Lex Mercatoria in International Commercial Arbitration

‘Support for the lex mercatoria and even wider general principles appear to be growing steadily among writers and those professionally involved in arbitrations…. this is the vision, promise and usefulness of lex mercatoria’ [1]

With the tremendous growth in international trade, international commercial arbitration has become a frequently-used mechanism to settle contractual disputes with the parties opting for arbitration instead of litigation, evident from the growing number of arbitration clauses present in contracts and the judicial proclivity for upholding arbitration clauses. Advantages of arbitration are many. First, arbitration is a speedier and less expensive mode of dispute resolution. Secondly, with the party autonomy given priority over everything else in cases of arbitration, parties have the discretion to appoint arbitrator or other fact finders they deem fit, competent and experienced in the particular business area. One additional advantage of arbitration, the parties’ ability to predetermine the law governing the resolution of the dispute, has gained growing recognition in recent years. [2] The clause signifying the substantive law to be applicable is often referred to as the ‘choice of law’ clause.

This power to determine the substantive law provides flexibility to the parties and enables them to reach at a consensus regarding the particular law after thorough negotiation and analyzing the pros and cons of every legal system, calculating the risks involved and choosing the one that will lead to a favourable outcome.

However, arriving at a consensus is not always that easy and uncomplicated with the result that the arbitration agreement is silent on the substantive law to be applicable. Sometimes this inability motivates the choice of ‘general principles of law’ with the parties believing that such a selection will lead to neutral and unbiased outcomes. Parties also sometimes supplement their choice of the law or avoid it altogether by referring to lex mercatoria. [3]

Parties power to choose the substantive law applicable are provided in the arbitration laws of the majority of the jurisdictions. For instance, under the English law the power to choose the applicable substantive law can be found under Section 46 of the English Arbitration Act, 1996, under Article 17(1) of the ICC Arbitration Rules and in the Indian law it can be found under Section 28 of the Arbitration and the Conciliation Act, 1996 [4] . The law dealing with the power to choose the substantive law, both under the English law and the Indian law, has been modeled on Article 28 of the UNCITRAL Model law [5] .

Section 28(1) (b) of the act provides that in cases of international commercial arbitration the substantive law designated by the parties shall be applicable. However, in the absence of such a designation the arbitral tribunal shall apply the rules of law it considers to be appropriate given all the circumstances surrounding the dispute by trying to infer the intention of the parties or by choosing that system of law which the transaction has its closest and most real connection. [6]

This section has been modeled on Article 28 of the model law. However, Section 28(1) which deals with the law applicable in cases of domestic arbitration has been enacted by the Indian legislature and was not present under the Model law. Section 28(1)(b)(i) and (ii) correspond to the Article 28(2) of the Model law albeit the content and the intent of the two provisions being radically different. Article 28(2) of the Model law mandates that in case of absence of designation of law by the parties the arbitral tribunal shall apply the law determined by the conflict of law rules which it considers applicable. But section 28(1)(b)(iii) is a notch liberal and provides for a freedom of choice to the arbitral tribunal and enables the tribunal to apply the rules of law it considers to be appropriate given all the circumstances surrounding the dispute. [7]

However, as stated earlier, the parties may fail to designate the rules of law applicable to the substance of the dispute. This is not problematic in cases of domestic arbitration since Section 28 clearly provides that the substantive law existing in India shall be applicable. However, in cases of international commercial arbitration the discretion lies with the arbitral tribunal who has the default power to apply the rules of law it considers to be ‘appropriate’ bearing in mind all the circumstances surrounding the dispute and trying to look for the law that parties are presumed to have intended to choose. The section also provides that the tribunal shall take into account the terms of the contract taking into account the usages of the trade applicable to the transaction. [8]

Jurists are of the opinion that in when exercising discretion in such situations the arbitral tribunal should not resort to either municipal laws or international laws for dealing with international commercial disputes when the different parties are involved. They believe that a national legal system is insensitive to the expectations of a disputing party from a different national legal background and international law is not adequate to deal with cross border transactions. [9]

There have been several instances, when the choice of law does not designate the specific substantive law, the arbitral tribunal has decided the case in accordance with lex mercatoria, perhaps equating it with the concepts drawn from their own legal experience or commercial background and their awards have been held to be enforceable under various jurisdictions where significant tests have arisen.

This paper shall deal with lex mercatoria and its application as substantive law in cases of international commercial arbitration. This paper proposes that arbitral tribunal should apply the principles of Lex Mercatoria, where the parties have failed to designate a specific substantive law, in order to achieve an equitable and a neutral outcome.

Lex Mercatoria

Lex Mercatoria, meaning literally ‘merchant law’ evolved as a system of custom and practice and represents the body of trading principles used by merchants throughout Europe during the medieval times. For a long time it has functioned as the international law of commerce and boasts of contractual freedom, alienability of property and devoid of legal technicalities with main emphasis on promotion of trade and commerce. [10]

The Lex Mercatoria broadly speaking has emerged from the equity clauses incorporated in International Commercial contracts, expressed in sufficiently wide terms authorizing arbitrators, in determining disputes, applying criteria transcending the national law of a country. Lex Mercatoria aims to allay fear existing in minds of the parties, especially the parties belonging to a different national legal background, relating to the local laws by assuring them that the dispute shall not be prejudicial to any of the parties and shall lead to a neutral outcome. [11] The biggest advantage of Lex Mercatoria is that it is neither a national law nor an international law but is a mixture of both.

Two approaches are generally considered when it comes to the principle of Lex Mercatoria. The autonomist concept regards Lex Mercatoria as having autonomous character independent from any national system of law. The positivists, on the other hand, believe that Lex Mercatoria in itself is not comprehensive and even though it is transnational it exists only by virtue of state laws and is therefore ultimately founded on national law. [12]

In order to determine what is lex Mercatoria one needs to determine the sources and the content of Lex Mercatoria.

Sources and content of Lex Mercatoria

There is a controversy amongst the proponents of the lex mercatoria concerning the sources from which it is drawn and the relative importance of the sources they deem admissible. In such a case it becomes important how one defines the concept of Lex Mercatoria. It includes mercantile customs formulated by international bodies such as the International Chamber of Commerce (e.g.INCOTERMS, rules for documentary credits), the usages of international trade and general principles of law [13] . Those which are in favour of some sort of flexibility in application of lex Mercatoria argue that it comprises of public international law, uniform laws, the general principles of law, and rules of international organizations, standard form contracts and reported arbitral awards. [14]

Lex Mercatoria is still in the making and cannot be considered to be a uniform codified set of laws. Owing to the differences existing with regards to the sources of lex Mercatoria it is not surprising that dispute exists with regard to the content of Lex Mercatoria.

According to JH Dalhuisen, lex mercatoria consists of hierarchy of norms which ought to be followed while applying them to settle a commercial dispute. Lex Mercatoria constitutes of the following in a descending order, i.e. fundamental legal principles, mandatory custom, mandatory uniform treaty law, the contract (or party autonomy in matters at the free disposition of the parties), directory custom, directory uniform treaty law, general principles largely derived from comparative law like ICC Rules, residually, domestic laws found through conflict of laws rules. According to JH Dalhuisen this hierarchy should be strictly applied in the order in which it is given. [15] .

However, not everyone agrees with the Dalhuisen’s approach and contend. Another list of elements was proposed by Professor ole Lando and Lord Mustill. It is impossible to provide an exhaustive list of all the elements of Lex Mercatoria. Some argue that it does not consist of any list owing to its dynamic character. [16]

Even though the question relating to the content of lex Mercatoria is unsettled its contribution to the resolution of international commercial disputes cannot be undermined.

Lex Mercatoria as substantive law

Lex Mercatoria does not find place in any sort of legislation in the world. Nor does it trace its existence to the Model law. The concept of Lex Mercatoria has emerged mainly from the arbitration clauses in international commercial contracts which are referred to as the ‘equity clauses’. These clauses sometimes clearly provide that the arbitral tribunal in deciding the dispute may not be bound by the strict principles of law and may resort to principles of equity and fairness, commonly referred to as ex aequo et bono. [17]

These equity clauses, permitting the arbitral tribunal to apply principles of equity and fairness and not be tied by strict interpretation of the arbitration agreement, have at times been challenged in the court of law as offensive to public policy. However, the view has been pretty much unanimous. In Eagle Star insurance Co v. Yuval insurance Co. Ltd [18] , Lord Denning commenting on the validity of such equity clauses, opined that

‘the clause seems to me to be entirely reasonable. It does not oust the jurisdiction of the court. It only ousts technicalities and strict constructions. This is what equity did in the old days and it is what arbitrators properly do under such a clause.

The international law association adopted a resolution at its 1992 conference in Cairo according to which arbitration awards based on transnational rules rather than a particular law are enforceable either when the parties have agreed that the arbitrator may apply transnational rules or if the parties have remained silent concerning the applicable law. [19]

Advantages of Lex Mercatoria:

Lex Mercatoria has been seen as a tool to clarify, to fill gaps, and to reduce the impact of peculiarities of individual countries laws and even International laws, often not designed for cross border transactions at all.

A lot of times the parties themselves specify a particular national system of law as its choice of substantive law in arbitration. The reason behind the choice is obvious. National legal system is a complete general body of law that aims to provide solutions for every legal conundrum. Moreover, it also provides certainty by making it easier for the parties to easily determine the law in case of a particular situation. However, its potential loss of neutrality prevents it from being used that often in arbitration. A national legal system may provide unfair advantage to one party and may control the outcome of the arbitration. Moreover, national legal systems do not possess the sophistication sufficient to handle issues in a complex international commercial transaction. By designating one particular system of law the parties are prevented from using the principles or method present in other systems and therefore are confined to one system even though it may be against the principles of equity and fairness. [20]

Similarly, international law also suffers from various drawbacks resulting in its diminished use as substantive law in arbitration. Various international treaties and conventions have attempted to set forth trade facilitating rules like the United Nations convention on contracts for the international sale of goods (CISG). CISG promises to be a neutral body of law thereby removing the problem of bias which exists in the case of national laws. However, CISG has been a result of various international compromises in an attempt to accommodate various legal systems of its contracting states. Moreover, CISG is not exhaustive and independently fails to address a lot of issues. It needs another general body of law to supplement and fill the gaps. For instance, The CISG does not apply to issues of validity, such as unconscionability, mistake, duress, and fraud. [21]

Lex Mercatoria promises to fill these gaps and provide an exhaustive set of laws capable of resolving international commercial disputes.

The main advantage of the law is its adaptability according to the needs of modern international commerce and its uniform applicability.

There are two immediate advantages to such rules of law. First, reflect real business needs and interests. Lex Mercatoria takes due account of the needs of international intercourse and permits cross fertilization between systems that be unduly wedded to conceptual distinctions and those that look for a pragmatic and a fair resolution in the individual case. [22] Secondly, they would be of uniform application and so avoid the vagaries of national laws. In cases of international commercial arbitration there is no need to localize the applicable law. Restricting the usage of applicable law to one particular national law does not yield result in cases of international commercial arbitration. By not constraining oneself to national laws the arbitrators unlike the judges have the authority and discretion to apply the law in the way they deem fit and give priority to equity and fairness over anything else. Application of Lex Mercatoria also eliminates the search for the proper law of contract or more generally the rule of conflict of laws. [23]

Moreover, flexibility of lex Mercatoria becomes more useful especially in long term contracts where the rights and the duties of the parties vary with time, where unforeseen circumstances may arise and where the parties involved are businessmen and not adversaries. [24]

Criticism of Lex Mercatoria

The Lex mercatoria has sufficient intellectual credentials to merit serious study, and yet it is not so generally accepted as to escape the sceptical eyes. Therefore, even though Lex Mercatoria has brought about enormous contribution to the field of international commercial arbitration, views on the applicability of the same has not been unanimous and has been met with cynicism.

Scholars believe that by allowing the arbitral tribunal to decide on some non-national standard such as general principles of law, lex Mercatoria or the law of international trade grants discretion and flexibility with respect to the applicable but correlatively provides it with a diminished level of guidance. The arbitrator while referring to such vague principles is forced to abandon a simple application of specific and certain rules. Therefore application of principles like Lex Mercatoria may provide discretion and flexibility to the arbitrator and give priority to equity and fairness but it does rob arbitration of certainty which cannot be undermined by the advantages. [25]

Moreover, scholars argue that Lex Mercatoria is not completely autonomous as it is proposed to be. Lex Mercatoria has been criticized to be insufficient in form and substance and it turns to national legal order for its implementation, its substance and its efficacy. It is thus well recognized that both national legal orders and the international legal order support and contribute to the lex mercatoria and “in so doing enhance its efficiency. Without this supplementary and complementary role of the national legal order, lex Mercatoria may prove on its own to be a set of inoperative rules. [26]

According to Philip D O’ Neill Jr and Nawal Salam, the problems associated with the new Lex Mercatoria, may be broadly divided into three basic categories. First there is no clear consensus on its sources. Secondly, the scope of application is unclear. It is difficult to ascertain where and when should lex Mercatoria be applied. Thirdly, Lex Mercatoria is not exhaustive and lacks content.

Some scholars have even doubted its existence and claim that there Lex Mercatoria lacks practicality and is a mere academic issue. Scholars like Kieth Highet have argued that lex Mercatoria is nothing but an enigma. It does not exist to the extent that scholars and practitioners talk about it and identify it. [27] Lex Mercatoria has been an idea as one whose time has passed since more sophisticated laws and rules now exist. [28]

Inspite of the criticisms, it must be accepted that the Lex Mercatoria has made remarkable impact upon the law of international commercial arbitration. It has attracted attention because it offers a pragmatic give and take approach amongst merchants shorn of all legal formalisms. With further development it can independently provide a certain and definite set of rules to deal with international commercial disputes in a manner more effective than the national or international legal system.