The Role of Equity in Decision-Making by Arbitrators

Introduction

Indian law stipulates that an Arbitral Tribunal is not a court of law and cannot decide a dispute on its own notions of “justice”¹ or equity (unless authorised by the parties)² and must plainly rely on the terms of the contract in dispute. This position gives rise to a perception that arbitrators do not have the flexibility to render awards with an equitable approach.

In practice however, a tribunal invariably decides disputes using principles and statutory provisions that are in fact deeply founded in equity. While a tribunal cannot emphatically base its decision simply and solely on a vague notion of equity, it would be inaccurate to suggest that a tribunal cannot resort to equity at all. However, the line between the permissible use of equitable principles by Arbitral Tribunals and an impermissible rewriting of the contract is very thin and is exemplified only in some case-specific instances.

This article accordingly attempts to highlight the difference between a permissible application of equitable principles by an Arbitral Tribunal (whether authorised or not authorised to do so by the parties) and impermissible transgressions by a tribunal into doing what it feels is just, dehors contractual terms.

Part I of this article explains the content and impact of the principles that appear to prohibit arbitrators to render awards on the basis of equity or justice, unless authorised to do so by the parties. Part II analyses the ability of arbitrators to effectively apply equity even without specific authorisation by parties. Part II also references indicative case law where awards have been set aside on account of the unauthorised use of equity.

Part I

Principle I — A tribunal cannot give effect to its own notions of justice

Army Welfare Housing Organisation v. Sumangal Services (P) Ltd.³ (AWHO), is one of the earliest decisions of the Supreme Court, holding that an Arbitral Tribunal is not a “court of law” and cannot exercise its powers “ex debito justitiae”.

While this ruling has been subsequently followed in several Courts reaffirming the position that a tribunal cannot decide disputes on notions of “justice” – the decision in AWHO⁴ really arose in the context of a tribunal’s power to pass an interim order under the erstwhile Arbitration Act, 1940⁵ (the 1940 Act). Section 41 of the erstwhile 1940 Act⁶ empowered only a court to grant interim reliefs, and no such power was conferred upon an Arbitral Tribunal in the statute itself. However, such power could be conferred on the tribunal by parties.⁷ The Tribunal in AWHO⁸ issued an interim order, without the parties having conferred any such power on the Tribunal. This action was therefore found to be beyond the jurisdiction of the Tribunal.

The Arbitration and Conciliation Act, 1996⁹ (the 1996 Act) has changed this position and Section 17 of the 1996 Act¹⁰ statutorily confers the power to grant interim relief on a tribunal. Therefore, the statutory basis behind the holding in AWHO¹¹ no longer holds true. The rationale in AWHO¹² that Arbitral Tribunals do not have the same capacity as a court in rendering a decision, has however been subsequently followed by courts in varying contexts.

For instance, in PSA SICAL Terminals (P) Ltd. v. V.O. Chidambranar Port Trust Tuticorin¹³, the Supreme Court referred to the decision and observations in AWHO¹⁴ in setting aside an award where the tribunal had substituted the payment formula contained in the contract. The Court held that this amounted to a rewriting of the contract which was against fundamental principles of justice and also patently illegal. This decision of the Court therefore could have been solely based on a violation by the Tribunal, of the principle that a contract cannot be rewritten without the consent of parties. Therefore, the reference to the principle in AWHO¹⁵ was not indispensably necessary to the conclusion of the court.

As will be explained in Part II, the tendency of courts in setting aside proceedings, to reiterate that an Arbitral Tribunal is not a court of law – usually arises on account of awards that do not sufficiently explain the basis for the relief granted by the Tribunal, and link it to contractual terms, evidence, and rules of law. This indicates that the problem is not really the relief that a tribunal grants, it is rather the explanation of the manner in which it reaches that result.

Principle II — A tribunal cannot give effect to its own notions of equity or fairness

Apart from the apparent prohibition on giving effect to its own notions of justice, Section 28(2) of the 1996 Act further expressly prohibits a tribunal from deciding a dispute “ex aequo et bono” or as “amiable compositeur” unless specifically authorised by parties to do so. While these phrases translate to different terms, these effectively refer to decision-making on the basis of equity.¹⁶

Section 28(3) of the 1996 Act further provides that in all cases (including where the tribunal is authorised to apply equity), the tribunal “shall” take into account the terms of the contract. Therefore, even where parties have authorised a tribunal to decide a dispute on the basis of equity, a tribunal cannot overlook the terms of the contract.

The question that therefore arises is — what really is the flexibility given to a tribunal when it has been authorised to decide on the basis of equity and fairness? Sections 28(2) and (3) of the 1996 Act effectively reflect Articles 28(3) and (4) respectively of the Model Law¹⁷. Guidance on these provisions may therefore be taken from decisions of other Model Law countries. One view, as explained in a decision of a Canadian Court of Appeal is that the arbitrators authorised to decide in accordance with equity do not need to strictly apply the relevant rules of law and can even mitigate the application of such rules. However, they cannot do the same with respect to contractual terms.¹⁸

This approach harmoniously considers both, Sections 28(3) and (4) while retaining some meaning for each of those provisions. In this view, there is some additional flexibility, when arbitrators are given the power to act in accordance with equity or good conscience or as amiable compositeurs under Section 28(3), but only insofar as the application of rules of law are concerned.

To the extent that those rules of law do not constitute mandatory rules (that cannot be contracted out of), or form part of public policy, the arbitrators may be free to ignore or avoid application of such rules. Statutory default rates of interest, or other similar statutory provisions that contain default rules “unless agreed otherwise by the parties” are examples of such non-mandatory rules. This additional flexibility does not however extend to expressly agreed contractual terms, thereby respective and preserving meaning to Section 28(4).

The Canadian Court of Appeal in Coderre¹⁹ ultimately took a slightly different view i.e. in most circumstances, an express authorisation to do equity or act as “amiable compositeurs” would not permit arbitrators to substantially rewrite a contract without parties’ authorisation. Yet, the Court noted that in some circumstances, express powers to act in equity or as “amiable compositeurs” would allow arbitrators to even strike out contractual terms, for example on the basis of internal inconsistencies in the terms of the contract.²⁰

There is no consistently settled view on precisely the extent to which arbitral powers are expanded when there is an express authorisation by parties under Section 28(3). It is apparent that some meaning has to be given to such an authorisation, thereby affording greater latitude in decision-making by arbitrators than other arbitrators not specifically authorised by the parties. However, it is equally apparent from Section 28(4) that this does not automatically allow arbitrators to ignore or override terms of a contract.

There is also little guidance available on the manner of authorising a tribunal to act in accordance with equity under Section 28(3). Pleadings in India very frequently seek a generic broad relief (in addition to specific reliefs), asking the tribunal to grant “any other relief” that it sees fit in its discretion, sometimes even with the express use of the term “equity”. It would be an interesting issue to be settled by courts whether this would amount to an authorisation in terms of Section 28(3), or does the law require a more specific and conscious authorisation to the arbitrators to decide on the basis of equity.

The resulting position on the expanded powers of arbitrators under Section 28(3) can be stated to be the following: first, that while appreciating and applying default rules of law, as explained above, arbitrators authorised to do equity may choose not to apply certain default and non-mandatory rules as per their discretion.²¹

Second, that in certain situations arbitrators can give effect to the parties’ intent behind a contract in interpreting or diluting the effects of some contractual terms, for example where literal interpretation of terms appear to be absurd or contrary to party intent evident in other contractual terms. This could be justified on the basis that arguably, an authorisation to the tribunal to do equity would effectively be a contractual term in itself allowing the tribunal to appreciate and apply other contractual terms on its notions of equity.

In such a scenario, a tribunal will have the ability to perform a balancing function between applying substantive contractual terms and applying its authorisation to render equity. In this event, even if a tribunal was to expressly not give effect to one contractual term, this could be argued as being in furtherance of the overall contract, and not contrary to it.

Interestingly, in common law countries like India, arbitrators may act in accordance with equity in the appreciating contractual terms even without an express authorisation under Section 28(3). This is so because a large body of Indian law actually stems from equitable principles, some common examples of which are explained in Part II below.

Before proceeding to Part II, it is important to highlight that the law does not consider arbitrators as inherently incapable of deciding on the basis of equity, despite not being a “court of law”. For instance, under Section 17 of the 1996 Act, a tribunal is expressly empowered to grant interim measures based on its view of what is “just and convenient”. This is the same as the power granted to a court under Section 9 of the 1996 Act²² to grant interim measures. The term “just and convenient” has been interpreted by at least one court to effectively be the same as equity,²³ — thereby meaning that the law itself also contemplates arbitrators acting on the basis of equity, albeit in specific scenarios.

Part II

A. Use of equity by arbitrators when not authorised by parties

There are in fact several principles and tools that a tribunal has at its disposal (of course relying on effective pleading and advocacy by the parties) to arrive at a decision that gives effect to justice and equity — without expressly saying so. Some of these are discussed below:

Implied terms

Contracts governed by common law systems, such as Indian law and UK law recognise that a contract may contain terms which are not reduced into writing. These are “implied” in the contract on the basis of certain tests such as the obviousness of the terms, the business efficacy they give to the contract and as long as they are not contrary to other express terms of the contract.²⁴

Contractual disputes may require such analysis when the fundamental circumstances in which the contract was entered into changes so materially that it becomes very doubtful that the parties could have intended the contract to continue as per its terms in such a drastically different situation.²⁵

One of the earliest expressions of the rationale behind implied terms, as extracted in a decision of the Calcutta High Court²⁶ clearly evidences its strong roots in equity. In that case the contract stipulated that the goods sold were to be sent to the buyer by rail. However, the railway authorities were not providing freight services at the time of the contract, and the parties had assumed that freight carriage services by the rail authorities would commence subsequently, which ultimately did not happen.

The Court interpreted the agreement to have an “implied condition” (arguably having much greater impact than ordinary terms) that the contract was conditional upon the assumption of sending freight by rail. This assumption having turned out to be incorrect, the Court held the contract to be void. The Court describes the existence of implied terms as:

…a general principle applicable to contracts where parties contract upon a common postulate; the contract will be impliedly conditional upon that common assumption holding good and will not be enforced by the Court so as to throw upon one of the parties a risk which neither of the parties intended that he should bear….”²⁷

(emphasis supplied)

The application of implied terms has been rare, and the Supreme Court of India in its famous decision in Alopi Parshad v. Union of India²⁸ held that there is no general principle of law that allows a court to depart from the terms of a contract on account of a change in circumstances completely outside the contemplation of parties. Even while holding so, the Supreme Court recognised the possibility of the effective grant of an equitable relief on the basis of implied terms.

The Supreme Court rationalised an English decision in Lindsay Parkinson & Co. Ltd. v. Commr. of Works²⁹ where the English Court had implied a term in the contract that prevented an unfair result. In Parkinson³⁰, the contract fixed a consideration and required a contractor to carry out construction of identified works as well as some unidentified additional works as would be communicated subsequently. The English Court implied a term in the contract that the unidentified additional work could not be excessive in relation to the fixed consideration. The English Court thus effectively acted equitably and mitigated the possibility of the harsh consequence of requiring the contractor to perform an unlimited scope of the “additional works” without any increase in the consideration.

The principle of implied terms has been recognised by the Supreme Court in several cases,³¹ while cautioning against its abuse and observing that its application should be limited.³² The path of implied terms can thus form a helpful tool for a counsel to give a tribunal some reasonable basis to effectively act in accordance with equity or fairness or mitigate the effect of other harsh terms.

Unconscionable terms

As opposed to implying terms into a contract, there may be situations where a tribunal endeavours to modify the effects of a harsh contractual term. In one such situation, in IOCL v. Shree Ganesh Petroleum³³, the Supreme Court set aside an award since the arbitrator had modified the terms of a dealership agreement. However, one of the factors considered by the Court was that there had been “no finding by the Arbitral Tribunal that any condition of the dealership agreement was unconscionable”³⁴, indicating that if the Tribunal had indeed found a particular term as unconscionable, the award may have been upheld.

This suggests that a tribunal does have some leeway in diluting or even striking out specific terms of a contract based on a finding that such term is unconscionable. This principle flows from Section 23 of the Contract Act, 1872³⁵, which expressly allows a “court” to treat terms that are opposed to public policy as being void/non-existent. The Supreme Court has specifically interpreted Section 23 of the Contract Act to allow nullification of some contractual terms on the basis that they: “are so unfair and unreasonable that they shock the conscience of the court. They are opposed to public policy and require to be adjudged void”³⁶.

Therefore, the principle in Section 23, allowing courts to ignore terms, is equally available, in principle, to a tribunal. This further indicates the existence of another tool available to an Arbitral Tribunal to apply the same principles as a court and render justice.

Estoppel

The rule of estoppel is an equitable principle that can be applied to prevent a party from changing its position as to the effect of a contract.³⁷ Described as a “natural result of the fusion of law and equity”,³⁸ this principle has been used even to uphold a position contrary to the terms of a contract, as long as the parties had acted on the basis of that position. Accordingly, principles of estoppel can be used by a tribunal to equitably give effect to the contract by relying on the conduct of parties and effectively superseding the terms of the contract, in appropriate circumstances.

Equity and fairness in statutes

Equity and fairness also exist in various statutory provisions that may be applicable in arbitration. For a most direct example, under Section 30 of the Specific Relief Act, 1963³⁹ a “court” can require a party to return any benefits received under a contract, where such contract is being allowed to be rescinded. Section 30 is in fact appropriately titled “court may require parties rescinding to do equity”.

The Supreme Court has held that despite the use of the word “court” in the Specific Relief Act, provisions of the Specific Relief Act can be applied by arbitrators.⁴⁰ The nature of a claim under Section 30 of the Specific Relief Act has in fact specifically been held by the Supreme Court as being “in personam”,⁴¹ and therefore, arbitrable. A tribunal can accordingly apply various provisions of the Specific Relief Act that are expressly or implicitly grounded in equity.

Similarly, numerous provisions require a “reasonable” result, effectively amounting to rules of law that aid fairness. One of the most common instances of this is Section 74 of the Contract Act, 1872⁴² which limits damages that may be awarded to parties. Where a contract specifies an amount of liquidated damages or a penalty to be paid to the non-breaching party, Section 74 limits the amount to be paid to the extent of “reasonable compensation” and does not allow a literal application of the contractual term stipulating the specified amount. This is one of the several examples where a statutory rule itself mitigates possibly harsh consequences of the literal application of a contractual term.

B. Instances where awards have been set aside on account of unauthorised exercise of equity by a tribunal

The prohibition against unauthorised exercise of equity has, similar to the principle against a tribunal rendering its own notion of justice, been used by courts only in rare circumstances where a tribunal did not make a credible effort to merge its reasoning with contractual provisions.

The commonality in all these situations is that the tribunal was convinced that the contract resulted in harsh consequences for one party and the tribunal mitigated the impact of these clauses. However, these awards were set aside since the award did not contain adequate reasoning justifying the relief granted on either (i) rules of law that are grounded in equity (as indicated in Section C above); or on (ii) the applicable contractual terms which gave rise to the presumption that the decision-making undertaken by the tribunal was based on unreasoned equitable considerations, without any specific authorisation to do so by the parties. An indicative analysis of some such decisions is as follows:

Termination clauses

In Board of Control for Cricket in India v. Deccan Chronicle Holdings Ltd.⁴³, the Tribunal found that BCCI, in terminating its contract with Deccan Chronicle had acted in an “unfairly discriminatory” manner. The contract therein did not provide “unfairness” or “discrimination” as one of the grounds for questioning the validity of a termination. The Tribunal therefore appeared to apply public law concepts to a purely contractual termination and held the termination to be in breach on account of discrimination.

The Bombay High Court accordingly set aside this decision of the Tribunal. The decision of the Bombay High Court could have been different if the Tribunal had, as an interpretative exercise — managed to weave in “discrimination” or unfairness into the contractual terms regulating termination — on the basis of equitable principles such as estoppel or by finding implied terms to a similar affect. What weighed with the Court was that the Tribunal simply assumed it had the power to hold a termination to be invalid on account of a principle of non-discrimination, without explaining the contractual or legal basis for it to be able to apply this principle. The High Court specifically observed that the Tribunal had not even attempted to reason why it had any public law powers or could exercise public law concepts (i.e. discrimination) in a private law sphere (contractual arbitration).⁴⁴

Assessment of damages where both parties are at fault

Similarly, an award that finds both parties to have contributed to a breach, cannot simply assess damages by way of an arbitrary percentage without any evidence of the monetary impact of each parties’ individual contribution to the loss, to a reasonable extent. The Delhi High Court thus set aside an award since the Tribunal had held that the claimant and respondent were both equally responsible for the breach and accordingly granted the claimant 50% of its claim, on the basis of a 50:50 allocation of responsibility, without any reasoning or evidence to arrive at the figure of 50%.⁴⁵ The Court criticised this approach, remarking that this was a “panchayati solution”, indicating the emphasis on the level of reasoning expected from a tribunal and consequently, set aside the award.

Risks arising out of “as is where is” basis transactions

Several transactions attempt to place the risk of any defect in the property being transferred on the buyer, by expressly stating that the sale is on an as “as is where is” basis, thereby putting the buyer to notice to be reasonably diligent in investigating any issues. A tribunal, in the absence of authority to act equitably cannot mitigate these risks even if the transaction results in a harsh or unfair result for the buyer – unless it uses equitable rules and principles such as those explained above.

Accordingly, the Delhi High Court set aside an award where a tribunal allowed a claim for refund for deficiencies in goods bought on an “as is where is” basis.⁴⁶ This was since the contract specifically provided for a refund only for goods bought on a “unit” basis, as opposed to purchase of an entire lot on an “as is where is” basis. The Court held that the contract specifically excluded refunds for purchases made on an “as is where is basis”. In setting aside the award, the Court concluded that the arbitrator had acted “on the basis of equitable considerations” by awarding a refund to the buyer despite the allocation of risks of deficiency to the buyer.

Fashioning remedies not sought by the parties

Similarly, a tribunal cannot fashion a remedy which is not sought for by either party. This has been held to amount to an exercise in equity, which in the absence of authorisation of parties, will result in setting aside of the award. This is the position both in India,⁴⁷ as well as other jurisdictions that apply the UNCITRAL Model Law,⁴⁸ which contains the same provision as in Section 28 of the 1996 Act.

Attempted mitigation of harsh contractual terms

A tribunal directing a refund of a deposit in a contract of sale, despite a term which provided that the deposit would be forfeited if the contract of sale was not completed, was held to be an unauthorised exercise in equity. The ignorance of the forfeiture clause was therefore set aside as being an unauthorised adoption of an “approach consistent with the principles of equity” by the tribunal.⁴⁹ Similarly, a tribunal cannot, on the notion of equity refuse to award a high rate of interest found either in the contract or trade usage and reduce the same. The Supreme Court has categorically held that this would be a violation of Sections 28(2) and (3) of the 1996 Act.⁵⁰

Conclusion

The general apparent prohibition against arbitrators deciding on the basis of equity or justice serves as a consistent reminder by courts to Arbitral Tribunals that their decisions have to be grounded in law and contract and be sufficiently reasoned. This does not mean that these decisions cannot be equitable or in accordance with the Tribunal’s idea of justice. Even without specific authorisation by parties, common law principles and statutory provisions provide enough scope for the application of various principles of law to reach an equitable result as explained above.

Arbitral equity assumes special significance in situations where a tribunal grapples with the harsh effects of certain contractual clauses or when fundamentally changed circumstances warrant that the contract be interpreted equitably and reasonably keeping in mind the intent and conduct of parties.

There is therefore no real prohibition for a tribunal to decide a dispute in accordance with its notions of equity and justice, as long as these notions are well founded and explained by application of appropriate rules of law and principles of interpretation of contracts that allow such an approach.

The views of the author are entirely personal and do not represent the views of any organisation or entity.