risk
A potential respondent facing a substantial claim needs to understand both the likelihood that an award will become payable and its potential amount and timing. This “Award Risk Assessment” is fundamental to decisions about cash flow and the recognition of or provisioning for financial liabilities.
An initial Award Risk Assessment should therefore consider best, expected and worst-case outcomes and include:
the likelihood of the claim succeeding;
likely damages;
pre-award and post-award interest;
the respondent’s legal and expert costs;
potential adverse costs payable to the claimant;
enforcement costs; and
the likely timing of payment.
The assessment should then be refreshed throughout the arbitration as the available information changes. Following commencement, for example, the nature and amount of the relief sought may become clearer. Expert evidence may provide greater certainty about quantum, while disclosure, witness evidence and legal submissions may alter the assessment of the claim’s prospects. Interest can also materially increase the quantum of the potential liability over time, particularly where it is compounded or calculated at a substantial contractual rate.
Ongoing Award Risk Assessment is therefore essential to a business facing the risk of having to meet a substantial award, but this assessment does not in itself reduce the primary risk.
For some businesses, investors, potential purchasers or financiers, the uncertainty associated with a potentially substantial adverse award may be an unacceptable risk. Contingent risk insurance can provide a mechanism for transferring some of that risk to an insurer. It is generally directed at risks considered relatively low in probability but potentially high in severity.
The cover is bespoke and may only respond above a substantial retention and up to an agreed limit. Underwriters commonly require a detailed legal analysis of the facts, applicable law, prospects and potential exposure. Timing is also important: if for example the merits deteriorate during the proceedings, insurance may be unavailable or prohibitively expensive.
Where insurance is obtained, the respondent will transfer an agreed part of its exposure to pay an adverse arbitral award. This may also assist the business when dealing with third parties concerned about the potential liability, including purchasers, investors and financiers.
Cost Risk
Financial risk in arbitration is not confined to respondents.
A claimant faces the possibility that its claim will fail, and the money invested in pursuing it will be lost. It may also be required to pay part of the respondent’s legal costs, over which it has limited control and potentially little visibility.
The decision to commence arbitration therefore requires a rigorous assessment of the prospects of success, the quantum of the likely award, the cost of pursuing the proceedings and possible adverse costs exposure. Commencing an arbitration can represent a significant financial commitment, particularly in complex commercial and investor-state arbitrations.
Any initial legal budget for an arbitration is necessarily imperfect. Arbitration costs are affected by a number of variables including the institution and tribunal, governing law and seat, number and conduct of the parties, the volume of documentary and expert evidence, and complexity of the dispute. Budgets can change significantly as a case develops. Claims may be amended, additional experts engaged or large volumes of documents disclosed. Proceedings can be bifurcated, hearings postponed or tribunals may require unanticipated evidence or submissions.
Adverse costs exposure presents similar difficulties. A claimant may have no visibility over the respondent’s expenditure and consequently estimate that exposure by reference to its own budget, which is itself subject to change. Arbitration differs from litigation in that a third-party funder is not exposed directly to an order that it pay adverse costs (as an arbitration tribunal has no jurisdiction over it). However increasingly, arbitral tribunals are making orders for security for costs where the claim has a litigation funder involved. Although this order cannot be made directly against the funder, the tribunal is able to achieve the same effect where the funder or claimant provides this security as if it is not provided the arbitration will be stayed.
Duration is itself financially significant. A longer arbitration increases professional fees for the arbitration and enforcement proceedings. Duration can extend accounting uncertainty, tie up reserves and increase the costs of capital as funds invested in the arbitration are tied up. This is a risk which is more acute in arbitration than domestic litigation where the requirement to have an award recognised and enforced in one or more jurisdictions can considerably extend duration.
A claimant should perform a robust risk assessment of the claim, examining the prospects of success, anticipated legal expenditure, duration and potential adverse costs. This risk assessment should be periodically updated as developments in the course of the arbitration may materially alter that assessment. For example, bifurcation of some issues to be heard separately may increase the overall budget, a security for costs application may reveal that the respondent’s costs are higher than anticipated, or critical witness evidence may affect the prospects of success.
This variability of the risks faced by claimants makes risk-transfer strategies attractive.
Third-party funding can transfer some or all of the claimant’s cost risk to a funder who provides non-recourse capital, with repayment and the funder’s return payable only from a successful outcome.
Capital protection insurance provides another mechanism for risk transfer for claimants and funders. In exchange for a premium, a claimant or funder can protect against the loss of an agreed amount of the capital spent pursuing the claim. Certain products may also provide a backstop against duration risk by responding if legal expenditure has not been recovered by a specified date. Capital protection insurance will be most readily available where there is a group of claims for example for a third-party funder who has a portfolio of claims or a claimant pursuing a series of arbitration claims.
After the Event (ATE) insurance will transfer the claimant’s potential liability for the respondent’s legal costs to an insurer. Where adequate cover is obtained, this can reduce the need for a claimant or funder to reserve internally against potential adverse costs liability and can assist with a direction from a Tribunal that security for the respondent’s costs be provided.
Enforcement Risk
A favourable award does not eliminate financial risk for a claimant. An award may be challenged or annulled, or a respondent may resist enforcement, potentially requiring lengthy and expensive recognition and enforcement proceedings across one or more jurisdictions.
Several mechanisms can be used to address this risk. One is the sale of a favourable award to a third party prepared to assume the enforcement risk. The claimant accepts an agreed amount in exchange for transferring the risks, costs and delay involved in collecting the award.
Another mechanism is Arbitration Award Default Insurance, usually obtained earlier in the arbitration. This can protect against the risk that a claimant obtains a favourable award but payment is delayed by way of challenges at the enforcement stage. Depending upon its terms, the policy may respond where an award remains unpaid after an agreed period, allowing the claimant to achieve greater certainty around the timing of recovery. This product has some similarities to judgment protection insurance which can protect a favourable court judgment against the risk of being overturned on appeal, but it involves a different assessment, being an assessment of the risk of enforcement action being finalised in a timely way. This assessment of enforcement risk will be informed by the proposed enforcement jurisdiction(s) and the nature of the assets of the respondent sought to be attached in order to realise the award.
Conclusion
The financial risk associated with arbitration is multidimensional and subject to change throughout the life of a dispute. A respondent may face a substantial award, accruing interest and significant defence costs. A claimant faces uncertain legal expenditure, adverse costs exposure and the possibility that proceedings and enforcement will continue substantially longer than anticipated.
Regularly updating the relevant risk assessment is therefore necessary and prudent. But robust measurement of risk does not, by itself, reduce that risk.
A range of funding, insurance and risk-transfer products can potentially assist. Third-party funding can address liquidity and expenditure risk, ATE insurance can mitigate adverse costs exposure, capital protection insurance can protect some of the investment in pursuing a claim, and contingent risk insurance may transfer part of a respondent’s potential award liability. Award sales and award default insurance can also provide options for managing enforcement and collection risk.
None of these products offers universal or complete protection. Availability, price, limits and terms will depend upon the nature, timing and quantum of the particular risk. Nevertheless, prudent claimants and respondents should consider these mechanisms as part of their broader financial risk assessment, and do so early enough to determine whether they can provide an appropriate solution for the business’s particular circumstances.
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Susanna Taylor
Consultant
Toremis Specialty