Arbitral awards and the business efficacy test

An oft-repeated principle underlying the scrutiny of arbitral awards by courts is that interpretation of terms of a contract is within the domain of an arbitrator.

This article examines the business efficacy test as an equivalent or even countervailing factor to ensure that the bargain struck between the parties is also given primacy in arbitral awards involving interpretation of commercial contracts.

Section 28(3) of the Arbitration and Conciliation Act, 1996, modelled on Article 28 of the UNCITRAL Model Law, states that in all cases where the place of arbitration is in India, the arbitral tribunal shall decide the dispute in accordance with the terms of the contract and shall take into account the usages of the trade applicable to the transaction.

Section 34 of the 1996 Act provides certain grounds for setting aside of an arbitral award which include, amongst others, a finding by the Court that the award is in conflict with the public policy of India. The term “public policy of India” in Section 34(2) of the 1996 Act includes patent illegality in an arbitral award.

Courts in India have applied the ‘patent illegality’ test to situations where an arbitrator has taken a view which is not a possible view or has interpreted a clause in the contract in such a manner which no fair-minded or reasonable person would do or where the arbitral award is found to be in contravention of the terms of the contract.

The jurisdictional test

It is well-settled that while considering a challenge to an arbitral award, the courts will have to make a distinction between an error falling within the jurisdiction of the arbitral tribunal and an error in excess of jurisdiction.

Error within jurisdiction

An error in interpretation or construction of a contract is an error within the jurisdiction of an arbitral tribunal, where there is a valid and lawful submission of disputes to the tribunal.

In Associate Builders v. DDA, the Supreme Court held that an arbitral tribunal must decide a dispute in accordance with the terms of the contract and that if it does not do so, the award would be patently illegal. However, if an arbitral tribunal construes a term of the contract in a reasonable manner, it will not mean that the award can be set aside on this ground, as the tribunal is legitimately entitled to take the view which it holds to be the correct one after considering the material and interpreting the provisions of the agreement.

Error in excess of jurisdiction

If an arbitrator wanders outside the contract and deals with matters not allotted to him, he commits a jurisdictional error or an error in excess of jurisdiction.

For example, an arbitrator cannot widen his jurisdiction by deciding a question not referred to him by the parties or by deciding a question not in accordance with the contract. If there is a specific term in the contract, or the law, which does not permit or give the arbitrator the power to decide the dispute/claim raised by the claimant, then the award passed by the arbitrator in respect thereof would be held in excess of jurisdiction. Similarly, a conscious disregard of the law or the provisions of the contract from which the arbitrator has derived his authority would also vitiate the award, as the arbitrator must operate within the four corners of the contract.

In Indian Oil Corporation, the Supreme Court recently set aside an arbitral award which dealt with disputes not contemplated by the arbitration clause in the relevant agreement, but arising under a separate agreement. The apex court found that the award was beyond the scope of submission to arbitration and reiterated that an arbitrator cannot rewrite the terms of a contract and would be acting in excess of its jurisdiction if he travels beyond the contract.

In the underlying facts of Indian Oil Corporation, the conclusion that the arbitral tribunal travelled outside its jurisdiction was relatively easier to arrive at. However, empirical evidence suggests that this test is frequently not easily applied.  

In Sudarshan Trading Co. v. Government of Kerala (a case under the Arbitration Act, 1940 which has been relied upon in subsequent judgments under the 1996 Act), the Supreme Court held, in the context of an objection that the arbitrator had exceeded its jurisdiction, that the court only needs to determine whether the claims are within the disputes referable to the arbitrator and cannot further analyse the claims to determine whether the arbitrator has acted correctly or incorrectly.

In Rashtriya Ispat Nigam Ltd. v. Dewan Chand Ram Saran, the Supreme Court, relying on Sudarshan Trading Co, held that where the view taken by the arbitrator was clearly a possible if not a plausible one, it is not possible to say that the arbitrator had travelled outside his jurisdiction, or that the view taken by him was against the terms of contract.

A slightly divergent situation arose in Food Corporation of India v. AM Ahmed & Co, where even in the absence of an escalation clause, the Supreme Court held that escalation of price on account of delay and gap of time is a “normal incident” and the arbitrator had jurisdiction to adjudicate on the question of escalation caused due to delay. Although the Food Corporation decision was also a case under the Arbitration Act, 1940, the said decision has been relied upon in subsequent decisions under the 1996 Act.    

Another approach can be seen in the judgment of the Supreme Court in South East Asia Marine Engg. & Constructions Ltd. (SEAMEC LTD) v. Oil India Ltd. Here, the contract between the parties provided that if a change in law resulted in additional cost, the respondent was required to reimburse the appellant for the same. The arbitral tribunal upheld the contention that a government order causing increase in cost of an essential material amounted to a ‘change in law’. The Supreme Court rejected this view of the arbitrator on the reasoning that the contract appeared to be a fixed rate contract and price fluctuations could not be brought under the contract, unless specific language pointed to its inclusion.

In PSA SICAL Terminals Pvt Ltd v. Board of Trustees of VO Chidambranar Port Trust Tuticorin, the arbitral tribunal passed an award holding that there was a change in law entitling the appellant to a higher level of tariff collection under a license agreement. The Supreme Court held that the arbitral tribunal’s finding on change of law was based on ‘no evidence’ and ‘ignorance of vital evidence’, thus rendering it perverse and vitiated on the ground of patent illegality. This approach effectively resulted in the Court substituting the findings of the arbitral tribunal with its own interpretation on merits.

In Ssangyong Engg. & Construction Co Ltd v. NHAI, the Supreme Court held that the arbitral tribunal’s reliance on a policy circular changing the formula for calculation of certain indices as provided in the contract, amounted to a unilateral addition or alteration of a contract, and that such a course of conduct would be contrary to the fundamental principles of justice in this country.

The authors suggest that an equally important facet of judicial scrutiny is, or ought to be, whether the interpretation preferred by the arbitral tribunal is in consonance with the commercial bargain/arrangement and wisdom of the parties.

A two-judge Bench of the Supreme Court observed in Nabha Power Limited (NPL) v. Punjab State Power Corporation Limited (PSPCL), that the principle of imparting “business efficacy to the transactions” was intended at all events by parties who are businessmen.

In Adani Power (Mundra) Ltd. v. Gujarat ERC, a three-judge Bench of the Supreme Court observed that the principle of business efficacy (connoting the power to produce intended results) could be invoked only if upon a plain literal interpretation of the term in the contract, it is not possible to achieve the result or consequence intended by the parties acting as prudent businessmen. Almost contemporaneously, the Bombay High Court, in Vestas Wind Technology India Private Limited v. Inox Renewables Limited and Others, upheld an arbitral award which construed a contract by applying the business efficacy test.

In the United Kingdom, commercial and appellate courts have long emphasised that interpretation of contracts should not merely be a literalist exercise focused solely on the wording, but should entail a more holistic consideration of the contract, taking into account the wider context and commercial purpose of the agreement and business common sense.

In Antaios Compania Naviera SA v Salen Rederierna AB, the House of Lords held that “if detailed semantic and syntactical analysis of words in a commercial contract is going to lead to a conclusion that flouts business common sense, it must be made to yield to business common sense”. Further, if there are two possible constructions, the court is entitled to prefer the construction which is consistent with business common sense. The commercial courts in UK have also emphasised that courts must construe contracts in their context and if and where there is a legitimate doubt about its meaning, the meaning which reflects the general sense and overall commercial aim of the transaction should be favoured.

Recently, in Union of India, Ministry of Railways, Railway Board v. M/s Jindal Rail Infrastructure Limited, the Delhi High Court set aside an arbitral award on the basis that the interpretation of a contractual provision by the arbitrator was ex facie erroneous. The arbitral award held that a clause in the agreement between the parties cannot be interpreted so literally that it “flouts common business sense” and renders the contract commercially unviable.

In summary, the judicial determination as to whether the interpretation of a contract by an arbitral tribunal is “a possible view” or so improbable that no fair-minded or reasonable person would take, may often be more subjective as opposed to ascertaining whether the arbitral tribunal has traveled outside or beyond its jurisdiction.

The authors suggest that consistent with the mandate of Section 28(3), the courts should, in cases involving commercial contracts, additionally satisfy themselves that the arbitral tribunal’s view is not only a plausible or possible view, but also advances or at least does not undermine the business efficacy of the commercial bargain between the parties. 

In the authors’ view, this will go a long way in ensuring that the courts recognise and give primacy to the interpretation most closely related to the contractual understanding between the disputant parties and thereby preserve the sanctity of commercial contracts.    

Ajit Warrier is a Partner at Shardul Amarchand Mangaldas & Co. specialising in the Dispute Resolution and Litigation Practice. Sajal Mendiratta and Arundhati Srivastava are Associates of the firm.

Disclaimer: 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. Further, the views in this article are the personal views of the authors.