Authors: Paul Starr, James McKenzie and James Wang
The Hong Kong Government published its highly anticipated Code of Practice of Third Party Funding of Arbitration (“Code”) on 7 December 2018.
The Code and the Government’s announcement that the operative parts of the newly amended Arbitration Ordinance (“AO”) will no longer be “under construction” and will come into effect on 1 February 2019. The changes usher in a new era of arbitration practice for Hong Kong, bringing the jurisdiction into line with other leading arbitration seats and providing new possibilities for legal financing of arbitration in Hong Kong.
As noted in our earlier article dealing with the Law Reform Commissions report, the reform has the potential to have an outsized and important impact on Hong Kong’s construction arbitrations.
Now that the final reforms are about to be enacted and the Code released, we set out below details of that Code and key takeaways for the construction industry from the final passage of reform.
I. Code of Practice
On 30 August 2018, the Department of Justice issued the draft Code of Practice for Third Party Funding of Arbitration and Mediation and launched a two-month public consultation to seek views on the draft Code. On 7 December 2018, the Code of was published along with a press release announcing that the amendments to the AO will come into effect on 1 February 2019.
A. To whom and how does the Code apply?
The Code applies to “third party funders”, as defined in section 98J of the AO: any person who is party to an agreement in writing to fund a party to arbitration proceedings and who does not have a legitimate interest in the dispute other than via the funding agreement.
The Code applies to any funding agreement commenced or entered into on or after 7 December 2018.
B. What are funders’ obligations?
- Funding agreement
A funder must ensure the funded party knows it is entitled to take independent legal advice, explain clearly in the funding agreement its key features and terms, provide a Hong Kong address for service and set out the name and contact details of the advisory body.
- Capital adequacy
A funder must maintain capacity to pay all its debts and cover its aggregate funding liabilities for a minimum of 36 months, as well as maintain access to at least HK$20 million of capital. A funder must also provide the advisory body with an audit opinion or reasonable evidence from a “qualified third party” (preferably an auditor) that the funder satisfies the minimum capital requirement.
- Conflicts of interest
A funder must maintain effective procedures for managing conflicts of interest and must not take any steps that may cause the funded party’s legal representative to act in breach of its professional duties.
- Confidentiality and legal professional privilege
A funder must observe the confidentiality and privilege of all information and documentation relating to the arbitration and the subject of the funding agreement.
The funding agreement shall set out that the funder will not seek to influence the funded party/its lawyers, take steps that cause the funded party’s lawyers to breach their professional duties, or seek to influence the tribunal.
A funder must remind the funded party of its obligation to disclose information about the funding.
- Liability for costs
The funding agreement must state whether, and to what extent, the funder will be liable for the funded party’s costs, including adverse costs, costs insurance premiums, security for costs and any other financial liability.
- Grounds for termination
The funding agreement must state whether the funder may terminate it, in the event that the funder reasonably: (i) ceases to be satisfied about the merits of the claim; (ii) believes there has been a material adverse change of the funded party’s prospects of success; or (iii) believes the funded party is in material breach of the agreement. The agreement must not give the funder a discretionary right to terminate in any other circumstance. The funded party may terminate the funding agreement if it reasonably believes that the funder has committed a material breach of the Code or the agreement which may lead to “irreparable damage”.
There are also several miscellaneous provisions which require a funder to: (i) make sure its promotional materials are clear and not misleading; (ii) in the funding agreement, provide a neutral, independent and effect dispute resolution mechanism; (iii) maintain effective procedures for complaints; and (iv) submit annual returns to the advisory body of any complaints or any failure to comply with the Code or Division 5 of Part 10A of the AO.
C. What are the consequences of non-compliance with the Code?
Failure to comply with the Code will not result in judicial or other proceedings. However, the Code is admissible in evidence before a Hong Kong court or arbitral tribunal.
II. Key Takeaways for the Construction Industry
With most construction contracts in Hong Kong containing arbitration clauses, the reforms are likely to significantly affect the construction industry and disputes concerning it. We think some the key takeaways from the reform are as follows:
A. Access to arbitration as a means of dispute resolution
Frequently, funding construction disputes lies with claimant sub-contractors who have neither the financial means nor resources to pursue potential claims against their often larger and more deep-pocketed contractor employers.
Accessibility to third party funding is likely to free up otherwise encumbered cash flow for these industry participants and has the potential to increase the number of claims brought in arbitration, allowing meritorious claims to be brought that might not have been able to without the support of such funding.
Third party funders can also assist impecunious contractors or sub-contractors in managing resources during a project. With such assistance, the contractor or sub-contractor can avoid having to allocate or find funds to deal with the claim.
B. Construction claim risk and administration
Third party funding will also allow construction industry claimants to spread their risk by not bearing the whole cost of bringing or defending a claim.
As major infrastructure disputes often involve multiple upstream or downstream disputes, portfolio financing and funding (which is a popular option with various funders) can allow holistic funding and management of disputes arising from projects. Our firm can work closely with funders to help infrastructure claimants best structure both their risks and achieve more favourable terms in funding. Such “portfolio funding” of consecutive or single project claims drives down funder costs which can be reflected in significantly more favourable pricing or profit sharing for the funded claimant.
Another advantage of third party funding to the construction industry will the mere presence of a funder, which can assist in discouraging vexatious or oppressive interlocutory applications or discovery processes which are often used by defendants to stifle a seemingly impecunious claimant’s claim in arbitration. Where a claimant is funded, its deeper pockets can allow it to expend the necessary legal costs to deal with these applications and may therefore discourage such applications being taken out in the first place.
A further corollary benefit is in the settlement of claims: knowledge of a funding arrangement (which is required to be disclosed by section 98U of the AO) may promote settlement by increasing the defendant’s perception of the claim’s strength.
C. Pick your funder and know your rights
Although there are now established players in the Hong Kong funding market, the passage and anticipated entry into force of the amended AO is likely to encourage other funders to enter the market.
Construction claimants should therefore take care in choosing any funder and should ensure they meet the Code’s the capital adequacy requirements and are financially able to see a claim through. A funder’s internal financing can vary significantly: some are publicly listed, some are backed by high net worth individuals whilst others have lines of credit available to them. The nature of a funder’s financing structure can affect not only its ability to maintain necessary funds but may influence its approach to management of claims. Different funders will focus on cases of different claim sizes, types and in differing jurisdictions.
Parties to a funding agreement should also be aware of potential risks that may arise from the agreement. In particular, although the Code requires the funder to observe the confidentiality and privilege of all information and documentation, construction industry claimants should still consider the effect on legal professional privilege of the funding agreement and documents provided to the funder in order to assess the claim.
In addition, construction industry claimants should do their due diligence on any funder and independent legal advice should be sought on the funder and the funding agreement. Our firm has relationships and depth of knowledge of the key funders in the market and can assist with this.
Potential conflicts of interest should be a key area of concern to construction parties seeking to use a third party to fund an arbitration.
One area of concern arises where a funder pays the legal costs directly. Although the Code requires the funding agreement to set out clearly that the funder will not seek to influence the funded party’s legal representative, the claimant should still be aware of the risk that the claimant’s lawyer may be unduly influenced by the funder and therefore favour the funder's interests and views over those of the claimant beyond the terms set out in the agreement.
This should militate that those construction industry claimants accepting funding carefully consider the nature and extent of a funder’s control over proceedings. The claimants should ensure the funding arrangement complies with the Code’s requirements on conflicts of interest and control.
With 1 February 2019 fast approaching, the construction industry must get ready for a new playing field for third party funding of construction arbitration.
In doing so, construction claimants should take particular care to examine all funding options and models as there remain key differences between funders and their level of involvement where a funding arrangement is agreed.
Including without limitation the matters set out in Part 10A of the AO and in the Code.
Subject to such mode of service as may be agreed with the funded party
The funded party has no obligation to disclose details of the funding agreement except as required by the funding agreement, or as ordered by the arbitration body, or as otherwise required by law.