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Supreme Court Clarifies the 'Fraud Exception' to Arbitrability

Contributed by: Samvad Partners


Section 8 of the Arbitration and Conciliation Act, 1996 (“Arbitration Act”) brought in a new approach to arbitration, under which a court had to mandatorily refer a matter to arbitration wherever a valid arbitration clause between the contesting parties was shown to exist. However, this was subject to the rider that disputes relating to the rights in rem are required to be adjudicated by courts and public tribunals, as being unsuited for private arbitration. In Booz Allen & Hamilton Inc. v. SBI Home Finance Ltd.,[(2011) 5 SCC 532](‘Booz Allen’) the Supreme Court enumerated categories of matters that could not be the subject of arbitration. One such category was matters involving prosecution for criminal offences.[Paragraph 36 (i) of Booz Allen case] Allegations of fraud and misrepresentation are routinely raised in respect of a number of commercial relationships, including those where the contracts contain an arbitration clause. Would all these disputes be subject to the ‘fraud exception’ to arbitrability?

In Ayyasamy v. Paramasivam and Ors.[(2016) 10 SCC 386] (‘Ayyasamy’) the Supreme Court held that only serious allegations of fraud, of a criminal nature, would be non-arbitrable. An example of the application of Ayyasamy to allegations of fraud and misrepresentation can be found in Ameet Lalchand Shah v. Rishabh Enterprises & Ors[(2018) 15 SCC 678]. Here the Supreme Court held that the allegations were ‘not so serious’, so as to warrant the exclusion of arbitration. In Rashid Raza v. Sadaf Akhtar[(2019) 8 SCC 710] (‘Rashid Raza’), the Supreme Court laid down two working tests for determining what amounted to serious allegations of fraud:

  1. Does this plea (of fraud) permeate the entire contract and above all, the agreement of arbitration, rendering it void?

  2. Whether the allegations of fraud touch upon the internal affairs of the parties inter se having no implication in the public domain?

In a recent sequel to this line of cases, Avitel Post Studioz Limited Ors., v. HSBC PI Holdings (Mauritius) Limited[Judgment dated August 19, 2020 in Civil Appeal No. 5145 of 2016 and Civil Appeal No. 5158 of 2016 with Civil Appeal No. 9820 of 2016, (2020) SCC 656] (‘Avitel v. HSBC’) the Supreme Court has further clarified and limited the scope of the ‘fraud exception’.

The Avitel Case

The brief facts of Avitel v. HSBC are as follows. HSBC PI Holdings (Mauritius) Ltd. (‘HSBC’) and Avitel Post Studioz Ltd. (‘Avitel’) entered into a Share Subscription Agreement and a Shareholders Agreement both containing an arbitration clause that provided for a Singapore-seated arbitration. HSBC had made an investment in the equity capital of Avitel India for a consideration of USD 60 million to acquire 7.8% of its paid-up capital. This was done on the basis that Avitel was in the final stages of negotiating a contract with the British Broadcasting Corporation (BBC) worth about USD 300 million in its first phase. Subsequently, HSBC grew suspicious about business activities of the Avitel Group and found that the money was not used for the intended purpose, but was siphoned off to companies in which the promoters of the Avitel group had an interest. A dispute arose and the case was referred to arbitration. HSBC simultaneously filed a complaint alleging criminal offences. However, this complaint was eventually closed, though HSBC had challenged this closure. The Arbitral Tribunal delivered an award in favour of HSBC, concluding that Avitel had made fraudulent misrepresentations to induce HSBC to make the investments.

HSBC subsequently sought interim measures under Section 9 of the Arbitration Act before the Bombay High Court to secure the award. HSBC argued that under Singapore law, the arbitral tribunal can decide claims involving allegations of fraud if any, and there was no bar to these issues being decided by an arbitrator. The High Court ordered in favour of HSBC, and directed Avitel to make a deposit to secure the award.

The Bombay High Court’s order was challenged before the Supreme Court, and it was argued by Avitel, that the issues decided in the arbitration fell outside the scope of arbitration, because of the allegations of ‘serious fraud’ made by HSBC. Avitel relied on an earlier judgment of the Supreme Court in N. Radhakrishnan v. Maestro Engineers[(2010) 1 SCC 72] (‘N. Radhakrishnan’) which held that wherever ‘allegations of fraud’ are raised in a case which there is an arbitration agreement, they should be tried in a court of law and not through arbitration.

In Avitel v. HSBC, the Supreme Court declined to follow N. Radhakrishnan as it was a case under the repealed Arbitration Act, 1940 and lacked value as a precedent. Relying on Ayyasamy, and Rashid Raza, the Supreme Court held that the issues arising in the case were arbitrable, and not covered under the fraud exception. Four important points were made in Avitel v. HSBC, narrowing the scope of the ‘fraud exception’ further:

  1. The same set of facts can lead to both civil and criminal allegations. This by itself is not sufficient to bring the case within the ‘fraud exception’.

  2. A contract obtained by fraud would fall within the ambit of section 17 of the Contract Act rendering the contract voidable, whereas fraud in the performance of the contract would amount to a tort, and result in damages, rather than a rescission of contract;

  3. Invalidity of the contract does not straightaway lead to the invalidity of the arbitration clause. For a case to fall within the fraud exception, it would have to be established that the arbitration agreement was itself not validly entered into.

  4. The allegations must have a ‘public flavour’ and should not be questions arising from the contract or breach of the contract. In the facts of the case the allegations of impersonation, false representations, and diversion of funds were all inter parties, and had no “public flavour” to qualify under the “fraud exception”.

Pro-Arbitration Takeaways:

The ‘fraud exception’ to arbitrability has always been controversial and the Supreme Court’s expansion of the exception in N. Radhakrishnan was perceived as a roadblock in the development of a pro-arbitration jurisprudence. In Avitel v. HSBC, the Supreme Court has all but removed this roadblock. While some doubts may persist about the reasoning given that N. Radhakrishnan ceases to be a precedent because it was decided under the 1940 Act, the approach of the Supreme Court in charting a pro-arbitration path cannot be faulted. The Court has made an important point that both arbitration and criminal proceedings can proceed alongside each other in most cases where allegations of fraud are made. It is only where the allegations touch upon the validity of the arbitration clause itself and there is a ‘public flavour’ to the case that the fraud exception would be attracted. With this judgment, it is increasingly unlikely that the raising of an allegation of fraud would be sufficient to stall an arbitration.

Disclaimer: This is an update for general information purposes only and does not constitute legal advice. Please contact us if you require further clarification on this subject.

Contributed by Samvad Partners

The above article has been authored by Mr. Arjun Krishnan(Partner) and Ms. A. Sneha Vardhani(Associate)

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