Pre-Deposit Clauses in Arbitration Contracts: Analyzing the LombardiEngineering Case

[Suyash Pandey is a third year B.A., LL.B. (Hons.) student at the National Law School of India University, Bangalore]

Recently, the Supreme Court (‘SC’) in Lombardi Engineering Limited v. Uttarakhand Jal Vidyut Nigam Limited  has invoked Article 14 of the Constitution of India to test the validity of the pre-deposit arbitration agreement between Lombardi Engineering (‘LE’) and Uttarakhand Project Development and Construction Corporation Limited (‘UPDCC’). A pre-deposit arbitration agreement requires the claimant to deposit a certain percentage of the claimed amount to initiate arbitration proceedings.

While the case came up as an application under section 11(6) of the Arbitration and Conciliation Act, 1996 (‘the Act’) for the appointment of arbitrators, the SC, further consolidating its recent trend of expansive jurisdiction under the Act’s section 11(6) applications, analysed the existence and validity of the arbitration agreement between parties to hold that the impugned clause of pre-deposit falls foul of the standard of manifest arbitrariness under Article 14 of the Constitution. The invocation of the arbitrariness doctrine can be attributed to the public nature of UPDCC since private parties are not subject to the arbitrariness doctrine. In doing the above, the author argues that the SC wrongly relied upon its observations in the judgement of ICOMM Tele Ltd. v. Punjab State Water Supply and Sewerage Board. Further, he argues that while the SC furthered its powers under section 11(6) of the Act at the stage of appointment of arbitrators, it misapplied the law in reaching its decision, thereby delivering an undesirable outcome.

Entrenching the Powers under Section 11(6) of the Act

It is well-established that one of the underpinning rationales of the Act is to ensure minimal court intervention. The idea of minimal court intervention is an extension of the party autonomy principle, which provides that the courts should respect the choice of procedure agreed between parties and, thus, shall respect their choice for the election of arbitration proceedings.

However, such a deferential attitude is not inappropriate in the context of clauses where the public interest is brought into question. One such situation concerning public interest could be when the arbitration clause violates the Constitution itself. Particularly in agreements involving the State and its instrumentalities, such as the one at hand, it has been constantly held that the actions of these entities shall be in consonance with the Constitutional principles, including the arbitrariness doctrine. In the present case, the court aptly goes into a Kelsenian analysis of the hierarchy of laws, placing the Constitution as the Grundnorm. It held that the arbitration agreement among parties is subjected, not only to the Grundnorm, that is the Constitution, but also to the Arbitration and Conciliation Act and/or any other state or central legislation. Thus, the layers of Grundnorm in the context of arbitration agreements include the abovementioned categories.

The aspect of the judgement determining the jurisdiction of the SC in the Act’s section 11(6) applications clearly defined the contours of inquiry. It also consolidated the movement of the SC towards a thorough and conclusive determination of the existence and validity of arbitration agreements at the Act’s section 11(6) stage itself. This movement becomes important in light of the controversial history behind the power of courts at this stage. For example, in 2015, the parliament introduced section 11(6A) of the Act which required the jurisdiction of courts to the “examination of the existence of an arbitration agreement”. While, interestingly, this section was deleted in 2019, the SC decisively held in Vidya Drolia v. Durga Trading Corporation that only a “prima facie review” is conducted during the referral stage. The purpose of the prima facie assessment is to identify arbitrable conflicts and clearly and ex-facie non-existent and unlawful arbitration agreements. It is not a comprehensive review. In any event, section 11(6-A) of the Act and the rationale behind its presence continued to direct a court’s jurisdiction at the referral stage even after it was deleted, due to the Vidya Drolia judgement.

Recently, however, the position of law has begun to shift. For example, it has been propounded in the case of Magic Eye Developers Pvt. Ltd. v. Green Edge Infrastructure Pvt. Ltd. that a comprehensive review of the validity of the arbitration agreement can be undertaken by the courts at the stage of appointment of the arbitrator itself. Such an approach of the SC has been forthcoming and is also essential considering that the determination of the legality of the arbitration agreement is fundamental to the entire process. Determining such legality at the threshold stage saves the time, cost and energy which might have gone into conducting the entire process, only for the agreement to be struck down at a later stage. Thus, the instant judgement plays a key role in furthering the evolving jurisprudence of a comprehensive review of arbitration at the initial stage itself.

However, while the SC significantly delineated the contours of section 11(6) of the Act, and, thereafter, used manifest arbitrariness under Article 14 of the Constitution to decide the legality of the impugned clause, it failed in the application of the law on pre-deposit clauses, rendering a decision that goes against the principle of party autonomy: which is a foundational principle of arbitration.

The SC’s Misreading of ICOMM: Suggesting a More Prudent Interpretation

As mentioned above, while the judgement seeks to consolidate the powers of the courts at the initial stage, it falters in the application of the law to determine the legality of the pre-deposit clause.

In the facts of the present case, clause 55(a) of the agreement between parties provided that:

“…the Party initiating the arbitration claim shall have to deposit 7% of the arbitration claim in the shape of Fixed Deposit Receipt as security deposit.”

A security deposit has been defined by the Black’s Law Dictionary as a protection, assurance, or indemnification given by a debtor to assure the payment of performance of his debt, by furnishing the creditor with a resource to be used in case of failure of the principal obligation. The definition has also been relied upon by the Calcutta High Court. In fact, the Delhi High Court has defined a security deposit as a ‘refundable deposit amount’. However, the Court failed to account for these definitions in interpreting the clause between parties. It held that in the absence of any clause stipulating the refund, the term security deposit does not mean a refundable deposit.  It is submitted that the interpretation should have, instead, been guided by the idea that in the absence of any clause to the contrary, a security deposit clause entails a refund of the deposit. Such an interpretation would have been conducive to the principles of party autonomy and minimal court intervention. If the court had interpreted the term ‘security deposit’ used in the clause as being a refundable/adjustable sum of money, the procedure that was decided by the parties at the time of signing the agreement would have been upheld, and the interjection of the court, to the extent of discarding these provisions, would have been avoided.

Moreover, in reaching the above conclusion on the arbitrary nature of the present clause, the SC misunderstood the ratio of the ICOMM judgement. Paragraph 42 of Lombardi seeks to lay down the ratio of ICOMM as holding that “pre-deposit conditions in the arbitration clause are violative of Article 14 of the Constitution of India being arbitrary”. However, in ICOMM, the impugned clause did not provide for a complete refund but rather sought to provide the refund only in proportion to the amount awarded with respect to the amount claimed. The remaining balance was forfeited. The judge in ICOMM criticised this aspect of the clause to stipulate that it deters the parties from initiating arbitration, rendering the process ineffective and expensive- which goes against the object of the Act. It is submitted that the understanding of ICOMM employed by the present court is sweeping in that it per se declares pre-deposit clauses arbitrary. Instead, the ratio of ICOMM is limited to the extent that pre-deposit clauses with forfeiture of money are arbitrary as they discourage the parties from resorting to arbitration.

Now, given the understanding of a security deposit expounded above, the SC should have rather sided with an interpretation that not only respected the party autonomy principle but also sent out positive signals to the international business community. It was held in the case of Voestalpine Schienen GmbH vs. DMRC Ltd that such a duty is higher in cases where one of the parties to the agreement is government (UPDCC in the present case). Such an interpretation, upholding the pre-deposit of security for initiation of arbitration, has been taken by the court in the case of S.K. Jain v. State of Haryana. In the said case, the court was faced with a pre-deposit clause stipulating the adjustment of the deposited money in the outcome of the arbitration. The court held that the said stipulation in the agreement is to preclude frivolous arbitral claims, and is, thus, reasonable. A similar approach in the present case would have been more prudent and in consonance with the principles of arbitration law as explained above.

Concluding Remarks

Therefore, the present judgement presented an opportunity for the Supreme Court between the cases of ICOMM and S.K. Jain. While the court relied upon the former to hold that pre-deposit agreements are violative of Article 14 of the Constitution, I have argued that such an understanding of ICOMM is flawed. The ratio of ICOMM, I have contended, is merely limited to pre-deposit clauses that involve the forfeiture of deposited money. Instead, the court, in order to render a decision in consonance with the principle of party autonomy should have relied upon S.K. Jain, along with the understanding of the security deposit expounded above. Since S.K. Jain stands for the legality of pre-deposit clauses which stipulate the adjustment of the deposited money with the final outcome of the arbitration and a ‘security deposit’, as explained above, has been interpreted by courts as a refundable deposit, a reliance on this understanding would have furnished a decision in line with the foundational principles of arbitration by upholding the agreement in the present case.

– Suyash Pandey

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