Arbitration under International Cotton Association rules

The claimant, a legal person established in Hong Kong, and the respondent, a legal person in mainland China, entered into a sales contract in April 2019. The contract stipulated the respondent would purchase Mexican cotton from the claimant, with a total price of USD1,042575.82, CIF Shanghai.

The agreed payment method was an irrevocable letter of credit. The contract incorporated the bylaws and rules of the International Cotton Association (ICA); any related obligations were to be governed by China’s laws, and disputes were to be resolved by the Shanghai International Arbitration Centre (SHIAC).

However, the claimant’s import registration certificate expired, resulting in a failure to complete the import customs clearance procedures. Additionally, the issuing bank refused to honour the letter of credit, citing the claimant’s short shipment of goods. After rounds of negotiations, the claimant stored the goods and underwent commodity inspection.

However, the two parties could not reach agreement about the collection of the goods. Consequently, the claimant demanded payment from the respondent, but the respondent neither paid nor retrieved the goods. As a result, the claimant decided to resell the cotton.

The claimant initiated arbitration proceedings with the SHIAC, and argued the respondent failed to fulfil its obligations for receipt and payment under the sales contract, thereby causing losses to the claimant. It contended that, in accordance with article 237 of the ICA Rules (2018 edition), the disputed contract should have been terminated on 1 October 2019.

Furthermore, according to article 238 of the ICA Rules (the settlement clause), the respondent should compensate the claimant for the difference between the contract price and the market price on the termination date, and cover the claimant’s losses for the import customs clearance and customs taxes it paid on behalf of the respondent.

The respondent argued that the application of the ICA’s bylaws and rules was contingent upon the parties explicitly designating arbitration and choosing to apply the ICA’s bylaws and rules, along with English law, to resolve disputes. The respondent contended that:

• The contract and the arbitration clause modified the mandatory applicable law provisions of the ICA bylaws, thereby effectively excluding their application;
• The claimant breached the contract first; and
• The ICA’s settlement clause contradicted the principle of damages for breach of contract under Chinese law and should not be applied.

The tribunal’s view

After the hearing, the arbitration tribunal concluded that the core of the dispute between the two parties lay in:

• The application of the bylaws and rules of the ICA in the case;
• The application of ICA’s settlement clause; and
• The determination of the liability for breach of contract.

For the first issue, the tribunal noted the sales contract’s arbitration clause specified the SHIAC and application of the bylaws and the rules of the ICA for arbitration. Despite article 300 of the ICA bylaws and rules (2018 edition) stating that arbitration should be conducted under English law in the UK, the parties had reached a written agreement to change the arbitration venue to the SHIAC in Shanghai while retaining the substantive part of the ICA bylaws and rules. This agreement was reaffirmed by both parties during the proceeding, reflecting their genuine intention.

Therefore, the respondent’s claim that the parties had entirely excluded the application of the ICA bylaws and rules by excluding ICA’s arbitration procedure clause was unfounded.

The tribunal further held that when the parties agreed to apply the bylaws and rules of the ICA in the contract, it could be understood as incorporating the substantive rules of the ICA bylaws and rules into the sales contract. As long as this incorporation did not violate mandatory or prohibitive provisions of the applicable law – which, in this case, was Chinese law – the substantive rules of the ICA bylaws and rules should be applied in the case.

Regarding the second issue, the tribunal held that, first, the ICA’s bylaws and rules, including the settlement clause and the return invoice rules, were widely adopted by the international cotton trade and constituted the industry’s global practice.

Secondly, judicial practice in mainland Chinese courts, recognising and enforcing arbitration awards made under the ICA Rules, in many cases has proved that the ICA’s settlement clause does not contravene China’s public policy, and the effectiveness of such awards is acknowledged by mainland Chinese judicial authorities.

Thirdly, articles 237 and 238 of the ICA Rules stipulate that the breach of one or both parties does not affect the validity and application of the ICA’s settlement clause agreed upon by the parties.

This means the application of the settlement rule is not restricted by the provisions relating to liability for breach of contract under China’s Contract Law. Considering the agreement of the parties, Chinese legislative provisions and China’s judicial practice, the tribunal concluded that ICA’s settlement clause did not violate China’s mandatory provisions or public policy. Therefore, it held the settlement clause in the ICA bylaws and rules should be applied to the case.

Accordingly, the tribunal determined that the settlement amount should be calculated as the difference between the price agreed in the contract and the market price of cotton, or cotton of similar quality on the date of termination, multiplied by the quantity agreed in the sale contract.

For the third issue, the tribunal held that although the settlement demanded by the claimant was not bound by liability for breach of contract under Chinese law, the provisions of Chinese laws agreed by the parties should still apply to matters other than the settlement, such as payment of goods and fulfilment of customs declaration obligations.

The tribunal concluded that although the claimant could, under the IAC Rules, demand settlement, it was still in breach of the contract due to the expiration of its registration certificate as an overseas supplier of imported cotton, and the shortfall in the claimant’s goods. According to Chinese law, the claimant does not have the right to hold the respondent liable for non-payment of the purchase.

Takeaways

This is an exemplary case of the application of international commercial transaction rules in arbitration. It fully reflects the characteristics of commercial arbitration mechanisms, such as expert determination, party autonomy and flexible procedures.

In this case, the parties chose a comprehensive set of international commercial trading rules that included applicable norms (English law) and arbitration procedure law (arbitration in the UK).

However, they also agreed on the quasi law (China law) and arbitration institutions (Chinese arbitration institution), resulting in multiple procedural and substantive conflicts. This posed a challenge for the arbitration institution and arbitration tribunal to accurately conduct the arbitration procedure and apply the laws.

The starting point for the arbitration institution and the tribunal was to strictly respect the autonomy of the parties and seek the “greatest common divisor” in procedure and substance. This involved applying the rules of Chinese arbitration institutions, the substantive rules of international trade and the substantive laws of China.

The practice of harmonising the conflicts among various legal rules, based on fully respecting the parties’ autonomy, is also a fundamental philosophy of international arbitration.

Conflict in contract terms deserves the full attention of businesses. When engaging in international trade, Chinese enterprises often encounter the application of international trade rules or foreign laws. These rules and legal texts may contain business rules and practices that Chinese enterprises are unfamiliar with.

When drafting contract terms, Chinese enterprises should familiarise themselves as much as possible with the core provisions in these trade rules, ensuring consistency between the substantive provisions in trade rules and the laws applicable to the transaction, as well as consistency between the provisions concerning dispute resolution procedures in trade rules and the dispute resolution provisions of the contract.

Xu Zhihe is the deputy head of the Department of Research and Information at SHIAC