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  • Insolvency Meets Arbitration in Hungary

    Introduction

    Efficiency, independence, flexibility, professionalism, and protection of sensitive information are among the main reasons why parties to disputes prefer to opt for arbitration instead of ordinary courts. These benefits, however, do not come without a cost.

    Arbitration can also be viewed as an expensive game where most of the fees are paid in advance by the requesting party. A financially distressed claimant may not be in a position to advance the costs and fees necessary to initiate an arbitration proceeding. A recent Hungarian court precedent highlights that, for this reason, in an ongoing liquidation, an arbitration agreement may not be enforceable.

    An Arbitration Agreement May be Rendered Incapable of Being Performed

    In recent years the number of initiated liquidation proceedings has skyrocketed in Hungary. Many insolvent debtors entered insolvency after being unable to repay the credit facilities they received prior to the financial crisis.

    Although most of these credit facility agreements contain arbitration clauses, an increasing number of insolvent debtors’ challenges to the banks’ decisions on drawstop, termination, or acceleration are being submitted to ordinary courts. The insolvent debtors usually argue that everyone should have the fundamental right and opportunity to assert or defend his or her rights before dispute resolution bodies, irrespective of financial condition, and thus they claim that the arbitration agreement was rendered incapable of being performed because the insolvent debtor is unable to advance the costs of the arbitration proceeding.

    Hungarian Precedent Declaring That an Arbitration Agreement With a Company Under Liquidation is Unenforceable

    At first the courts were divided on how to tackle these types of cases and whether to rely on the exemption granted by the Hungarian Arbitration Act, which allows ordinary courts to hear a case on its merits when an arbitration agreement is incapable of being performed. In 2014 the Supreme Court of Hungary issued its guidelines confirming that an arbitration agreement is not enforceable with respect to a company under liquidation, since such agreement is by definition incapable of being performed as a result of the claimant’s insolvency.

    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 arbitrations the claimant must advance the arbitration costs in any case, and may not request any suspension or exemption from it; (iii) in arbitration proceedings the insolvent company’s creditors are not able to join; (iv) arbitration proceedings are not open to the public; (v) the arbitration proceeding is a one-instance proceeding without a right to appeal and with only a limited ability to have the award set aside; and (vi) arbitration proceedings are less effective than ordinary court proceedings.

    Question Marks Behind the Supreme Court’s Reasoning

    The need for support for financially distressed companies to enable them to obtain a fair trial is understandable, but 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” and thus to declare that, despite the agreement of the parties, ordinary courts will decide on the matter.

    In our view the argument that because arbitration proceedings are closed to the public and creditors cannot intervene the rights of the debtor company are prejudiced to such an extent that its consent to arbitrate can be disregarded is unconvincing, to say the least. Similarly, it is questionable whether non-availability of an appeal, even in theory, should render an arbitration agreement “incapable of being performed” just because the claimant is under liquidation. Why would non-availability of appeal matter for insolvent companies but not for others? Similarly, we see no foundation for the court’s opinion that arbitration proceedings are less effective than court proceedings. How was “efficiency” measured by the ordinary courts? Is this statement scientifically, economically, or legally grounded, or just proof of the ordinary courts’ traditional bias against arbitration in general?

    The Supreme Court is also silent about a potential scenario in which the formerly insolvent company’s solvency is restored. Would a restored solvency re-establish the arbitration agreement’s formerly defective status?

    Unique Nature of the Hungarian Interpretation

    It has to be noted that the issue discussed above and the interpretation of law in this context is not unique to Hungary. The exemption from being bound by an arbitration agreement on the basis that it is “incapable of being performed” has its origin in the UNCITRAL Model Law on International Commercial Arbitration.

    The Hungarian innovation is that, according to the Supreme Court’s interpretation, every arbitration agreement concluded by a company which then falls under liquidation is by definition incapable of being performed. To our knowledge there is no other jurisdiction that has interpreted the scope of Article 8 (1) of the UNCITRAL Model Law this widely, giving claimants in financial difficulty the ability to easily bypass their contractual undertakings with regards to arbitration. In our view such interpretation opened a Pandora’s box entitling companies who may have no more to lose to initiate lawsuits in bad faith to hinder enforcement and delay the closure of the liquidation proceeding.

    This article was originally published in Issue 3.1 of CEE Legal Matters Magazine

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