ARTICLE
2 June 2021

Arbitrability Of Fraud Disputes In India- Supreme Court's Attempt To Solve The Intriguing Puzzle

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RPV Legal

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Globally, arbitration is the most convenient and preferred mode for the resolution of commercial disputes since it offers a timely resolution of disputes, procedural flexibility, confidentiality, neutrality and...
India Litigation, Mediation & Arbitration

Introduction

Globally, arbitration is the most convenient and preferred mode for the resolution of commercial disputes since it offers a timely resolution of disputes, procedural flexibility, confidentiality, neutrality and most importantly, the execution of arbitral awards in countries that are signatory to the New York Convention. However, it is not immune from unsettled issues, making it necessary for the Courts crease out the wrinkles. One such vexed issue is whether frauds are arbitrable? or to put it alternatively whether matters involving serious allegations of fraud should only be tried by the court of competent jurisdiction and the parties should not be relegated to arbitration?

Questions regarding the arbitrability of fraud have always been highly contentious. Having said that, this article focuses on the arbitrability of fraud, more particularly the inconsistency in judicial pronouncements in India relating to the arbitrability of fraud, by examining the judgments starting from pre-independence India. The article also analyses the repercussions of the conflicting decisions of the Supreme Court and the Court's final attempt to correct the error in its recent landmark judgment in Vidya Drolia & Ors. v. Druga Trading Corporation1 ("Vidya Drolia") and N.N. Global Mercantile Pvt. Ltd. v. Indo Unique Flame Ltd. & Ors2("NN Global").

The Abdul Kadir Era

The erstwhile legislation of Arbitration & Conciliation Act, 1940 ("1940 Act") did not provide exclusivity regarding any category of cases that can be treated as arbitrable or non-arbitrable. However, the courts in India have on many occasions rendered judicial pronouncements which demarcated the arbitrable disputes from non-arbitrable.

The first authoritative precedent on the subject, fraud was laid down by the Supreme Court in Abdul Kadir Shamsuddin Bubere v. Madhav Prabhakar Oak3 ("Abdul Kadir"). The judgment was pronounced within the broad contours of the (now repealed) 1940 Act. The Court while deciding whether serious allegations of fraud have been levelled against a party, held that where serious allegations of fraud are made against a party and the party who is charged with the fraud desires the matter to be dealt in an open court, that would be sufficient ground for the court to not order an arbitration agreement to be filed and not to make a reference. However, merely because some allegations have been made that books of accounts are not correct or that certain items are exaggerated, would not be enough to induce the court to not make a reference to arbitration. The Court while placing reliance on an English judgment in Russel v Russel4 held that it is only in cases of allegations of fraud of a 'serious nature' that the court would refuse the reference to arbitration.

This judgment marked the beginning of an era and has been the basis of various decisions of High Courts and Supreme Court for over the next five decades, where frauds of 'serious nature' remained covered under the blanket exception of arbitrability.

Evolution of Jurisprudence on Arbitrability of Fraud after the advent of Arbitration & Conciliation Act 1996 Act ("1996 Act").

The N Radhakrishnan Case

The decision of the Supreme Court in Abdul Kadir was although good in law, however, it was rendered in context to the 1940 Act. The Court in Sundaram Finance Lt. v NEPC India Ltd5 has held that the 1996 Act is very different from the 1940 Act. The provisions of the 1996 Act have, therefore, to be interpreted and construed independently. In light of the same, it became necessary that the global practices of arbitration were in sync with the current legislation. After the advent of the 1996 Act, there wasn't any major judicial pronouncement by the Supreme Court in context to the arbitrability of fraud until 2010 in N. Radhakrishnan v M/s. Mastero Engineers & Ors.6 ("N Radhakrishnan")

In N. Radhakrishnan, the parties had entered into a partnership deed to carry on engineering works under the name of "Maestro Engineers". Eventually, disputes arose between the parties, and serious allegations of malpractices in account books and manipulation of finances were leveled by one party against the other. An Application was filed under Section 8 of the 1996 Act to refer the parties to the arbitration. The Supreme Court in this case, after relying on its former decision in Abdul Kadir, held that the matters of serious allegations of malpractices in account books and manipulation of finances of partnership firm cannot be decided by the arbitrator. The Court held that matters involving serious allegations of fraud should be tried in a court of law as it is was more competent and have the means to decide such complicated matters.

Attempt to correct the error

The decision of the Court in N Radhakrishnan was declared per incuriam in Swiss Timing Ltd v Organizing Committee5 ("Swiss Timings") in 2014. The Court held that the judgment in N Radhakrishnan does not lay down the correct exposition of the law and cannot be relied upon vis a vis on two grounds:

a. The Supreme Court while rendering the judgment in N Radhakrishnan ran counter to its previous decisions in Hindustan Petroleum Corpn. Ltd. v. Pinkcity Midway Petroleum's ("Hindustan Petroleum") and P. Anand Gajapathi Raju v. P.V.G. Raju("P. Anand Gajapathi"). In Hindustan Petroleum, this Court held that if there existed an arbitration clause in an agreement between the parties to the dispute, it would be binding for the civil court to refer the disputes to an arbitrator. Similar views were also expressed by the Court in P. Anand Gajapathi. However, the ratio laid down in the aforesaid cases was not taken into consideration or brought to the notice of the Court.

b. Moreover, the provisions contained in Section 16 of the 1996 Act, which lays down the cardinal principles of arbitration i.e. principle of severability and doctrine of kompetenz – kompetenz was also not considered by the Court.

Subsequent Rulings that marked stride in the right direction

Test to determine "seriousness of fraud" evolved in Ayyasamy case: In 2016, the Supreme Court in the case of A. Ayyasamy vs. A. Paramasivam8 ("Ayyasamy") conceptualized dual criterion to assess the arbitrability of fraud, bifurcating the allegations of fraud into fraud simpliciter and complex frauds. The Court observed that the mere allegations of fraud simpliciter would not nullify the effect of an arbitration agreement between the parties and the parties can be relegated to arbitration. However, where there are serious allegations of fraud, they are to be treated as non-arbitrable and it is only the civil court that should decide such matters.

The Court held that the serious allegations of fraud must be such that:

  1. it makes a virtual case of a criminal offense; or
  2. they are complex in nature and the decision on these issues can be decided only by the civil court on appreciation of voluminous evidence; or
  3. the serious allegations of forgery/fabrication of documents in support of the plea of fraud are being made; or
  4. the fraud is alleged against the arbitration agreement itself; or
  5. the fraud permeates the entire contract, including an agreement to arbitrate.

The Court while referring to its earlier decision in Booze Allen & Hamilton v. SBI Home Finance Limited("Booze Allen")9 expressly recognized that the statutory scheme of 1996 Act does not preclude any disputes to be arbitrable or non-arbitrable but went on to hold that where simple allegations of fraud touch upon the internal affairs of the party inter se and such allegations have no implication in the public domain or do not affect the rights in rem, the arbitration clause need not be avoided, and the parties can be relegated to arbitration. However, a note of caution was put by the Court stating that when the case of fraud is set up by one of the parties on the basis of which the party wants to wriggle out the arbitration agreement, a strict and meticulous inquiry should be made by the Court and it only when the Court is satisfied that there exist serious allegations of fraud and the Court shall be the right forum to deal with the subject matter rather than relegating the parties to the arbitration, then alone an application under Section 8 should be rejected.

Ayyasamy judgment in particular tried to lay down a format, the precedential value of which would provide impetus in initiating the arbitration proceedings in the cases of simple allegations of frauds.

Rashid Raza Test for Complex Fraud- Later, in 2019 the Supreme Court in Raza Rashid v Sadaf Khan10 ("Raza Raza") building upon the above holding of Ayyasamy laid down a dual test for distinguishing simple allegations of fraud as opposed to complex frauds. The dual test as laid down by the Court in affirmation with Ayyasamy were:

  1. Whether the plea under Section 11 of the 1996 Act for the appointment of an arbitrator, permeates the entire contract and agreement rendering it void.
  2. Whether the alleged fraud was related to the internal affairs of the parties, thereby having no impact in the public domains.

The Supreme Court by applying the twin test held that, there were no allegations of fraud that could vitiate the partnership deed as a whole or, in particular, the arbitration clause concerned in the said deed. The Court also held that matter would not fall under the public domain as the allegations made pertain to the affairs of the partnership and siphoning of funds from the partnership funds.

Solving the intriguing puzzle: Although the Ayyasamy ruling was stride in the right direction, however, the conundrum revolving around the issue of arbitrability of fraud still lingered and once again came up before the Supreme Court in Avitel Post Studioz Limited v. HSBC PI Holdings (Mauritius) Limited11 ("Avitel"). In this case allegations of fraud were made in criminal proceedings involving serious offenses like forgery and impersonation. The Court after observing the tests laid down in Ayyasamy and Rashid Raza laid down the Public Flavor Test and held that "serious allegations of fraud" warranting the exclusion of arbitration could arise only on the satisfaction of two tests:

  1. When the arbitration clause/agreement itself is non-existent.
  2. When the allegations of arbitrary, fraudulent, or mala fide conduct are made against the state or its instrumentalities, thus necessitating the hearing of the case by the writ court.

The Court additionally held that false representation, diversion of funds, and impersonation are all inter parties' disputes and have no public flavor.

Current Legal Position- The Dawn of Change

The latest case in the saga of the evolution of arbitrability of frauds in India is Vidya Drolia. While placing concurrence with its earlier decisions in Swiss Timings, Ayyasamy, Rashid Raza, and Avitel, the Supreme Court explicitly overruled the dicta laid down in N Radhakrishnan and held that allegations of fraud are arbitrable, provided, they relate to a civil dispute. The Court also 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 that affect rights in rem and therefore necessitate adjudication in the public domain.

Most recently, the Supreme Court has re-affirmed Vidya Drolia's findings with respect to the arbitrability of fraud in N.N Global and held that the civil aspect of fraud can be adjudicated by the Arbitral Tribunal unless the allegation is that the arbitration agreement itself is vitiated by fraud. However, the criminal aspect of fraud viz. forgery or fabrication being essentially in the realm of public law, can only be adjudicated by a court. The Supreme Court also held that all civil or commercial disputes, whether contractual or not, which can be adjudicated upon by a civil court, can also be adjudicated through arbitration unless such arbitral proceedings are expressly excluded by statute or by necessary implication.

Conclusion

The embargo imposed by the N Radhakrishnan case which was a glaring error impeding the growth of arbitration in India has finally been dealt with by the Supreme Court in Vidya Drolia and NN Global by taking a pro-arbitration approach. At present, the settled legal position concerning the arbitrability of fraud in India is that the allegations of fraud that permeate the entire contract and do not simply affect the internal affairs of the parties but instead affect the rights in rem are non-arbitrable. The principles of arbitrability of frauds developed by the courts are conducive. However, as we move forward their effectiveness remains to be seen in the cases where the parties may raise the allegations of fraud to willfully avoid the arbitral process.

Footnotes

1.Vidya Drolia v. Durga Trading Corporation, 2020 SCC OnLine SC 1018

2. N.N. Global Mercantile Pvt. Ltd, 2021 SCC OnLine SC 13

3.  Abdul Kadir Shamsuddin Bubere v. Madhav Prabhakar Oak, AIR 1962 SC 406.

4. Russel v Russel, 1880 14 Ch D 471

5. Sundaram Finance Lt. v NEPC India Ltd, (1999) 2 SCC 479

6. N. Radhakrishnan v. Maestro Engineers, (2010) 1 SCC 72

7.  Swiss Timing Ltd. v. Commonwealth Games 2010 Organising Committee, (2014) 6 SCC 677

8.  A. Ayyasamy v. A. Paramasivam and Ors, (2016) 10 SCC 386

9. Booz Allen & Hamilton Inc. v. SBI Home Finance Ltd, (2011) 5 SCC 532

10.  Raza Rashid v Sadaf Khan, (2019) 8 SCC 710

11.  Avitel Post Studioz Limited and Ors. v. HSBC PI Holdings (Mauritius) Limited and Ors, (2020) SCC OnLine SC 656 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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