Third-Party Funding: Rational Economic Actors and the Investment Arbitration System Should Protect Against Potential Ill-Effects
By David L. Earnest, Shearman & Sterling LLP
Third-party funding in investment arbitration is here to stay. The question, therefore, is how best to address issues that may arise with the involvement of third-party funders. Chapter 8 of the Draft Report of the ICCA-Queen Mary Task Force on Third-Party Funding in International Arbitration (the “Draft Report”) presents a timely and necessary review of the central issues that the international investment law community is grappling with. This blog entry is intended to explore some of themes in Chapter 8 of the Draft Report.
First, even if a foreign investor can rely on an investment treaty to assert a claim, the ability to initiate arbitration is typically accompanied by at least one other condition precedent: the capacity to pay for legal counsel. Since many claimants are in the difficult position of having lost their investment completely, and the crucial business revenue or capital it provided, third-party funding is seen as “an essential tool for facilitating access to justice” (Draft Report at p. 158). This concept of “access to justice” is buttressed by the fact that investment arbitration is likely the only neutral, and therefore viable, legal forum available to a foreign investor to seek relief from a sovereign respondent. The question, therefore, becomes, does the notional benefit of “access to justice” outweigh the potential ill-effects, namely frivolous claims, which can potentially arise with third-party funding? This leads to the next topic.
Second, does third-party funding create or inhibit frivolous claims in investment arbitration? If, as the Draft Report discusses, third-party funders are actually more conservative and conduct thorough due diligence on the merits of a claim (Draft Report at p. 161), shouldn’t claims that proceed with the backing of third-party funding have heightened legitimacy? On the one hand, in purely economic terms, the answer should be yes: the business model of third-party funding would not work otherwise. The risk a third-party funder faces in losing its investment in the claim should, in principal, lead to an objective culling of unmeritorious or frivolous claims. On the other hand, risk is, of course, subject to one’s appetite, and whether a claim proceeds will ultimately depend on the individual motives of the claimant and the third-party funder. Perhaps more importantly, there are legitimate concerns that third party funders work on the principle of portfolio investing, which may increase the risk of funding frivolous claims. In the investment space, the portfolio effect refers to the decrease in overall risk in a portfolio of high-risk, but (relatively) uncorrelated assets. This means funders hedge the risk of any one given claim by investing in a portfolio of claims, which helps them deliver substantial average returns, even if some claims may fail abjectly. With this said, and putting economics and risk to one side, empirically speaking, there is no evidence that third-party funding in and of itself results in frivolous claims (Draft Report at pp. 159-160). Additionally, the risk of frivolous claims is not unique to investment arbitration, but has been has long been a concern with litigation funding in national courts (Draft Report at p. 161). Yet, this particular concern is diminishing, as can be seen from the recent relaxation or elimination of prohibitions against funding international arbitrations in some important jurisdictions, most notably Hong Kong and Singapore (Draft Report at p. 3). For argument’s sake, however, isn’t the investment arbitration system equipped to handle a situation where a “privateer” – under the guise of a third-party funder – backs a truly frivolous claim?
Third, investment arbitration tribunals can, and should, use the tools they are already equipped with to remediate, and therefore discourage, frivolous claims. Unlike most litigation or even international commercial arbitration, investment treaties contain significant procedural and substantive requirements to establish a tribunal’s jurisdiction or the admissibility of a claim. Indeed, the ICSID Arbitration Rules, the Dominican Republic-United States-Central American Free Trade Agreement (CAFTA-DR), the United States-Peru Trade Promotion Agreement (PTPA), the Comprehensive Economic and Trade Agreement (CETA) between Canada and the European Union, among others, all empower investment arbitration tribunals to make a dispositive award based on preliminary objections to an allegedly frivolous claim. Thus, to protect against frivolous claims advancing too far down the procedural path, a tribunal’s jurisdiction and the merits of the claims must be thoroughly vetted to ensure they meet the threshold requirements.
In addition to the foregoing, what is potentially the most blunt and effective tool in a tribunal’s arsenal is to issue a costs award against a spurious claimant. Investment arbitration tribunals have recognized that they have this power (see e.g. Transglobal v. Panama, ICSID Case No. ARB/13/28, Award, 2 June 2016, para. 126 (“The starting point for the Tribunal in a case of abuse of process is that Claimants should bear the costs of the proceeding and attorneys’ fees and expenses of Respondent, provided that the latter are reasonable.”); Adel A Hamadi Al Tamimi v. Sultanate of Oman, ICSID Case No. ARB/11/33, Award, 27 October 2015, para. 477). While this may be effective against a claimant, the prospect of a significant costs award may not deter an unscrupulous third-party funder if it has not contractually assumed that liability. After all, the funder is a “third-party” to the dispute and therefore outside the jurisdiction of the tribunal. Moreover, while an ICSID tribunal has previously issued a security for costs order against an impecunious claimant backed by a third-party funder (RSM Production Corp. v. Saint Lucia, ICSID Case No. ARB/12/10, Decision on the Respondent’s Request for Security for Costs, 13 August 2014), this is the only security for costs order ever issued by an ICSID tribunal and this occurred in “exceptional” circumstances generally unrelated to the third-party funder’s involvement. Thus, while costs awards can be an effective tool to admonish frivolous claims, there is the potential for them to miss their mark if the third-party funder is insulated from liability. This highlights the Draft Report’s interesting principles on security for costs (Draft Report at 114-15), which suggests a mechanism for disclosure of funding agreements and the funder’s obligation to cover adverse costs.
Overall, in view of the foregoing, the benefits of third-party funding should outweigh any potential ill-effects that can and should be moderated by the investment arbitration system itself. The Draft Report is a welcome commentary that offers a number of guiding principles for the international investment law community, and third-party funders, to take into consideration going forward.
The author is an attorney at Shearman & Sterling LLP. The views expressed herein are those of the author only and shall not be attributed to Shearman & Sterling LLP or its clients.