Severability of Arbitration Clauses when the Underlying Agreement is Void Ab Initio

[Ankit Kapoor is a II Year, B.A. L.L.B (Hons.) student at the National Law School of India University, Bangalore]

Earlier last year, in Samyak Projects Private Limited v. Ansal Housing & Construction, a single judge of the Delhi High Court invalidated an arbitration clause as the underlying agreement was void ab initio. This represents a departure from the general rule of severability of arbitration clauses from invalid underlying agreements. This position has also been applied by the Supreme Court in Union of India v. Kishorilal Gupta, and has been repeatedly reaffirmed (e.g. Damodar Valley Corporation v. K. K. Kar; Indian Drugs & Pharmaceuticals Ltd. v. Indo Swiss Synthetic Gem Manufacturing Co. Ltd.).

However, this position has significantly relied upon the English judgment of Heyman v. Darwis, which the UK Court of Appeal overturned in Fiona Trust & Holding Corporation v. Yuri Privalov ([2008] 1 Lloyd’s Rep 254). Furthermore, an inconsistency in the Kishorilal Gupta approach has been observed, since the Supreme Court of India adopted a different stance in 2011 in Reva Electric Car Company Pvt Ltd v. Green Mobil, which has also found subsequent reaffirmation in Ashapura Mine-Chem Ltd v Gujarat Mineral Development Corporation.

It is relevant to re-examine the Kishorilal Gupta position, as its very origin has been overturned abroad, and different positions have seemingly been adopted in India itself. This re-examination becomes important as it: (1) provides certainty to the currently unclear expectations of commercial parties and associated institutions; and (2) determines the congeniality of the arbitration environment, by regulating the extent of state intervention. The current literature is silent on the final position following these new developments. Accordingly, in this post I argue that while posited law requires that the arbitration clause not be severed from the underlying agreement, it is normatively tenable to do so. Lastly, I argue that this change be pursued by judicial interpretation until an amendment can be introduced in Parliament.

Positive Legal Position

As mentioned earlier, this question first appeared before the Supreme Court in Kishorilal Gupta. Relying on Heyman v. Darwins, it held that when the underlying contract is void ab initio, the arbitration clause cannot operate on those disputes, for its operative force depends upon the existence and validity of the contract. The Court had held that when the underlying contract is void ab initio, the survival of the arbitration clause is implausible. This is because it would involve arbitrating the rights and liabilities of the parties to an agreement out of which no such rights and liabilities could ever flow (see Jaikishan Dass Mull v. Luchhiminarain Kanoria). As noted in Andritz OY v. Enmas Engineering Pvt. Ltd, “if an agreement is void ab initio, the arbitration clause contained in such an agreement would not be a life boat in a sinking ship but a lifeless boat in a ship which never commenced its voyage” [emphasis added]. This position is premised on the doctrine of ‘ex nihilo nihil fit’ (nothing comes out of nothing) and has been numerously affirmed by the Supreme Court (see Indian Drugs & Pharmaceuticals Ltd. v. Indo Swiss Synthetic Gem Manufacturing Co. Ltd.; Magma Leasing & Fin Ltd & v. Potluri Madhavilata.

However, the emerging contradictory position, as noted above, does not deplete the precedential value of this jurisprudence. First, in Fiona Trust, the Court held that the invalidity of the arbitration agreement should be based on direct independent vitiating factors rather than a parasitical challenge to the underlying contract (“Fiona Trust standard”). However, given Kishorilal Gupta, this stream of jurisprudence cannot be considered as posited law in India. More importantly, however, the context of its application is distinct from India. Statutory recognition to the judicial principle of severability is provided under section 16(1) of the Indian Arbitration and Conciliation Act, 1996 (the “Arbitration Act”), which is analogous to section 7 of the English Arbitration Act, 1996. However, the latter’s construction specifically includes situations where the contract “did not come into existence”, thus obligating the judiciary uphold severability even when underlying contract is void ab initio. On the other hand, the Indian statute’s construction provides discretion to the judiciary to determine the appropriate contexts of severability. As the Fiona Trust reasoning is based on statutory interpretation of a uniquely constructed foreign statute, the reasoning based on Heyman v. Darwins is not per se overturned in India.

Secondly, the Reva Electric stream of jurisprudence recognized severability, but did so in the context of a memorandum of understanding, and not a contract. By not engaging with the reasoning posited under Kishorilal Gupta or Fiona Trust, the judges in these cases implicitly acknowledge this peculiar context.  

Normative Position

In this section, I will undertake a two-fold normative analysis of the positive legal position: first, through legal principles and logical reasoning; and second, in light of public policy considerations.

Critical Legal Analysis

The observation that no rights and liabilities emerge from a void ab initio agreement is inaccurate. For instance, the right against unjust enrichment is guaranteed in all cases under section 65 of the Indian Contract Act, 1872. Furthermore, parties pleading that the agreement is non est factum can request for a ‘cancellation of the instrument’ under section 31 of the Specific Relief Act, 1963. These are examples of rights that have been statutorily accrued to parties even in cases of initial invalidity of the agreement, which entitle them to approach appropriate the tribunal for its enforcement.

While the Fiona Trust standard is legally inapplicable, it must be adopted as it principally sounder. It recognizes that the promises to arbitrate, though collateral, are distinct and independent from the underlying contract. While the contractual promise deals with an obligation to perform and compensate, a promise to arbitrate is to merely determine arbitration as the adjudicatory mechanism for the ensuing rights and obligations out of that agreement. Each promise is distinct in purpose and consequence, and thus the capacity to make each such promise must be viewed independently. Additionally, Lord Hoffman had noted in Fiona Trust that carving out an exception to severability may create a mischief. Parties who had willfully consented to arbitration may revoke such consent to favor traditional litigation that may better satisfy their momentary commercial interest.

Critical Policy Analysis

In terms of public policy consideration, the normative decision must be weighed against coherence with the state’s objective and consequence to immediate stakeholders. All three organs of the government have favored a pro-arbitration stance, wherein the objective has been to provide maximum effect to the consent of the parties and minimize state intervention. Commercial parties factor potential legal costs of enforcing their rights before they make investments. The complexity, expensiveness, and length of litigation disputes in India have increased potential cost of enforcement. Arbitration, on the contrary, due to its flexibility, inexpensiveness, and swiftness in dispute redressal has emerged as a viable alternative to commercial parties.[1] This is especially true for international commercial parties who, owing to their ignorance of domestic legal rules, need to hire domestic law firms, which further increases their transaction cost.

The position of most global investment hubs inter alia USA, UK, Singapore, and Switzerland has been to affirm the Fiona Trust standard. Investing parties clearly prefer arbitration to litigation;  thus, a broader assurance of severability would provide them with greater incentive to transact. As India seeks to attract more foreign investment, it must be mindful of rational commercial parties’ expectation, especially in an era of global competitiveness. Thus, to attract foreign capital it must conform to the same standard. To avoid blatant injustice, an order of the tribunal can in any case be challenged before a court under section 34 of the Arbitration Act.

Appropriate Mechanism for Change

As the normative position on this issue is to uphold severability even when the underlying contract is void ab initio, this section will consider the mechanism most appropriate to adopt this changed position. A statutory amendment to the Arbitration Act, so as to make its section 16(1) analogous to section 7 of the English Act, is the most appropriate means as it creates binding legal obligations without any scope for discretion, thus providing greater certainty to all parties. Furthermore, legislative enactments allow consultative dialogues with concerned stakeholders, whereby issues such as retrospective application and recognizable exceptions can be anticipated.

However, in the short-run, the judiciary can achieve this objective by overturning the Kishorilal stream of jurisprudence through a transformative interpretation of section 16(1) of the Arbitration Act. Section 16(1)(b) provides the scope for severability of an arbitration clause while leaving the extent of its application within the domain of judicial interpretation. So far, the Court has been using this discretion to invalidate the arbitration clause when the underlying contract is void ab initio. In keeping with the pro-arbitration policy, the Court can prospectively utilize its discretion to uphold severability akin to the Fiona Trust standard. 

Conclusion

The severability of an arbitration clause when the underlying contract is void ab initio is a question that has been numerously raised before the higher courts of India. While the position adopted since Kishorilal Gupta is still good law in terms of precedential value, it is normatively untenable as it is based on flawed legal reasoning and is inconsistent with the overarching arbitration policy.  

– Ankit Kapoor

[1] Blackaby Nigel, Constantine Partasides, et al in Redfern and Hunter on International Arbitration, An Overview of International Arbitration (6^th edn, OUP 2015) 15.