The new DIS supplementary rules for third-party notices in arbitration

August 2024 | SPOTLIGHT | LITIGATION & DISPUTE RESOLUTION

Financier Worldwide Magazine

August 2024 Issue

On 15 March 2024, the German Arbitration Institute (DIS) introduced supplementary rules for third-party notices in DIS arbitration proceedings. The supplementary rules allow parties to an arbitration to include a third party in the proceedings and ensure that the third party is bound by the arbitral tribunal’s findings such that it cannot contest those findings in subsequent proceedings.

The ‘recourse trap’ and functions of third-party notices

In a complex economy based on a division of labour, disputes are rarely limited to only the two parties facing each other in court or arbitration proceedings. If one party to a contract – the claimant – succeeds in holding the other party – the respondent – liable for a breach of contract, the respondent will often have recourse claims against one or more third parties.

If, for instance, an automobile manufacturer (customarily referred to as an OEM in the automotive industry) purchases a component from its tier 1 supplier and the component has a defect, the OEM will typically raise warranty claims against its contractual partner, the tier 1 supplier. If, however, the defect is attributable to a part of the component that was supplied by a tier 2 supplier, the tier 1 supplier may have a recourse claim against its contractual partner, the tier 2 supplier.

Allocating the damage caused by the defective part to the party ultimately responsible for the defect – the tier 2 supplier – may, therefore, require two subsequent court or arbitration proceedings: one by the OEM against the tier 1 supplier and, assuming the OEM is successful, another by the tier 1 supplier against the tier 2 supplier. Being both the target of the OEM’s claims and the owner of a potential recourse claim against the tier 2 supplier, the tier 1 supplier finds itself confronted with several challenges, as outlined below.

First, the tier 1 supplier will have to defend against the OEM’s claim but may not be in possession of the technical information regarding the tier 2 supplier’s part required for a successful defence. As far as the alleged defect of its part is concerned, the tier 2 supplier is evidently better positioned to mount a defence.

Second, while the tier 1 supplier will prefer to await the outcome of the OEM’s proceedings before asserting its recourse claim, the tier 1 supplier may have to initiate proceedings against the tier 2 supplier earlier to suspend the statute of limitations and prevent its claim – at that time still contingent – from becoming time barred.

Third, and most importantly, a decision in the OEM’s proceedings against the tier 1 supplier holding that the tier 2 supplier’s part was defective will not ensure that the tier 1 supplier succeeds with its recourse claim. This is because the judgment in the first proceedings has no res judicata effect for the tier 2 supplier.

The court or arbitral tribunal deciding on the tier 1 supplier’s recourse claim is not bound by the judgment in the first proceedings and, thus, may come to a different conclusion regarding the defectiveness of the part. The tier 1 supplier may thus lose in both proceedings.

This situation – which is sometimes called the ‘recourse trap’ – is where, in state court proceedings, the rules on third-party notices come into play. The German Code of Civil Procedure, for example, gives the tier 1 supplier the ability to include the tier 2 supplier in the OEM’s proceedings by serving a third-party notice.

As the recipient of a third-party notice, the tier 2 supplier has the option to join the OEM’s proceedings as an intervenor and to support the tier 1 supplier in its defence against the OEM’s claim. If the tier 2 supplier joins the proceedings, this may ameliorate the tier 1 supplier’s information problems. Notably, the tier 2 supplier may not plead facts or rely on legal arguments that conflict with the tier 1 supplier’s pleadings.

The third-party notice suspends the statute of limitations regarding the tier 1 supplier’s recourse claim, thereby removing the need to initiate separate proceedings against the tier 2 supplier before the OEM’s proceedings are completed.

The most important effect of a third-party notice, however, is that the recipient – in our example, the tier 2 supplier – will be bound by the court’s decision in the OEM’s proceedings. This effect is not limited to the court’s ruling (i.e., its disposition of the OEM’s claim) but extends to the court’s decision on preliminary questions of fact or law, such as the determination that the tier 2 supplier’s part was defective.

Third-party notices, thus, serve an important function in state court proceedings. They help avoid multiple (successive) proceedings on the same issues and reduce the risk of conflicting decisions, thereby facilitating an efficient conduct and resolution of complex disputes.

The ‘recourse trap’ in arbitration

The ‘recourse trap’ can occur in any proceedings – including arbitration. Yet, neither the arbitration laws of most jurisdictions nor the rules of arbitration of the major arbitral institutions contain provisions on third-party notices. The DIS has sought to fill that gap. By introducing supplementary rules, which are modelled after the provisions in the German Code of Civil Procedure, the DIS has become the first major arbitral institution to give parties to DIS arbitration proceedings the option to issue third-party notices.

Advantages compared to a joinder

Most institutional rules of arbitration offer parties the right to join third parties as regular parties to the proceedings. A joinder may, however, not always be the best option. In particular, the respondent may be reluctant to join a third party as a regular party to the proceedings. This may be the case because the respondent’s recourse claim against the third party is not yet due or quantifiable.

Another reason not to join the third party may be to avoid a ‘two-front battle’ (i.e., defending against the claimant’s claims while simultaneously seeking to rebut the third-party’s defence). The respondent may want the third party to have a more limited role that is confined to supporting its defence against the claimant.

By limiting the role of the third-party to that of an intervenor, the supplementary rules offer an attractive alternative to a joinder in these situations.

How to agree upon the supplementary rules

Since arbitration proceedings are based on the consent of their participants, a third party cannot validly be involved in arbitration proceedings without its own consent and that of the opposing party. The supplementary rules, therefore, aim to ensure that parties to the arbitration proceedings consent to the involvement of a third party, and that third party’s consent to the binding effect of the arbitral award issued in those proceedings.

The incentives for the respondent in agreeing to the supplementary rules seeking to involve a third party – the tier 1 supplier in our example – are clear. They help the respondent avoid the perils of the ‘recourse trap’. The claimant – the OEM in our example – may itself want to involve one or more third parties in the proceedings (e.g., if it is unclear which of several tier 1 suppliers is responsible for the defect).

Under the supplementary rules, the costs of a third-party notice are to be allocated only between the party giving the notice and the third party. Accordingly, the claimant’s cost risk in the proceedings will not increase due to a third-party notice by the respondent. The third-party may be incentivised to agree to the supplementary rules because supporting the respondent in its defence against the claimant’s claim may allow it to avert its own liability to the respondent and, thereby, avoid the costs of subsequent proceedings.

To this end, they grant the third party, inter alia, the right to be heard and to be treated fairly. The latter requires that the third party is allowed to participate in the nomination of the arbitrators.

The supplementary rules provide model clauses which can easily be agreed upon. They can, in principle, be agreed upon under any statutory arbitration law. The rules must be agreed upon by the potential parties to the initial arbitration as well as the potential third party. For the initial proceedings, the supplementary rules must be combined with a DIS arbitration clause. There is no such requirement regarding the venue of potential subsequent proceedings against the third party. Those proceedings may be conducted under the arbitration rules of another institution or in state court.

Like an agreement to arbitrate, the supplementary rules can be agreed with respect to a particular dispute (before or after it has arisen), all disputes arising out of a particular transaction or project, or as a framework agreement that applies to all disputes arising between the parties.

Summary

The supplementary rules provide a fair and balanced framework for parties to complex disputes to avoid the ‘recourse trap’ and resolve their dispute more efficiently while taking advantage of the benefits offered by arbitration proceedings. Accordingly, the rules make arbitration an even more attractive dispute resolution mechanism for complex disputes involving multiple parties.

Carsten van de Sande and Antonia Hösch are partners and Anna Kaehlbrandt is an associate at Hengeler Mueller. Ms van de Sande can be contacted on +49 69 17095 or by email: carsten.vandesande@hengeler.com. Ms Hösch can be contacted on +49 69 17095 706 or by email: antonia.hoesch@hengeler.com. Ms Kaehlbrandt can be contacted on +49 69 17095 399 or by email: anna.kaehlbrandt@hengeler.com.

Carsten van de Sande, Antonia Hösch and Anna Kaehlbrandt

Hengeler Mueller