PRC LAW DOES NOT PROHIBIT THIRD PARTY FUNDING FOR ARBITRATION, COURT DECISIONS SAY

In two related decisions, different PRC courts have upheld third party funding arrangements for arbitration, finding that they were not prohibited by PRC law or the CIETAC Rules and did not provide valid grounds to challenge an award.  In a third decision, a third party funding arrangement for litigation was held to be invalid because it violated public policy.

These are the first cases in which the PRC courts have considered certain specific issues in the context of third party funding, including disclosure, conflicts of interest, confidentiality and public policy.  The decisions underline the pro-arbitration approach adopted by many PRC courts in recent years, whilst also suggesting greater caution in relation to the use of third party funding in the litigation sphere.

TWO POSITIVE DECSIONS ON THIRD PARTY FUNDING OF ARBITRATION

The first two decisions arose out of a CIETAC arbitration concerning a dispute under an aircraft operating lease agreement.  The claimant used third party funding to fund its claims and successfully obtained an award in its favour in December 2021.

Grounds of challenge

The award debtors challenged enforcement of the award in Jiangsu Wuxi Intermediate Court, including on the ground that the use of third party funding violated the confidentiality of the arbitration ((2022) Su 02 Zhi Yi No. 13).

The award debtors also applied to Beijing No. 4 Intermediate Court to set aside the award ((2022) Jing 04 Min Te No. 368).  Two of the four grounds relied upon related to third party funding.  The award debtors argued that:

• The third party funder was aware of the substantive and procedural issues in the arbitration and (especially given its disclosure obligations as a listed company) could disclose the outcome of the arbitration, which violated the confidentiality of the arbitration; and
• The co-arbitrator appointed by the award creditor had failed to disclose that the law firm he worked for had business dealings with the actual controller of the shareholders of the third party funder, giving rise to a conflict of interest.

Decisions

Wuxi Intermediate Court rejected the enforcement challenge in May 2022, holding that the use of third party funding in the arbitration did not violate the CIETAC Rules or the confidentiality of the arbitration.

Beijing No. 4 Intermediate Court dismissed the application to set aside the award in a detailed decision rendered in November 2022.  The court considered Article 281 of the PRC Civil Procedure Law (which provides the legal basis for challenging a foreign-related award) and reviewed several issues relating to third party funding of arbitration.  In particular, the court held that:

1. Third party funding of arbitration is not prohibited by PRC law. The key question was whether the third party funding of the arbitration violated PRC law, the arbitration rules or the integrity of the arbitration.  The court answered each of these questions in the negative.  The court also opined that the parties had a right (provided they complied with any relevant laws) to involve third party funders,  akin to their right to engage legal counsel or experts of their choice.
2. There was no breach of disclosure obligation or conflict of interest. The disclosure obligation of an arbitrator arose when the arbitrator knew or ought to know of circumstances which might cause justifiable doubts as to his or her independence and impartiality.  If the arbitrator was not aware of the circumstances in question and they did not affect the arbitrator’s independence and impartiality, there would be no breach of the disclosure obligation.  In the present case, the law firm where the challenged arbitrator served as a consultant did not itself have business dealings with the shareholders or actual controllers of the third party funder.  Rather, the arbitrator’s law firm was a member of an association of independent firms.  The law firm cited by the award debtors was another independent law firm member of that association located in a different jurisdiction to the arbitrator’s law firm.  These facts were not sufficient to establish a conflict of interest on the part of the arbitrator.
3. Existence of funding was disclosed. Although there is currently no express legal obligation to disclose the existence of third party funding under PRC law, the court noted with approval the fact that voluntary disclosure was made in this case (which it said protected the right of the tribunal and the counterparty to relevant information).  The court also went further and indicated as a general matter that it would encourage parties to voluntarily disclose the existence of third party funding.
4. There was no breach of confidentiality. The key to the confidentiality of an arbitration was to protect information about the case from being disclosed to the public.  The mere fact that certain non-parties to the arbitration (such as a third party funder, a shareholder of a party, or a tribunal secretary) were aware of such information did not necessarily breach the principle of confidentiality.

A MORE CAUTIOUS APPROACH TO THIRD PARTY FUNDING OF LITIGATION

The approach of the arbitration-related decisions discussed above contrasts with the more cautious approach taken by at least one PRC court in relation to third party funding of litigation.

In May 2022, Shanghai No. 2 Intermediate Court found a third party funding arrangement for litigation to be invalid because it violated public policy ((2021) Hu 02 Min Zhong No. 10224).

The funding agreement was concluded in 2017 between the funded party, the funder and a law firm (which was a related party of the funder).  The agreement obliged the funded party to engage the law firm to represent it in the litigation, and provided that the funding arrangement should be kept confidential.

The funded party succeeded in the litigation but refused to pay the funder its 27% share of the proceeds (as stipulated in the agreement).  As a result, the funder commenced PRC court proceedings.

At first instance, the court held the funding agreement to be invalid because it violated public policy. The funder then appealed to Shanghai No. 2 Intermediate Court, which upheld the decision of the first instance court and rejected the appeal.

As a starting point, the court noted that there was no established rule of PRC law in relation to third party funding of litigation, and opined that it should therefore be prudent when deciding on the validity of the agreement.

The court then found that the agreement was contrary to public policy based on its specific terms.  In particular:

1. The fact that the funder and the law firm were related parties hindered the effective legal representation of the funded party because the law firm would not be independent, especially where conflicts arose between the funded party and the funder.
2. The court suspected that the agreement was an attempt to circumvent applicable PRC regulations limiting the contingency fees which may be charged by lawyers. Pursuant to current PRC regulations, a contingency fee payable to a lawyer is not allowed to exceed 18% (at a maximum) of the amount in dispute (and this percentage is progressively reduced as the amount in dispute increases).  The funding agreement in this case, however, essentially enabled the law firm, through its related party funder, to recover 27% of the amount received by the funded party.
3. The agreement could enable the funder to exercise excessive control over the ligation, infringing the freedom of the funded party to retain counsel of its choice or exercise other rights in relation to the litigation.
4. The existence of the confidentiality clause providing for non-disclosure of the litigation funding agreement was harmful to the good order of litigation.

Finally, the court was concerned that the use of third party funding in litigation was contrary to good morals because it would induce the parties to initiate litigation at a low cost instead of choosing other dispute resolution mechanisms.

COMMENTARY

As always when seeking to draw lessons from PRC court decisions, it is important to bear in mind that no precedential value attaches to the decisions discussed above (because PRC courts are not required to follow any previous decisions except those published by the PRC Supreme People’s Court as Guiding Cases).

The decisions nevertheless provide a helpful indication of the attitudes of PRC courts to third party funding and related issues.

Both the Beijing court and the Shanghai court adopted the same starting point for their analysis (namely, the lack of express regulation of third party funding), yet reached very different conclusions as to whether third party funding is allowed in arbitration and litigation respectively.

At least in part, that appears to have been a result of the starkly different facts which were before the two courts.  In particular, two of the key concerns expressed by the Shanghai court were the relationship between the funder and the law firm, and the agreement not to disclose the existence of the funding arrangement.  Neither of those points arose in the Beijing proceedings.  Indeed (and on the contrary), there was voluntary disclosure of the funding arrangement, and this appears to have been a factor which provided comfort to the Beijing court in ruling that the arrangement did not invalidate the award.

Moreover, the scope of the decisions was different.  The Shanghai court was asked to rule on the validity of the litigation funding arrangement itself, whereas the Beijing court was asked to rule as to whether the existence of the arbitration funding arrangement provided grounds to set aside the award.  A degree of caution should therefore be exercised in drawing comparisons between the two cases.

Taken together, however, the decisions suggest that the attitude of the PRC courts to third party funding is similar to the legislative approach adopted in some other major jurisdictions, with a (relatively) more permissive attitude in relation to third party funding of arbitration contrasting with greater caution in relation to third party funding of litigation.

While each case will be determined on its own facts, the decisions also illustrate some of the key factors that are likely to be taken into account by the PRC courts in assessing the legal implications of third party funding arrangements.  These include the nature of any relationship between the funder and the law firm representing the funded party and the disclosure (or otherwise) of the funding arrangement.  Pending express regulation of the issue, the decisions underline in particular that it would be good practice in relevant cases to voluntarily disclose the existence of third party funding arrangements, in order to minimise the risk of subsequent successful challenge to the awards.

This article has been authored by Herbert Smith Freehills Kewei, a joint operation between Herbert Smith Freehills LLP and Kewei Law Firm based in the Shanghai Free Trade Zone.

For more information, please contact Weina Ye, International Partner, or Kathryn Ye, Associate, of Herbert Smith Freehills Kewei Joint Operation.