Banks in Hungary as in many jurisdictions, prefer arbitration over litigation before ordinary courts to resolve disputes arising out of a financing transaction. Efficiency, flexibility, professionalism and protection of sensitive information are among the main reasons for this preference. However, the large number of insolvencies in recent years revealed a difficulty in enforcing arbitration clauses.
The question of enforceability of the arbitration agreement often arises from a challenge to the validity of the entire loan agreement (or at least certain parts of it) by the borrower in financial difficulties. If such or similar dispute arises, the financially distressed claimant may not be in a position to advance the relatively high costs to initiate arbitration proceedings.
The arbitration agreement may be rendered incapable of being performed
Since the beginning of the financial crisis the number of debtors unable to meet their financial obligations has increased substantially. Most of these debtors commenced negotiations with the banks to achieve grace periods and standstill arrangements or the restructuring of the loans. For various reasons (the analysis of which is outside the scope of this article), banks in Hungary were often able to fulfil these requests, and the outcome was rather termination and acceleration in most cases. Debtors often challenged the banks’ decisions on drawstop, termination or acceleration; some chose to also initiate bankruptcy or final insolvent dissolution proceedings.
Arbitration proceedings are expensive, particularly for anyone in financial difficulties. A trend of submitting claims to ordinary courts has emerged, arguing that a person should have a fundamental right and possibility to assert or defend its rights before dispute resolution bodies, irrespective of its financial condition. The legal argument of the petitions for establishing the competence and jurisdiction of ordinary courts is unenforceability: debtors claim that the arbitration agreement shall be rendered “incapable of being performed”.
Hungarian precedent declaring that an arbitration agreement with a company under liquidation is unenforceable
In response to the emerging of these cases, ordinary courts were divided on how to handle this type of case, and whether or not they could rely on an exemption granted by the Hungarian Arbitration Act allowing ordinary courts to hear a case on its merits despite a valid arbitration clause in the underlying agreement. In 2014 the Supreme Court of Hungary issued a its guidelines confirming that an arbitration agreement is not enforceable with respect to a company under liquidation, since such agreement is incapable of being performed as a result of the pending liquidation. The Supreme Court of Hungary provided the following reasoning for this view:
- i. the costs of the arbitration proceedings exceed the costs of an ordinary court case;
- ii. in arbitration matters the claimant must advance the arbitration costs in any case, and may not request the suspension of this obligation or exemption from it;
- iii. in arbitration proceedings the insolvent company’s third party creditors are not able to intervene or interplead;
- iv. arbitration proceedings are not open to the public, which is detrimental to the interests of other creditors;
- v. the arbitration proceeding is a one instance proceeding without a right to appeal or contest the award and the setting aside of an award is available only in limited circumstances;
- vi. arbitration proceedings are less effective than ordinary court proceedings.
The need for support for financially distressed companies to enable them to obtain a fair trial (or, to that end, at least the chance of a fair trial) is understandable. However, the arguments of the Supreme Court of Hungary are not entirely convincing in establishing legitimate reasons for rendering an arbitration agreement “incapable of being performed”. Some of the reasons difficult to deny, but it is hard to see their relevance in the context of evaluating the enforceability of an arbitration agreement. For example, it is unconvincing, to say the least, that the arbitration proceedings being closed to the public and that the creditors cannot intervene prejudices the rights of the debtor company to such an extent that it raises the question of the enforceability of its valid contractual undertakings. Equally it is questionable whether non-availability of an appeal, even in theorem, should render an arbitration agreement “incapable of being performed” just because the claimant is under liquidation. Why would non-availability of appeal matter in respect of insolvent companies but not others?
Insolvency laws set out the rules under which an administrator or liquidator of an insolvent company may challenge, terminate, rescind from or set aside agreements and contractual obligations. These rules also guarantee that no cherry-picking occurs and only entire agreements may be set aside by the liquidator. In effect, the decision of the Supreme Court of Hungary by-passes the statutorily defined (and limited number of) circumstances where this could happen; and establishes an extraordinary exemption. This, in the view of many, goes beyond the scope of the traditional function of courts to apply laws, and breaches the prohibition of court created laws.
It has to be noted that the issue discussed above and the interpretation of law in that context is not a Hungarian novelty. The exemption from being bound by an arbitration agreement on the basis that it is “incapable of being performed” has its origin in Article 8 (1) of the UNCITRAL Model Law on International Commercial Arbitration which was implemented into the Hungarian Arbitration Act. Thus, in principle, banks should be aware of the risks that there may be special circumstances when an arbitration clause cannot be enforced. However, by specifying the general term of “incapable of being performed” and applying it to all cases where a party is under financial difficulty the Hungarian Supreme may have gone too far. Pandora’s Box is now open and a company which may have no more to lose, following the acceleration of its loan, could very easily hinder enforcement or the collection of the debt by filing for an insolvency procedure and commencing a lengthy ordinary court procedure against the banks. The consequence of this is not only significant delay, but also that the claim of the bank will be registered by the liquidator as “disputed”, which makes a creditor’s position in an insolvency scenario even worse, depriving them from their fundamental creditors’ rights such as the right to vote.
To be blunt, the Supreme Court of Hungary’s decision is not a surprise in light of the traditional borrower-friendly approach of Hungarian courts. Banks and other financing entities could only hope that the tide will turn, and their interests will be taken into account with a more balanced emphasis in future decisions.