Doctrine of severability in arbitration: A brief review of Indian law and a proposed exception
When one thinks about the doctrine of severability in arbitration and its application by different courts in India, it would be safe to say that it has had a somewhat chequered history. Before the 1996 Act was enacted, the Supreme Court, in several decisions, had made it clear that an arbitration agreement was an integral part of the underlying contract and that it would cease to exist in the eventuality of the main contract perishing for either not being concluded or being void ab initio. Once the 1996 Act came into existence with the principles of severability and kompetenz-kompetenz being codified, issues of severability and kompetenz-kompetenz came up before the Court. In twocases decided in the early 2000’s, the Court in very certain terms held that in light of Sections 8 and 16 of the 1996 Act, it was not upto the court to decide the validity of the arbitration agreement. However, these rulings were soon undone when a seven Judge bench in the Patel Engineering case blatantly disregarded the principle of severability by holding that with respect to Sections 8 and 11 of the 1996 Act, there could not be a mechanical reading of the arbitration agreement by the concerned judicial authority, effectively meaning that questions of validity of the arbitration agreement could be looked into by the judicial authority before referring the matter for arbitration.
This article attempts to see whether the Apex Court has been consistent and correct in its application of the severability principle. It also makes an argument that the doctrine of severability should not apply in cases where the underlying contract suffers from illegality during its formation. However, this does not mean that the principle of kompetenz-kompetenz will not apply and the reasoning behind the same has been discussed.
Doctrine of Severability and its application by the Supreme Court
The Supreme Court’s current position on severability can be derived from an analysis of its judgments in the Enercon, World Sport Group and Ayyasamy cases. The Court has made it clear that there needs to be minimum judicial intervention and that any objections regarding the validity or existence of the arbitration agreement have to be considered by the arbitral tribunal in accordance with Section 16 of the Arbitration and Conciliation Act 1996. Before proceeding to briefly examining the application of this doctrine by the Courts, it would be helpful to see whether any decision has been able to tread a tightrope between capturing the essence of the doctrine as far as arbitration is concerned as well as ensuring that the powers of the court are not undermined.
An Ideal Interpretation of the Doctrine by the Court?
Unfortunately, the current position is not the one which was laid down in the Swiss Timing case, where a single judge bench of the Apex Court was successful in correctly applying the principles of severability as well as kompetenz-kompetenz. The Court while reiterating the fact that the arbitral tribunal was empowered to look into the validity of the arbitration agreement, made a distinction between contracts that were void and those that were voidable. It held that in those cases where the contention was that the contract was voidable, the arbitral tribunal should have the power to look into the validity in accordance with Section 16 of the Act. However, in cases where it could be seen that the contract was void or illegal and the same could be determined without looking into any detailed evidence, it would not be prudent to refer such cases for arbitration as it would save time and money of the concerned parties.
The Current Position: A case of subtle inconsistent interpretations
In Enercon v. Enercon GMBH, the Court made it clear that the question of conclusion of the main contract was irrelevant as according to the doctrine of severability, the existence and validity of the arbitration agreement was independent of the underlying contract. However, and more importantly, the court also held that under Section 45 of the Act, only in those cases where it could be proved that the arbitration agreement itself was ‘null and void, inoperative or incapable of being performed,’ would the court be in a position of not referring the matter to arbitration. While interpreting these terms, the Court held that they included situations and issues enumerated in Sections 14 to 20 of the Contract Act.
This means that when it is contended that an arbitration agreement is voidable due to misrepresentation or fraud, the court would be in a position to not refer the same to arbitration. This is problematic because not only is this in direct contravention of Section 16(1) of the Act which gives the Arbitral Tribunal the power to rule on the validity of the arbitration agreement, it also goes against the judgment of the SC in World Sport Group, wherein it was held that a contention by one party alleging fraud (Section 17 of the Contract Act) would not mean that the arbitration agreement was inoperative or incapable of being performed.
Unfortunately, this inconsistent and incorrect application of this doctrine can also be seen in cases where the issue of non-stamping of the contract has been raised. In April 2019, the Bombay HC, in Gautam Landscapes Pvt. Ltd. v. Shailesh Shah, followed the principle of severability and held that arbitration should not be stalled in light of the fact that the contract was insufficiently stamped. Providing interim relief since non-stamping of a contract was not a defect which could not be cured, the Court reiterated the correct position of law that Section 11(6A) only authorised the court to examine the existence of the arbitration agreement and once that was done, all other issues would be considered by the tribunal. This was in line with the object of Section 11(6A), which was to reverse judgments like Patel Engineering that had widened the scope of Section 11 and were in contravention of the kompetenz-kompetenz principle. However, this judgment was overruled by the SC within a few weeks in Garware Wall Ropers Ltd. v. Coastal Marine Constructions & Engineering Ltd. The Court held that a contract could not exist unless it was properly stamped. It used Section 7(2) of the 1996 Act to hold that the arbitration agreement existed within a contract and in accordance with Section 11(6A) the arbitration agreement would not exist if the contract did not exist.
There are two main problems with this decision of the court. First, the Court incorrectly observed that an arbitration agreement did not have a separate independent existence. It held, “...Indian Stamp Act applies to the agreement or conveyance as a whole. Therefore, it is not possible to bifurcate the arbitration clause contained in such agreement or conveyance so as to give it an independent existence...” Instead of adhering to the doctrine of severability and recognising what the Bombay HC had observed in Gautam Landscapes (that defect of stamp duty is not an incurable one) the court went ahead to rule that the arbitration agreement was not enforceable, something which should have been left for determination by the arbitral tribunal.
Second, the Court failed to follow the clear wording of Section 11(6A) which was inserted to counter the effect of judgments like Patel Engineering and SMS Tea Estates. It held that SMS Tea Estates was binding since it did not find any mention in the 246th Law Commission Report and hence was not excluded by Section 11(6A). Although this is extremely problematic, SMS Tea Estates itself held that non-stamping would result in the situation where the instrument could not be enacted upon. Hence, SMS Tea Estates recognised the existence of such a contract and merely commented on its enactment in law. This would also be in line with the fact that the legislature used the term ‘existence’ in Section 11(6A)
Illegality in the Underlying Contract: A Proposed Exception to the Severability Principle
An exception to the severability principle in arbitration needs to be illegal contracts. However, this should not have any effect on the kompetenz-kompetenz principle and accordingly, arbitral tribunals should have the power to rule on their own jurisdiction as well as decide upon the existence as well as validity of the arbitration agreements. As seen from the current position on severability from cases like Enercon and World Sport Group, the principle mandates that only a direct illegality in the arbitration agreement can prevent arbitration and that any illegality in the underlying contract would not have any effect on the arbitration agreement.
Therefore, it is important to clarify that the illegality being spoken about here is that which is seen at the stage of formation of the underlying contract and not any illegality that may be discovered subsequently by one of the parties. It is equally important to understand that the principle of severability is needed to prevent situations where parties might want to avoid arbitration and therefore might allege that the contract has become invalid due to multiple factors after the contract was formed. However, when it comes to the situation where the contract formation or legal capacity to enter a contract is under question, separating the underlying contract from the arbitration agreement in accordance with the severability principle and Section 16(1)(a) becomes problematic.
While the principle of severability and cases like Enercon ensure that courts do not have to look at the underlying contract, it is crucial to make a distinction between void and voidable contracts as was made in the Swiss Timing case as well as the World Sport Group case. This means that when there are allegations of the contract being voidable, severability and kompetenz-kompetenz need to be strictly applied and the matter should be referred to arbitration. However, when the allegations concern the very process of contract formation like the capacity to enter into a contract, it is crucial that the courts look into this at the referral stage itself as the same can have a bearing on the arbitration agreement being ‘null and void, inoperative or incapable of being performed.’
While this article encourages minimum judicial hindrance to the process of arbitration and reiterates that the principle of kompetenz-kompetenz is crucial, it is important that only where an allegation of illegality in contract formation has been made, should severability under Section 16(1)(b) be inapplicable; there should be a compulsory judicial review of the same and the arbitral tribunal’s decision regarding this finding is not considered final.
Perhaps cognizant of this issue, the Law Commission recommended that ‘existence’ in Section 11(6A) should include whether the agreement was null or void. However, this was not included in the final amendment. This article supports the fact that this was not included since, even though testing illegality is crucial, the solution does not lie in defying the kompetenz-kompetenz principle.
The hesitation of the legislature regarding this issue can be seen from a reading of Section 16(1)(b).It states that where a contract has been found to be null and void, the same should not ipso jure result in the invalidity of the arbitration clause. The arbitral tribunal would have to determine whether the illegality in the contract would have any effect on the arbitration agreement or not. Essentially, S. 16(1)(b) itself provides for an exception to the severability principle as an absence of such a provision would have allowed the arbitral tribunal to proceed irrespective of the illegality in the underlying contract.
An interesting argument that has not been considered by the courts is whether severability presumes the validity of the underlying contract or acts as a principle supporting kompetenz-kompetenz of the arbitral tribunals. It can be argued that the term ‘independent of the other terms of the contract’ under Section 16(1)(a) of the 1996 Act, has been included therein only for the purpose of preserving the kompetenz-kompetenz principle and not to presume the validity of the underlying contract.
Making the severability principle an exception in cases where an allegation regarding the very formation of the contract has been brought forward and ensuring that the decision of the arbitral tribunal is reviewable would not only be in consonance with the kompetenz-kompetenz principle but would also help prevent certain problems that have not been envisaged or discussed by the legislature. First, there have been concerns raised regarding the expertise and competence of arbitral tribunals to decide issues like the legality of contract formation by applying the relevant substantive and procedural laws. Second, certain ethical concerns have been raised regarding the arbitral tribunal’s powers to decide on the legality of the underlying contract as the arbitrators might benefit from the outcome. This might also result in a situation where the arbitral tribunal might not follow the ‘protection’ laid down in Section 16(1)(b) and might apply the severability principle even on finding that the underlying contract suffers from an inherent illegality which has an effect on the arbitration agreement also.
Finally, even though the SC has repeatedly stressed on the fact that judicial intervention at all stages be minimum, contracts that are illegally entered into are in direct contravention to the public policy of a country, something which arbitrators cannot be expected to protect. When there is illegality in contract formation, the severability doctrine actually allows the concerned parties to escape adjudication by the courts, something which courts should not allow.
In conclusion, the SC has been fairly inconsistent in applying the severability principle to arbitration agreements. When it comes to cases involving non-stamping of contracts, there is a tendency of the courts to sway towards a literal and extremely strict interpretation of statutes like the Stamp Act instead of finding unique ways of preventing problems of non-stamping by allowing the arbitration to continue while the contract is stamped to avoid unnecessary delay. It is crucial that the determination, in cases where the underlying contract is alleged to be illegal, is not left solely with the arbitral tribunal. Accordingly, it is important to amend Section 34 to provide for a judicial review in such cases to protect our public policy as well as not go against the principle of kompetenz-kompetenz by allowing the arbitral tribunal to determine the same before the review takes place.
[[i]] Atharv Gupta is a final year student at the National Law School of India University, Bangalore.
This article was reviewed by Snehal Dhote and Karina Katrak.
Preferred Citation –Atharv Gupta, “Doctrine of severability in arbitration: A brief review of Indian law and a proposed exception”, Arbitration & Corporate Law Review, Published on 30th December 2020.