SEVERABILITY OF ARBITRATION

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 (6th edn,
OUP 2015) 15.