When Contract Meets Constitution: The Implications of the Supreme Court Judgment in Lombardi
Madhav Goel and Anjali Sharma*
Insights, commentaries, and articles by the TrustBridge team, first published here. TrustBridge seeks to improve India’s business environment by improving the rule of law.
In India, the scope of judicial intervention under the scheme of the Arbitration and Conciliation Act, 1996 (the “Act”) is narrow and intended to be largely procedural. However, courts have often not adhered to this brief. In 2014, the 246th Law Commission Report noted that the bar of judicial interventions in arbitration was low. In 2015, the report of the Justice Srikrishna Committee on Institutionalisation of Arbitration observed that efforts to encourage arbitration were impeded by excessive court involvement in the arbitration process. The 2015 amendment to the Act introduced Section 11(6A), which sought to limit the role of courts in appointing arbitrators to “...examining the presence of an arbitration agreement”, thereby underscoring the idea of minimal court intervention in arbitration matters.
Since then, however, in several judgments, courts have ruled on matters that the Act leaves for parties to decide contractually. For instance, in Perkins Eastman Architects DPC v. HSCC (India) Ltd. (2020), the Supreme Court ruled against the unilateral appointment of a single arbitrator even when this was contractually agreed upon by parties. In ICOMM Tele Limited v. Punjab State Water Supply and Sewerage Board & Anr. (2019), the Supreme Court held that an arbitration clause containing a requirement of a pre-deposit as a condition to initiate arbitration was arbitrary. Generally, the Court’s review of arbitration clauses in contracts has been in cases where the government or its instrumentalities are counterparties. In such cases, courts have not shied away from applying even the lens of constitutional review, particularly Article 14, to such clauses. However, the impact of such judgments is uncertainty in regard to the validity of such contractual clauses even in completely private contracts.
In a recent judgment, Lombardi Engineering Ltd. v. Uttarakhand Jal Vidyut Nigam Ltd. (2023) (hereafter, Lombardi), the Supreme Court has further cemented the basis for review of arbitration clauses on the grounds of being violative of Article 14. In this article, we examine the implications of this judgment, both from the perspective of arbitration as a dispute resolution mechanism and the broader question of contractual autonomy in commercial transactions.
Background of the Lombardi judgment
Lombardi Engineering Ltd., a Swiss company, petitioned the Supreme Court to appoint an arbitrator in its contractual dispute with Uttarakhand Jal Vidyut Nigam Ltd., a wholly owned corporation of the Government of Uttarakhand. In this matter, the arbitration clause in the agreement stipulated that to invoke arbitration, Lombardi Engineering Ltd. would have to pre-deposit 7% of the total claim value with the Uttarakhand Jal Vidyut Nigam Ltd. While the petition was filed under Section 11(6) of the Act, Lombardi Engineering Ltd. also challenged this stipulation as arbitrary and hence violative of Article 14 of the Constitution of India.
In considering the matter, the Supreme Court examined the Act and the hierarchy of laws under the Indian legal system and reached three important conclusions. First, it held that even under a petition under Section 11(6) of the Act, there is no bar on the court to prima facie apply the Article 14 test of arbitrariness to examine arbitration clauses in a contract. Second, it held that if the court decides that the arbitration clause is arbitrary and contrary to Article 14, it can invalidate such a clause in the agreement. Finally, the court observed that arbitration clauses in contracts must comply with the provisions of the Act as well as the Constitution.
The implications of Lombardi
In allowing constitutional review grounds to apply to arbitration clauses in contracts, the Supreme Court has created several challenges. First, it has made the job of the high courts dealing with arbitration matters harder. These courts have to undertake an Article 14 review without much guidance on what might constitute arbitrariness. This can become another source of judicial discretion, inefficiency and delay in arbitration matters. Second, the possibility that different high courts and benches will take varying views on what makes an arbitration clause arbitrary will generate legal uncertainty. Even lawyers drafting these clauses will not be able to effectively advise parties about what might later be subjected to judicial review. Finally, in its observation on the priority of the Constitution over arbitration clauses in contracts, the Supreme Court has failed to clarify the important question of whether Lombardi will apply only to cases where the party ‘benefiting’ from an arbitrary arbitration clause is ‘State’ under Article 12, or even to contracts between private parties. The prevailing jurisprudence is that except for certain rights, such as those guaranteed by Articles 17, 19, and 21, fundamental rights are available only against the state. However, when the legality of arbitration clauses can be tested against the touchstone of Article 14, the door opens for applying the arbitrariness test to arbitration clauses in all contracts, not just those contained in contracts with the government.
The broader question of contractual autonomy
Lombardi’s ratio is not necessarily limited to cases where one party is ‘state’ under Article 12 of the Constitution. Nor has the court laid down any boundaries or provided any guidance on its applicability. In fact, the judgment explains the applicability of Article 14 to arbitration clauses by merely assessing the hierarchy of laws in the Indian legal system - with the Constitution (i.e., the Grundnorm) at the top, followed by statutes, and finally by contracts at the bottom. In Lombardi, the Supreme Court did not test the validity of the arbitration clause against the Act itself, but applied the much higher standard of constitutional law principles to a private contract. In doing so, it may have blurred the line between private and public law.
Contracts are the subject matter of private law. As long as parties meet the baseline standards laid down in the general and specific statutes governing contracts, they are free to design contracts to suit the needs of transactions. If contractual clauses have to be judged on subjective ideas such as arbitrariness and unfairness, these ideas need to be legislated with clarity in the laws that govern contracts. For instance, the reasons due to which certain arbitration clauses did not stand the test of Article 14 need to make their way into the Act. If this feedback loop is not closed, and courts continue to judge contractual clauses on constitutional standards, and that too after parties agree to abide by these clauses, there will be uncertainty around the validity of contracts further compounded by different courts’ interpretations of what is arbitrary in the context of different contracts.
This new strand of jurisprudence, i.e. application of constitutional law principles not to a statute but to a private contract, may also spawn a new type of litigation that seeks to expand its applicability not just to arbitration clauses but to other types of contractual clauses as well. It will only take a few imaginative lawyers testing these grounds in court. The onset of such litigation runs the risk of some court, in the future, ruling on these matters in a way that impacts other types of contractual clauses. In the time that it takes for clear precedent to emerge, there will be reduced certainty in private contracts, especially in long-term contracts, where parties may strategically resort to such challenges to avoid fulfilling their obligations under the contract.
Conclusion
Many recent Supreme Court decisions have addressed issues of subjectivity and arbitrariness in the arbitration clauses in contracts. The judgment in Lombardi has cemented the idea that such clauses can be subjected to judicial review on constitutional grounds. This goes against not just the stated policy intent of minimal judicial intervention in arbitration, but also has the potential to increase uncertainty around the validity of such clauses. Further, the lack of guidance on the applicability of Lombardi to state versus private contracts has the potential to introduce greater uncertainty in contracting and, consequently, a reduction of contractual autonomy. By allowing subjective grounds for review of contractual clauses, Lombardi has created a pathway for such matters to come to courts repeatedly, further burdening an already overburdened court system. The hope is that subsequent judicial pronouncements limit Lombardi’s ratio to the facts of its case rather than its current expansive scope.
*The authors are at the TrustBridge Rule of Law Foundation.
Cite as: Madhav Goel and Anjali Sharma, When Contract Meets Constitution: The Implications of the Supreme Court Judgment in Lombardi, The Bridge, February 2024