Vidya Drolia Case: Final Chapter in the Arbitrability of Fraud Saga?

[Sumit Chatterjee and Rajashri Seal are students at the National Law School of India University, Bangalore]

On 14 December 2020, the Indian Supreme Court delivered its judgement in Vidya Drolia v. Durga Trading Corporation (‘Vidya Drolia’), addressing a host of issues pertaining to the domestic arbitration framework in India. By laying down a definitive checklist to determine whether a particular dispute can be the subject matter of an arbitration, the Court brought much-required clarity to the growing debate surrounding the arbitrability of disputes based on their subject matter in the Indian context. 

While the decision covered multiple issues, like the arbitrability of tenancy disputes for instance, the judgement assumes great significance for its observations pertaining to the curious landscape of the arbitrability of fraud in India. In Vidya Drolia, the Court reaffirmed the presumption in favour of arbitrability even in matters relating to fraud, as was recently laid down in Avitel Post Studioz Limited v. HSBC PI Holding (‘Avitel’). The decision has finally brought an end to the previously held belief that an allegation of fraud would be a justifiable ground to refuse to refer a dispute to arbitration.

This post will analyse the position of law on the arbitrability of fraud in India before the Vidya Drolia decision. It will look at the shift in the approach of the courts in deciding such cases, and critically examine the cases which signalled such a shift. The courts moved from a cautionary approach, which refused any reference to arbitration on the mere allegation of fraud due to reasons of public policy, to a progressive, pro-arbitration approach which recognised the arbitral process as a fair and just alternative to traditional dispute resolution mechanisms. It will then analyse the decision in Vidya Drolia, and elucidate its effects on the fraud exception to the arbitrability of disputes in India.

The Curious Landscape of Arbitrability of Fraud in India: The pre-Vidya Drolia Position

In order to better appreciate the contribution of Vidya Drolia, it is important to situate it against the backdrop of earlier cases that have dealt with the issue at length. 

The first such decision was N. Radhakrishnan v. Maestro Engineers, wherein the Supreme Court held that a dispute would not be arbitrable if it involved “serious allegations of fraud”. The Court neither explicitly defined the scope of ‘serious allegations of fraud’ nor laid down a test to determine what makes an allegation a “serious” one. Rather, with reference to the case, it held that since the appellant had alleged that the respondent had committed malpractices in the account books and manipulated the finances of the partnership firm, the dispute could not be referred to an arbitrator. Hence, the allegations of financial impropriety were considered to be ‘serious’. However, as Shivam Singh argues, such an interpretation posed two problems. First, it ignored the statutory mandate of section 8 of the Arbitration and Conciliation Act, 1996, wherein a judicial authority before whom a subject matter is brought concerning the arbitration agreement is under a positive obligation to refer the parties to arbitration; and second, it exposed the Court’s lack of trust in the arbitration machinery’s ability to adjudicate specific types of disputes.  

Next came Ayyasamy v. Paramasivam. In this case, the Supreme Court laid down two paradigms for determining the seriousness of the alleged fraud. The Court held that mere fraud simpliciter would not nullify the arbitration agreement between the parties. This category would include those simple allegations which touch upon the internal matters of the parties concerned and have no bearing on the public domain. However, when the allegations make out a criminal case, or when such allegations are so complicated that they need to be examined by a civil court in light of the voluminous evidence that would be adduced, the court can dispose of the application under section 8 and proceed to examine the case on merits. The Court also said that in serious allegations of fabrication or forgery of documents, or where the fraud permeated the entire contract – including the agreement to arbitrate – or when the fraud affected the validity of either the entire agreement or the arbitration clause itself, the matter could not be referred to arbitration.

Thereafter, in Rashid Raza v. Sadaf Akhtar, the Supreme Court applied the principles from Ayyasamy and laid down a two-pronged test. First, it had to be determined whether the allegations of fraud permeated the entire contract, and especially the arbitration agreement, thereby rendering it void. Next it had to be determined whether the allegations pertained to the internal affairs of the parties inter se or whether they had an implication on the public domain. Since Rashid Raza pertained to a partnership dispute and the siphoning of funds, and there was no allegation which would have vitiated the entire partnership agreement, or more specifically, the arbitration clause, the Court referred the matter to an arbitrator.

The last such decision was Avitel. Herein, the Supreme Court interpreted the tests laid down in the cases post Ayyaswamy. It held that the first test is satisfied only when it is clear that the party against whom the breach has been alleged, could not have entered into the arbitration agreement in the first place, and thus, no arbitration agreement or clause can be said to exist. The second test is satisfied when allegations of “arbitrary, fraudulent, or malafide conduct” are made against either the State or its instrumentalities and thus, require to be heard by a court exercising writ jurisdiction, as the matters lie in the public domain. 

Vidya Drolia: Upholding the Presumption of Arbitrability

The Supreme Court in Vidya Drolia exposited the observations made in Avitel to address the two major justifications which supported the non-arbitrability of fraud, as were seen in N. Radhakrishnan. The first was the consideration of public policy, which made it imperative for any dispute where an allegation of serious fraud had been made, to be resolved in a public forum, such as a court of law.

In Vidya Drolia, the Court established that considerations of public policy affecting an arbitration were to be resolved after referring to section 34(2)(b) of the Act, which laid down the grounds on which an arbitral award can be set aside. It held that the justification for the fraud exception stemmed from misconstruing the grounds laid down under the said provision, as it was based on the premise that even if there existed no express or implied bar on a reference to arbitration under the mandatory law, the same could be applied on grounds of public policy.

The Court clarified the two reasons as to why such an interpretation was misguided, and defeated the very public purpose behind the Act. First, under section 34(2)(b), sub-sections (i) and (ii) lay down the grounds on which an award can be set aside. While sub-section (i) deals with cases where the subject matter is incapable of being decided by arbitration, sub-section (ii) states that any award in contravention of the public policy of India is liable to be set aside. It is therefore evident that the non-arbitrability of the subject matter of a dispute, and a conflict with public policy, are distinct and independent grounds for the setting aside of an arbitral award. As a result, a dispute would only be non-arbitrable on the grounds of a violation of the public policy if a statute granted exclusive jurisdiction for the courts, or a specialised tribunal; thus, barring a reference to arbitration under such a statute. In the absence of such a restriction, there must be a general presumption in favour of the arbitrability of any dispute. The underlying rationale behind the enactment of the Act is to promote and develop a robust arbitration framework, and it is the duty of the courts to ensure that the intent of the drafters is not defeated because of a misguided interpretation of protecting public policy.

Second, the Court demonstrated how a prohibition on the reference of a dispute to arbitration, based on an allegation of fraud essentially questioned the fairness and effectiveness of the arbitral process. Any prohibition on a reference to arbitration, based on an allegation of fraud, is based on the assumption that courts of law are better equipped to adjudicate such matters than an arbitral tribunal. However, such an understanding fails to acknowledge arbitration as a fair, just and impartial dispute resolution mechanism, which is tailored to provide parties with the best opportunity to present their case.

Furthermore, arbitration, as a party-driven process, also relies on the skill and expertise of arbitrators to decide a dispute in a fair and impartial manner. The arbitral process aims to ensure a just outcome to the parties, and the Act also provides adequate safeguards against any abuse in the arbitral process which the parties can rely on. Therefore, an a priori determination of non-arbitrability, based on the subject matter of the dispute, is flawed as it presumes that the arbitral process is not capable of providing the parties with a just and fair outcome.

Finally, the Court upheld the two-part test laid down in Ayyaswamy, which was further developed in Ramiz Raza as well as Avitel, and reconciled the same with its deliberation on the standard for determining the arbitrability of any dispute. It also overruled the decision rendered in N. Radhakrishnan, and laid down a comprehensive standard to determine whether a particular subject matter could be classified as non-arbitrable. The standard for non-arbitrability thus relied on factors such as, whether: (a) the dispute affects rights in rem, (b) it affects the rights of third parties, or requires central adjudication, (c) the subject matter has any relation to sovereign or public interest functions of the State, or (d) the mandatory law has expressly or implied barred any reference to arbitration.

In light of the same, the Court held that matters pertaining to fraud can be the subject matter of arbitration proceedings, provided the fraud does not “vitiate and invalidate the arbitration clause”, or raise questions which affect rights in rem and therefore necessitate adjudication in the public domain.

Conclusion

The Supreme Court’s jurisprudence on the arbitrability of fraud has been chequered, to say the least. However, it appears that the Court has clarified the uncertainty surrounding the position of law on the issue with its decision in Vidya Drolia, by reinforcing the presumption in favour of arbitrability and upholding the ratio laid down in Avitel. It also marks the end of the road for the ‘fraud’ exception, as the Court revealed the inconsistencies in prohibiting a reference to arbitration based on an a priori assessment of the subject matter of a dispute, such as an allegation of fraud. Hence, unless the underlying conditions of such a reference necessitate the adjudication of the dispute in a public forum, a dispute is arbitrable. This case will hopefully demonstrate the arbitration-friendly jurisprudence of the Supreme Court and its intent to recognise and promote the arbitral process as an alternate dispute resolution mechanism. 

– Sumit Chatterjee and Rajashri Seal