Court of Appeal grapples with the relationship between an arbitration clause and the rights of third parties: decision in Fortress Value case upheld but on different reasons

In May 2012, the Commercial Court dealt with the circumstances in which a third party beneficiary of a right under a contract will be treated as a party to the arbitration agreement therein under the Contracts (Rights of Third Parties) Act 1999 (the 1999 Act).  The factual background to the decision is contained in our previous post: in summary, the two individual appellants ("TT") with the benefit of an exclusion clause and an indemnity under a Partnership Deed to which they were not party, sought to have tortious claims against them stayed in the court for determination by arbitration in accordance with the arbitration clause in the Partnership Deed.  The Commercial Court found that TT could not insist that the claims be brought by arbitration. The Court of Appeal has now rejected an appeal by TT against that decision, albeit upholding the decision for reasons different to those given by the Commercial Court (see Fortress & Ors v Blue Skye & Ors [2013] EWCA Civ 367).

The Court of Appeal disagreed with the position of the Commercial Court that the distinction between a contractual right of action (the indemnity) and a contractual defence (the exclusion clause) afforded to a third party was determinative of whether the third party could enforce the arbitration clause. Section 1(6) of the 1999 Act effectively provided that, for the purposes of the 1999 Act, no such distinction should be drawn.  The 1999 Act contemplated that the right to take the benefit of a contractual exclusion may be subject to a term providing for submission of disputes to arbitration but this would be a question of construction of the agreement.

The Court of Appeal examined the provisions of s8 of the 1999 Act, which ensure that, where appropriate, the provisions of the Arbitration Act 1996 (the 1996 Act) apply in relation to third party rights under the 1999 Act. It concluded that very clear language was required in order to make a right of a third party to avail himself of an exclusion clause subject to an arbitration clause in the same agreement. (This meant, conversely, that such party was not entitled to insist on arbitration of claims against him should he wish to rely on that exclusion clause as a defence).  The Partnership Deed did not include such clear language. 

Where non-parties to a contract are granted rights thereunder it is important for the dispute resolution provisions (both their nature and their scope) to be carefully drafted to try to avoid fragmented resolution of disputes in multiple fora, if this is what the parties intend.  The wording of many arbitration clauses which refers to disputes arising "between the parties" will not usually be sufficient for a third party with substantive rights under the contract to be treated as a party to the arbitration agreement, such as to be able enforce its terms.  Clear wording demonstrating the contracting parties' intent to grant a procedural right to the third party will be required.

The statutory background

Section 1 of the Act provides

"1 Right of a third party to enforce a contractual term.

(1)    Subject to the provisions of this Act, a person who is not a party to a contract (a "third party") may in his own right enforce a term of the contract if –

(a)    the contract expressly provides that he may, or

(b)    subject to subsection (2), the term purports to confer a benefit on him. 

(2)    Subsection (1)(b) does not apply if on a proper construction of the contract it appears that the parties did not intend the term to be enforceable by a third party. 

(3)    …

(4)    This section does not confer a right on a third party to enforce a term of a contract otherwise than subject to and in accordance with any other relevant terms of the contract.

(5)    … 

(6)    Where a term of a contract excludes or limits liability in relation to any matter references in this Act to the third party enforcing the term shall be construed as references to his availing himself of the exclusion or limitation. 

Sub-section 1(4) clarifies sub-section 1(1) – the right of enforcement is subject to the contract's terms and conditions.  It is therefore open to the parties to limit or place conditions on the third party's right; for example, if he wishes to enforce the right he is to do so by way of arbitration, not litigation (see the Explanatory Notes which accompany the 1999 Act).

The relevant statutory provisions in relation to arbitration are set out in s8 of the 1999 Act which provides:

"8 Arbitration provisions

(1)    Where – 

(a)    a right under section 1 to enforce a term ("the substantive term") is subject to a term providing for the submission of disputes to arbitration ("the arbitration agreement"), and

(b)    the arbitration agreement is an agreement in writing for the purposes of Part I of the Arbitration Act 1996,

the third party shall be treated for the purposes of the Act as a party to the arbitration agreement as regards disputes between himself and the promisor relating to the enforcement of the substantive term by the third party.

(2)    Where –

(a)    a third party has a right under section 1 to enforce a term providing for one or more descriptions of dispute between the third party and the promisor to be submitted to arbitration ("the arbitration agreement"),

(b)    the arbitration agreement is an agreement in writing for the purpose of Part I of the Arbitration Act 1996, and

(c)    the third party does not fall to be treated under subsection (1) as a party to the arbitration agreement,

the third party shall, if he exercises the right, be treated for the purposes of that Act as a party to the arbitration agreement in relation to the matter with respect to which the right is exercised, and be treated as having been so immediately before the exercise of the right."

The contractual background

TT were managers of an investment structure based around an English limited partnership, regulated by the Partnership Deed.  TT were not parties to the Partnership Deed but its terms purported to confer substantial rights upon them.  

Clause 17.2.1 excluded TT from liability for loss to the partners or partnership arising in connection with their services.  Under Clause 17.2.2 the partnership agreed to hold harmless TT against any and all liabilities incurred by reason of their role as managers. 

Clause 17.14 referred to the 1999 Act providing that "Any person (other than the Parties to this agreement) who is given any rights or benefits under this agreement (including pursuant to Clause 17.2…) shall be entitled to enforce those rights or benefits against the parties in accordance with [the 1999 Act]". 

Clause 17.11 provided that the Partnership Deed and the rights, obligations and relationships of "the parties hereto" under the Partnership Deed were governed by English law.  It also provided that any dispute arising out of or in connection with the Partnership Deed that "the parties hereto are unable to resolve between themselves" shall be settled by arbitration. 

Enforcing the indemnity

It was accepted that, were TT to enforce their right to an indemnity under Clause 17.2 their right would, in terms of s8(1) of the 1999 Act, be subject to a term providing for the submission of disputes to arbitration and they would be treated as parties to the arbitration agreement for this purpose.  Therefore, were TT to seek to enforce the indemnity by way of litigation, the counter-party could apply for a stay pursuant to s9 of the 1996 Act; were they to enforce by way of arbitration, there could be no challenge to jurisdiction on grounds that the TT were non-parties to the arbitration agreement.  This is because s8(1) deals with a situation in which the third party's substantive right is conferred subject to disputes being referred to arbitration.  Section 8(1) is based on a "conditional benefit approach", ensuring that the third party who wishes to take action to enforce his substantive right is not only able to enforce it effectively by arbitration but is also bound to enforce his right by arbitration.

TT's argument in relation to claims against them

TT argued that the effect of the contractual terms on their true construction was to entitle them to rely on the arbitration clause despite not being parties to the Partnership Deed and the provisions of the 1999 Act rendered such provision effective. The argument was that claims against them could only be brought in arbitration on the basis that:

1. in defence of those claims, TT could potentially rely on the exclusion in Clause 17.2 which is a benefit which they could take advantage of because of the effect of s1(1) of the 1999 Act (as emphasised in Clause 17.14); and
2. Clause 17.2 was, like all other terms in the Partnership Deed, subject to the agreement to refer disputes to arbitration; and
3. TT were, by reason of s8(1) of the 1999 Act to be treated as parties to the arbitration agreement as regards a dispute which potentially engages the availability of the defence under Clause 17.2; or, if TT could not rely on s8(1) of the 1999 Act,
4.  TT could rely on s8(2) of the 1999 Act and choose to exercise their right to rely on the arbitration agreement which is sufficiently widely drawn to encompass a dispute between the principal limited partner and a third party such as TT arising out of or in connection with the Partnership Deed.

Grappling with the effects of the 1999 Act and the parties' intentions

The Court of Appeal sought to reconcile the provisions of the 1999 Act with the parties' intentions.  Whilst the circumstances here were that TT wished for the claim against them to be brought in arbitration proceedings, the Court took a principled approach and looked to the potential consequences of interpreting s8(1) as treating a third party wishing to engage an exclusion defence in a contract to which it was not a party as a party to the arbitration agreement.

TT argued that there was an intention to confer on them the right to have the protection of the exclusion determined in arbitration.  However, if TT's argument was correct, a third party would have had a burden imposed on him to which he did not agree (namely, a positive obligation to submit to an arbitration as respondent). This burden would cut across the principle that arbitration is a consensual process.  There was a distinction between conferring a conditional benefit (whereby, in order to benefit from an indemnity, the third party must pursue it in arbitration) and compelling third parties to submit to a process of arbitration which those third parties had not themselves initiated. The third party would have a choice to seek an indemnity, knowing that if he does, it must be way of arbitration.  If TT were correct, they would have no choice whether or not to be a party to, and bound by, an arbitration initiated by a party to establish a liability to which the exclusion in Clause 17.2.1 may or may not afford a defence.  This, the Court remarked, would be a striking outcome.

The Court highlighted the limits of s8(1): it provides that a third party is treated as a party to the arbitration agreement as regards disputes with the promisor relating to enforcement of the substantive term by the third party, not in respect of all disputes arising out of and in connection with the agreement. Section 8(1) allows for the promisor to give the third party an enforceable substantive right subject to a procedural condition (that enforcing that right must be by way of arbitration), which procedural condition can be waived by the promisor.  Section 8(1) does not provide a positive procedural right to the third party to insist on arbitration.

TT argued, in the alternative, that if s8(1) could not be used to bring about arbitration at the election of the third party, s8(2) must bring about this result so as to avoid fragmented dispute resolution.  Section 8(2) did not present TT with the same conceptual difficulties as s8(1) because a third party would only be treated as a party to the arbitration agreement if it chose to enforce the term which provides for disputes to be referred to arbitration.  However, the Court noted that s8(2) of the 1999 Act was only available where the contract, on its true construction, gives a third party a right to arbitrate (for example, where the contract gives the third party a unilateral right to arbitrate or a right to arbitrate a dispute other than one concerning a right conferred on the third party under s1 of the 1999 Act, for example, a tortious claim), and the third party has chosen to exercise this right.  Clause 17.11 in the Partnership Deed referred to disputes that "the parties hereto" are unable to resolve, without any indication that this was intended to refer to non-parties to the Partnership Deed. Clause 1.3 of the Partnership Deed provided that references in the deed to "parties" are references to parties to the Partnership Deed.  The Partnership Deed could have contained a provision entitling the third parties to insist that any claim against them by any party to the Partnership Deed in connection with or arising out of the Partnership Deed should be determined by arbitration, but it did not do so.

Practical implications

When so many transaction and finance documents now explicitly provide rights for third parties, the clarification provided by the Court of Appeal is important and welcome. The decision highlights the need for the parties to any agreement to give careful consideration to the way in which third party rights can be enforced and in which forum all disputes involving them are to be resolved.  The reasoning of the Court of Appeal makes very clear that the parties could have achieved the position for which TT argued by drafting to include not only the substantive rights to an exclusion and an indemnity but also the procedural right for third parties to insist on claims against them in connection with the Partnership Deed being brought in arbitration.  The case therefore provides a reminder that dispute resolution provisions should not be considered as "boiler plate" clauses or reviewed in isolation but should be water tight in all circumstances in which a dispute may arise in connection with the contract. 

For further information, please contact Nick Peacock, Partner, Hannah Ambrose, Professional Support Lawyer or your usual Herbert Smith Freehills contact.