Arbitrability Of Fraud Disputes

A surge in commercial disputes has led the corporate sector to have their matters adjudicated by arbitrators rather than in open courts. However, it is not immune from issues. One question which hinders the process of arbitration in India is whether Frauds are arbitrable under the Arbitration & Conciliation Act, 1996 ("Arbitration Act").

It is a settled principle of law that all the civil proceedings can be dealt with under the arbitration act but it has not been explicitly mentioned whether the frauds relating to civil disputes will be arbitrable and the concept had to be evolved by the Courts.

Earlier Position of Law relating to Arbitrability of Fraud Disputes

The Arbitration Act, 1940 had no specific provisions for arbitrability of frauds and the issue was first raised in a landmark judgment by a bench of 3 judges of the Supreme Court in Abdul Kadir Shamsuddin Bubere v. Madhav Prabhakar Oak("Abdul Kadir"). It was held by the Court that the question of fraud involved several intricacies which have to be dealt with in court. The Apex Court further placed reliance on the English judgment of Russel v Russel that "In a case of fraud, the court will generally refuse to send the dispute to arbitration even if the party charged with the fraud desires a public enquiry. But where the arbitration is by the party charging the fraud, the court, will not necessarily accede to it, and will never do so until a prima facie case is made out".

This judgement marked the beginning of an era where frauds remained covered under the blanket exception of arbitrability for a substantial period of time.

In N. Radhakrishnan v M/S. Mastero Engineers & Ors ("N Radhakrishnan"), the parties had entered into a partnership deed for the purpose of carrying on engineering works under the name of "Maestro Engineers". Due to some differences, one of them voluntarily retired and alleged that others at the firm had been engaging in malpractice and manipulation of finances. . A Division Bench of the Supreme Court in this case held that matters of serious allegations of malpractices in account books and manipulation of finances of partnership firm cannot be properly dealt with by an Arbitrator. It thus rejected the application filed under Section 8 of Arbitration Act. The Apex Court while deciding this case placedreliance on the Abdul Kadir case, however this judgment was later severely criticized.

Evolution of the Scope of Arbitrability of Frauds

Booz-Allen & Hamilton Inc v SBI Home Finance Ltd forms the cornerstone in the jurisprudence of arbitrability of disputes. The Court classified the types of disputes and laid down grounds for determining the types of disputes that were arbitrable in consonance with the type of rights involved in the case, i.e. rights in rem and rights in personam. A right in rem is exercisable against the society at large whereas rights in personam are protected solely against one individual. Thus all disputes relating to right in personam can be settled through arbitration but the disputes involving rights in rem cannot be settled through the means of arbitration.

The Apex Court in Swiss Timing Ltd v Commonwealth Games Organizing Committee ("Swiss Timings") tried to rectify the course laid down in N Radhakrishan. The court declared the judgment to be per incuriam. The appointment of the arbitrator under Section 11 was resisted on the ground of pendency of proceedings in the trial court. The court applied "Doctrine of Severability" to the arbitration agreement. It further stated that, while considering any objection with regard to the existence or validity if the arbitration agreement, the arbitration clause, which forms a part of the contract, has to be treated as an independent agreement.

The lesser strength of the bench in the Swiss timing case meant it could not overrule the judgment of N Radhakrishnan, which complicated the matter. It dealt only with specific parts, and the numerous complexities regarding the different types of frauds remained unsettled. Thus, we can say that the judgment was not exhaustive and did not lay down the guidelines or provisions which could operate as a standard procedure for settlement of disputes relating to frauds under the Arbitration Act.

Fraud Simpiciter and Complex Frauds

The Supreme Court in A. Ayyasamy vs. A. Paramasivam ("Ayyasamy") tried to bifurcate the types of offences into Arbitrable and the Non-Arbitrable offences. The court observed that in cases where the subject matter falls exclusively within the Public Fora, such disputes would be non-arbitrable and would be decided by the courts alone. The court further observed that every civil or commercial dispute, either contractual or non-contractual, which can be decided by a court, is in principle capable of being adjudicated and resolved by arbitration unless the jurisdiction of the Arbitral Tribunals is excluded either expressly or by necessary implication.

It was held by the Court that a judge must be able to distinguish between Fraud Simpliciter and Complex Frauds. Mere allegations of fraud simpliciter would not amount to nullifying the arbitration agreement between the parties and only the cases with serious allegations of fraud should be decided by the Courts. It was further held that where allegations of fraud touch upon the internal affairs of the party inter se,having no implication in the public domain, the arbitration clause need not be avoided and the parties can be relegated to arbitration.

The Ayyasamy judgment could not overrule the Radhakrishnan judgment due to the lesser strength of the bench. Thus, this case 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 fraud.

Rashid Raza Test for Complex Frauds

In Raza Rashid v Sadaf Khan ("Rashid Raza") the Supreme Court in affirmation with the Ayyasamy judgment laid down 2 tests for distinguishing between Fraud Simpliciter and Complex Frauds.

Whether the plea under Section 11 for the appointment of arbitrator permeates the entire contract and agreement rendering it void.

Whether the alleged fraud was related to the internal affairs of the parties, thereby having no impact in the public domain.

The Supreme Court by applying the twin test held that, there were no allegations of fraud which could vitiate the partnership deed as a whole or, in particular, the arbitration clause concerned in the said deed.

Present Scenario

The Supreme Court has made the Arbitrability of Frauds clearer in its recent judgment of Avitel Post Studioz Limited v. HSBC PI Holdings (Mauritius) Limited ("Avitel"). The issue arose after an order was passed under Sector 9 in favor of HSBC. HSBC alleged misrepresentation and fraudulent inducement by Avitel in order to get HSBC to invest money in equity capital of Avitel. The award was passed in favor of HSBC at Singapore International Arbitration Centre and HSBC applied for interim measures in India. Avitel contended that since allegations of frauds have been made in criminal proceedings involving serious offences like forgery and impersonation, such dispute is not arbitrable.

The Court after observing the tests laid down in Ayyasamy case (also applied in Rashid Raza) laid down twin test (Public Flavor Test) and held that "serious allegations of fraud" warranting the exclusion of arbitration could arise only on the satisfaction of two tests:

Serious allegations of fraud excluding the arbitration could only arise when the arbitration clause/agreement is non-existent.

The allegations of arbitrary, fraudulent or mala fide conduct are made against the state or its instrumentalities, in which case, the questions would lie in the public domain and must be entertained by a writ court.

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

Vidya Darolia v Durga Trading Corporation is the latest case in the saga of evolution of arbitrability of frauds in India. The Supreme Court while placing concurrence with the decisions in Ayyasamy, Swiss timings and Avitel explicitly overruled the N Radhakrishnan Case and held that allegations of frauds in civil disputes are arbitrable.

A Four Fold test was propounded and the Court held that disputes are not arbitrable when the cause of action/subject matter of the dispute (1) relates to actions in rem, that do not pertain to subordinate rights in personam that arise from rights in rem (2) affects third party rights; have erga omnes effect; require centralized adjudication, and mutual adjudication (3)relates to inalienable sovereign and public interest functions of the State (4) is expressly or by necessary implication non-arbitrable under a specific statute.

Any affirmative answer in relation to these four points enunciated by the courts would render the dispute non arbitrable. The Court further 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 which affect rights in rem and therefore necessitate adjudication in the public domain.

The embargo imposed by N Radhakrishnan case has finally been removed after heavy legal deliberation; the Courts have now set a pro arbitration approach.

Presently, the settled law for arbitrability of fraud in India is that those disputes which involve criminal elements, and which would not simply affect inter parties, instead relate to 'public wrongs', and have an effect in public domain are non-arbitrable.

The Supreme Court has kept its protective approach intact by excluding disputes that have an effect in the public fora. The principles of arbitrability of frauds developed by the courts are conducive to arbitration, but their effectiveness is yet to be seen. There will still remain a tussle between the Courts and Tribunals with regards to the cases where there is no effect on the parties or the cases in which the effect will lie in the public domain. Thus, the courts will have to deliberate on these matters individually and this will still plague the system for a foreseeable future.

Also see: The End Of A Saga- The Conundrum Of Arbitrability Of Landlord-Tenant Disputes