Author - Siddharth Melepurath and Harsh Pandey are 4th year B.A. LL.B. (Hons.) students at National Law University Odisha.
I. Introduction
Pre-arbitral deposit clauses in arbitration agreements generally involve a party depositing a specified amount to initiate arbitration. Recently, the Supreme Court of India (“SC”), in Lombardi Engineering Limited v. Uttarakhand Jal Vidyut Nigam Limited (“Lombardi”) laid down, in a Section 11(6) petition under the Indian Arbitration and Conciliation Act, 1996 (“the Act”) that the pre-arbitral deposit clause in the contract is violative of Article 14 of the Indian Constitution, and scrapped the same. The SC took this view primarily in light of the ratio in ICOMM Tele Ltd. v. Punjab State Water Supply and Sewerage Board and Ors. (“ICOMM”).
This article attempts to juxtapose the position taken by Lombardi with earlier judgments that deal with pre-arbitral deposit clauses. It further establishes how the SC wrongly construes the ratio in ICOMM while inadvertently laying down a dangerous precedent in the eyes of commercial contracts and arbitration clauses in them. Firstly, the article traces major judgments leading up to Lombardi and examines the pre-arbitral deposit clauses in these judgments. Secondly, the article analyses Lombardi and how it wrongfully attempts to answer the question about pre-arbitral deposit clauses.
II. Navigating Pre-Arbitral Deposit clauses through past precedents
A. SK Jain v. State of Haryana
SK Jain v. State of Haryana (“SK Jain”) was an appeal to quash a memo directing the claimant party to deposit 7% of the claimed amount before the Arbitral Tribunal. As per the clause in SK Jain, the security deposit was to be adjusted against the cost award in the arbitration, and any balance was to be refunded to the claimant within one month. The impugned clause in SK Jain read as follows:
“25-A(7) It is also a term of this contract agreement that where the party invoking arbitration is the contractor, no reference for arbitration shall be maintainable unless the contractor furnishes to the satisfaction of the executive Engineer-in-Charge of the work a security deposit of a sum determined according to details given below and the sum so deposited shall, on the termination of the arbitration proceedings be adjusted against the cost, if any, awarded by the arbitrator against the claimant party and the balance remaining after such adjustment in the absence of any such cost being awarded, the whole of the sum will be refunded to him within one month from the date of the award”
Therefore, in SK Jain, the SC adopted a favourable position towards pre-arbitral deposits and held that there was a “logic” behind a pre-arbitral deposit clause in an arbitration agreement, which was to prevent frivolous claims.
B. ICOMM Tele Ltd. v. Punjab State Water Supply and Sewerage Board and Ors.
ICOMM was the second major judgment on pre-arbitral deposits in India. As per the clause in ICOMM, a refund could only take place in proportion to the amount awarded with respect to the amount claimed, with the balance being forfeited to the losing party. For instance, a party X has initiated arbitration with a claim amount of ₹50,00,000, and has furnished a pre-arbitral deposit of 10% (₹50,000) to that effect. An award is passed in favour of X worth ₹25,00,000. In this case, the pre-arbitral deposit that will be refunded to X would be in proportion to ₹25,00,000 i. e. ₹25,000, which is not equivalent to the amount X deposited initially.
The clause in question in ICOMM was as follows:
“25(viii). It shall be an essential term of this contract that in order to avoid frivolous claims the party invoking arbitration shall…shall furnish a "deposit-at-call" for ten percent of the amount claimed, on a Schedule bank in the name of the Arbitrator by his official designation who shall keep the amount in deposit till the announcement of the award. In the event of an award in favour of the claimant, the deposit shall be refunded to him in proportion to the amount awarded with respect to the amount claimed and the balance, if any, shall be forfeited and paid to the other party.”
One of the major problems with such a clause was that, even in case the claimant party won, there was no guarantee that the amount deposited would be fully refunded. Rather, going by this clause, there were chances that the claimant party had to even forfeit the deposited amount to the losing party, simply because it had to be in proportion to the award. ICOMM correctly noted that such disproportionate and uncertain refund was unjust.
Further, while distinguishing the case from SK Jain, the SC observed that the 10% deposit-at-call was without any direct nexus to the filing of frivolous claims – since it was a pre-requisite for all claims. These two reasons prompted the SC to observe that there was a “clog” in the process of arbitration and it was being discouraged. Resultantly, the clause in ICOMM was struck down, being violative of Article 14 of the Constitution. In the following section, we will note how the third major judgment on pre-arbitral deposits wrongfully mixes up precedents and adopts a flawed position.
III. The Lombardi judgment: What went wrong?
In Lombardi, when certain disputes arose between the parties, the Petitioner issued a notice of arbitration to appoint an arbitrator. In response, the Respondent terminated the erstwhile contract alleging non-compliance of work and non-fulfilment of the contractual obligations. Analysing both SK Jain and ICOMM, the SC observed that they are wholly distinguishable and the facts of the instant case did not apply to the facts of ICOMM. However, surprisingly, it held in favour of the Petitioner that the clause was arbitrary and violative of Article 14 of the Constitution. Following is the impugned clause in Lombardi:
“CLAUSE-55: ARBITRATION: (a) All questions and disputes…shall be conducted in accordance with the provisions of the Arbitration and Conciliation Act, 1996…However, 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.”
Comparing this clause with the one in SK Jain, we find that both these clauses involved a certain percentage of the claim amount to be deposited. We note that the clause in Lombardi was impliedly refundable. In common parlance, a security amount is given to guarantee the fulfilment of a purpose, and is refunded once the purpose is fulfilled. It has already been established that the broad purpose of pre-arbitral deposits is to prevent frivolous claims. Therefore, if a claimant has deposited an amount and is successful in his claim, he is entitled to be refunded after establishing the non-frivolity of the claim. On the contrary, if the claim is frivolous, he shall not be entitled to any refund. Further, it is also settled position (here and here) that security deposits are inherently refundable. Therefore, we submit that the clause was refundable, i.e. of the same nature as the one in SK Jain.
Additionally, judgments such as M/S Garg and Co. v. State of Haryana and Ors. and Brij Gopal Construction Co. Pvt. Ltd. v. Haryana Shehri Vikas Pradhikaran also observe that pre-arbitral deposit clauses, which refund the balance after adjusting the deposited amount with the cost award were more similar to the clause in SK Jain. However, the SC, in Lombardi misconstrued the clause to be of the same nature as the one in ICOMM, paving the way for a generalised position against pre-arbitral deposits. Such a stance is no different from the incorrect and over-the-top position taken earlier by the Kerala High Court, saying that all pre-arbitral deposits are arbitrary.
Therefore, we submit that firstly, there is no sound reasoning given in Lombardi as to why SK Jain was flawed and why it could not be considered in this case, especially being a stronger bench than ICOMM. Additionally, SK Jain not being overruled in ICOMM only reinforces the idea that SK Jain is not bad law. Secondly, we reiterate that ICOMM is not a bad judgment. It seems that the SC, in Lombardi, has incorrectly considered only a part of the ratio in ICOMM and has failed to understand the rationale with which ICOMM was laid down.
IV. Can such a decision be taken under a Section 11(6) petition?
In addition to the aforementioned error in reliance, there are additional problems with Lombardi. It is to be noted that Lombardi is a Section 11(6) petition, which pertains to appointment of arbitrators and functions to be performed by the parties. However, according to Lombardi, the SC has done this exercise before in three distinct judgments, which deal with “operation of law” – TRF Limited v Energo Engineering Projects Limited, Perkins Eastman, and Voestalpine Schienen GMBH v Delhi Metro Rail Corporation Limited. Lombardi then uses this “operation of law” to expound upon Kelsen’s grundnorm theory – how the Constitution is the ultimate source of law or “grundnorm” and that an arbitration agreement cannot fall foul of provisions of the Act or the Constitution. The principle behind this stance is that the concept of party autonomy cannot be “stretched” to such an extent that it becomes violative of fundamental rights and the Constitution. An arbitration clause has to be in consonance with the operation of law (in this case, the Constitution). Further, Lombardi incorrectly relies on ICOMM and Vidya Drolia and Ors. v Durga Trading Corporation (“Vidya Drolia”) to defend its stance of dealing with issues of constitutionality under a Section 11 petition.
Firstly, Lombardi’s reliance on ICOMM vis-à-vis its position on Section 11 is misplaced because of the simple reason that ICOMM was a Special Leave Petition (“SLP”) under Article 136 of the Constitution. Therefore, it granted extraordinary jurisdiction to the SC to determine questions of law or public importance in exceptional circumstances. On the other hand, Lombardi is a Section 11(6) petition under the Act, which does not have such a wide ambit as ICOMM.
Secondly, in order to understand why the reliance of Lombardi on Vidya Drolia is wrong, it is essential to examine Section 11(6A) of the Act. According to this section, courts have to confine to the examination of the “existence of an arbitration agreement”, while considering a Section 11 application. Now, according to Vidya Drolia, the existence of an arbitration agreement presupposed its validity, and both of them were intertwined. Lombardi uses this to rule that “validity” had to be checked first in order to determine “existence”, and therefore, the clause had to be checked under Article 14. “Validity” of an arbitration agreement is restricted to the requirement of formal validity, in the sense that the arbitration agreement be in writing.
However, it is to be noted that Vidya Drolia’s position on “existence” has now been overruled in the SC’s judgment on unstamped arbitration agreements – Re: Interplay between Arbitration Agreements under the Arbitration and Conciliation Act 1996 and the Indian Stamp Act 1899 (“Re: Interplay”). The SC, in this judgment, observes that Vidya Drolia had incorrectly presumed that Section 11(6A) had been omitted via the 2019 Amendment Act when in fact, such omission had not been notified. This, the SC noted, had resulted in Vidya Drolia’s erroneous position on existence and validity of an arbitration agreement. The SC in Re: Interplay then proceeded to observe that pending notification from the Central Government, courts should give true effect to the legislative intent behind Section 11(6A). It further observed that the true legislative intent was to confine the scope of reference under Section 11(6A) to the examination of the existence of the arbitration agreement, basis Section 7 of the Act.
V. Conclusion
It needs to be mentioned that the manner in which pre-arbitral deposits have been discouraged as a “hindrance” to arbitration raises concern. This has also resulted in an antagonistic position now being adopted towards pre-arbitral deposits in general. Thus, while the SC’s verdict has been lauded for its primacy shown to the Constitution and fundamental rights, it inadvertently sets a precedent that may complicate future arbitrations. The authors believe that in a time where the SC is time and again using its curative jurisdiction to intervene in arbitration matters, its misapplication of precedents and constitutional principles in Lombardi necessitates a relook.
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