When a deal is being negotiated, dispute resolution clauses are usually a low priority, with efforts instead focused on the substantive terms of the transaction. But by treating dispute resolution as an afterthought, parties are potentially leaving money on the table.
A contract’s dispute resolution clause can have a significant impact on the resilience of the parties’ obligations in the face of conflict and on the long-term relationship of the parties. A well-drafted clause can save costs and time at the inception of a dispute, facilitate a more efficient resolution, and even deter breaches of the agreement by having an effective dispute resolution mechanism already in place. Conversely, deficient dispute resolution clauses can complicate and prolong disputes and create uncertainty in their resolution and possibly even leave a party with an inadequate remedy when faced with a breach by the counterparty. In addition, from a strategic perspective, the dispute resolution clause can alter the balance of power in settlement negotiations.
Drafting an effective dispute resolution clause requires the parties to think through their likely posture in disputes that may arise and then translate that posture into a clause that maximizes the prospect of successful and efficient dispute resolution. Of the various decisions that must be made, the most fundamental is choosing whether the battlefield for the conflict will be litigation in a national court or arbitration under the rules of an arbitration institution. Each mechanism has its pros and cons, and which to choose will always be context-specific. The parties’ respective positions may mean they each prefer a different process. Properly negotiating the dispute resolution clause will help ensure that a fair solution is found for both parties, and create greater certainty for the efficient resolution of disputes.
In this article, we explore the key differences between litigation and arbitration for disputes in the private equity context, and considerations to guide parties in negotiating appropriate dispute resolution clauses.
Arbitration vs. litigation: Pros and Cons
In some respects, court litigation and arbitration are similar. Both have a decision-maker to whom the parties make written and oral submissions and present evidence. In contractual disputes, the decision will generally be based on the governing law chosen by the parties. However, in other respects, the processes differ substantially in ways that affect the conduct of the dispute and its resolution.
Some features of arbitration can come as a surprise to parties used to litigating disputes, particularly in U.S. or common law courts. With some exceptions, arbitration procedures generally do not allow for U.S. style depositions of potential witnesses, and tribunals typically have no power to compel testimony. Document discovery or disclosure exercises are much more limited than is usually the case in common law courts. All of these features can reduce the overall time and cost of arbitration, but it can also potentially limit the range of evidence to which parties have access.
Despite these limitations, a dispute resolution clause specifying arbitration is well worth considering when private equity firms are negotiating a deal. Court proceedings are almost universally held in full public view by default, subject only to limited circumstances where a court may grant an application to have some evidence redacted or the proceedings heard in private. Arbitration, by contrast, is almost always private and confidential, which a private equity firm may find particularly desirable when resolving a dispute. Confidentiality protects commercially sensitive information (for example, concerning structuring and pricing), helps to limit and manage reputational issues arising from adverse publicity, and supports the preservation of long-term relationships between disputing parties.
Arbitration also generally allows the parties more control over who the decision-makers will be. Court systems allocate cases to a judge. In arbitration, parties normally influence the composition of the tribunal. The parties can seek to reach agreement on the identity of a sole arbitrator, or where the tribunal is comprised of three members, each side usually appoints one arbitrator, and the third generally is appointed with some input from both sides. This allows better selection of arbitrators with relevant industry experience.
Enforceability of decisions is one of the most important considerations in choosing the dispute mechanism. There is usually no point pursuing a decision that cannot be enforced. Arbitral awards issued in the major arbitration-friendly jurisdictions will be enforceable in any of the 172 countries that are signatories of the Convention on the Recognition and Enforcement of Arbitral Awards (commonly known as the “New York Convention”). This provides relatively straightforward enforceability for arbitral awards in most jurisdictions. Arbitral awards are also generally not subject to appeal and can only be challenged on very limited grounds.
By contrast, enforcing court judgments outside of a court’s jurisdiction will depend on the particular court and foreign jurisdictions involved. Enforcement is also likely to depend on whether there are bilateral treaties in place between the relevant countries governing the reciprocal enforcement of court judgments. If there is no applicable treaty, enforcement can be difficult, onerous, or even practically impossible. Even if there is, court decisions can be subject to appeal, which may delay enforcement for months or years.
Arbitration caveats
When arbitration is selected, it is vital to ensure that the arbitration agreement is properly drafted. The drafting should be informed by careful consideration of the nature of the contract, the parties to the contract, the types of disputes that might be expected to arise under it, and the jurisdictions likely to be involved in any dispute or enforcement procedure.
Risks arise where there is a suite of agreements between overlapping parties, and these agreements contain incompatible arbitration agreements. This can lead to the fragmentation of disputes and parallel arbitration proceedings. Careful drafting of arbitration agreements can remove this risk by enabling the parties to proceed under a single arbitration if a dispute arises under multiple contracts.
Common dispute scenarios
We turn now to consider common dispute scenarios that may arise in the private equity context, and how these affect the preferable dispute resolution mechanism.
Disputes between GPs and portfolio companies
Potential disputes between GPs and portfolio companies can include allegations of breach of duty or mismanagement of the portfolio company; disputes relating to conflicts between fiduciary duties owed to the LPs and to portfolio company shareholders; disputes relating to the exercise of put rights or other exit rights; and failure by portfolio companies to recognise specific GP rights as to board representation, voting rights or other corporate governance issues.
Whether litigation or arbitration is preferable often depends on whether the GP would benefit from the threat of open court proceedings, whether the coercive powers of courts are likely to be required (including interim measures, such as freezing injunctions), and whether the portfolio company is expected to comply with the decision of the court or tribunal.
Disputes between GPs and counterparties
Disputes may arise between GPs and counterparties in relation to a purchase or sale of portfolio company interests. In these instances, court litigation is likely to be a preferable forum for GPs in light of the generally broader disclosure and coercive powers at a court’s disposal, and the pressure that open court proceedings and public reporting of the dispute may place on counterparties.
Disputes between GPs and LPs
While uncommon, disputes can arise between GPs and LPs under the main fund agreements. These most frequently involve allegations that fund managers or the GP have breached duties owed to the LPs; allegations of mis-selling or breaches of securities laws; disputes over capital calls or failures by LPs to meet them; disputes over valuations or remuneration payable to managers; or breaches of confidentiality.
Generally, arbitration tends to be seen as preferable for GPs in light of the confidentiality benefits, comparatively limited disclosure, and the potential for the arbitrator(s) to have industry expertise. However, LPs will not always be able or willing to consent to arbitration, and it is not uncommon for fund agreements to provide for court jurisdiction.
Disputes between GPs and personnel
Disputes can also arise between GPs and their staff for a range of reasons, including issues arising from employment, or disputes over entitlement to carried interest. Whether arbitration or litigation is preferable may depend on the gravity of the situation, and whether the GP’s preference is for the dispute to be kept out of the market. Arbitration is likely to provide a faster and cheaper alternative to court litigation, with the added benefit of confidentiality. However, the threat of the court’s coercive powers may act as a stronger deterrent against misconduct by bad leavers.
Disputes between GPs and States or State-owned entities
GPs often deal with sovereign wealth funds or other State or parastatal entities (such as national oil companies and national pension funds). When disputes arise in the course of such dealings, local national courts may be a risky proposition. In certain jurisdictions, there may be legitimate concerns about a lack of impartiality when State interests are at play. Arbitration provides a neutral forum for the resolution of these disputes, and strengthens enforcement prospects against a State’s commercial assets in New York Convention jurisdictions.
Dispute resolution clauses are always worth negotiating
Choosing the right battlefield for dispute resolution will allow parties to resolve their disputes in a faster and more cost-efficient manner, whereas the wrong battlefield can lead to long delays and unnecessary costs, impact a party’s prospects success, and even create an impossibility of enforcing the decision.
Whichever mechanism is chosen, it is important to remember that dispute resolution clauses are not boilerplate provisions. Drafting errors can have a tailspin effect at the outset of a dispute and can easily be avoided. Unless a party is content to leave money on the table, dispute resolution clauses should always be carefully considered and, where necessary, properly negotiated.
Private Equity Report Spring 2024, Vol 24, No 1