The Enforceability of Arbitration Clauses in Draft Agreements

Introduction

The foundation of arbitration rests on a simple yet profound principle: no consent, no arbitration. This indispensable element came under scrutiny in the landmark case of Afcons Infrastructure Ltd. v. Cherian Varkey Construction Co. (P) Ltd.¹. In this case, the Supreme Court of India held that courts cannot send parties to arbitration under Section 89 of the Civil Procedure Code, 1908² (CPC) in the absence of the parties’ express consent. This judgment emphasises how consent is not just a procedural requirement but the bedrock of arbitration itself. In the absence of consent, the very premise of arbitration collapses, turning it into an involuntary imposition rather than a chosen remedy. The question that arises here is how to determine whether there is consent between the parties to resolve disputes through arbitration.

The legislature, under Arbitration and Conciliation Act, 1996³, has entrusted referral courts with the responsibility of determining the existence of arbitration agreement between the parties before referring them to the Arbitral Tribunal. One of the essential requirements for establishing the existence of an arbitration agreement is that it must be in writing. Furthermore, if the record of such an agreement emerges from the exchange of letters, telex, or any mode of electronic communication, then the arbitration agreement is deemed to be in writing between the parties.

But what would be the scenario if the dispute arises between the parties at the stage of finalising the contract wherein parties are still negotiating the terms of the contract and have incorporated certain clauses, including an arbitration clause, but the agreement has not yet been signed. Would the inclusion of the arbitration clause or the exchange of such a draft agreement amount to the existence of an arbitration agreement?

Existence of valid arbitration agreement

It is essential to understand the fundamental principles outlined under Contract Act, 1872⁴ (ICA) to understand the formation of concluded contract between parties. Section 4 of the ICA⁵ provides that communication of a proposal is complete when it comes to the knowledge of the person to whom it is made. Similarly, the communication of acceptance is complete as against the proposer, when it is put to the knowledge of the proposer. Further, Section 7 of the ICA⁶ explicitly states that for a proposal to get converted into a promise, the acceptance must be absolute and unqualified, and it should be conveyed in a usual and reasonable manner.

These principles of contract formation under the ICA also apply to the formation of arbitration agreement under Section 7 of the Arbitration and Conciliation Act⁷. Section 7 of the Arbitration and Conciliation Act contemplates a situation wherein an arbitration agreement may be formed through exchange of letters or even through written reference of a document that has an arbitration clause. An arbitration agreement need not be signed and executed formally to be binding on the parties. However, for an arbitration agreement to be valid, the parties must be ad idem (of the same mind) and must accept the terms and conditions specified in the agreement.

In cases where a dispute arises during contract negotiations — such as when one party sends a draft agreement to the other with material alterations to the terms — the altered draft constitutes a counterproposal. In such a scenario, where the contract is in number of parts, a binding arbitration agreement is formed only when the contracting party expressly provides its absolute and unqualified acceptance of the revised terms.

Acceptance by conduct

It is well settled position of law that an offer can also be accepted by the conduct, for instance, a company sends a café a high-end espresso machine, stating in small print, “If you keep and use this machine, you agree to purchase it for $2,000”. The café owner, loving the machine, starts making lattes with it every morning. Their use of the machine constitutes acceptance by conduct or if a publishing company sends a law firm a set of legal encyclopedias with a note: “If you do not return these within 14 days, you agree to purchase the full set for $500”. The firm places them in their library and starts using them for case research. Their use indicates acceptance of the offer. Therefore, a question that arises here is whether the communication of unilateral offer/counterproposal amounts to the acceptance of arbitration agreement by the conduct of the parties?

The said question was briefly discussed by the Supreme Court in U.P. Rajkiya Nirman Nigam Ltd. v. Indure (P) Ltd.⁸, wherein the Supreme Court addressed an appeal regarding the existence of an arbitration agreement. The dispute arose when the parties decided to enter into an agreement for a joint venture to submit a tender to the Board and, in this regard, exchanged a draft agreement that included arbitration clause. The respondent, after altering material terms of the draft agreement, sent the revised version to the appellant and also unilaterally submitted the amended agreement to the Board. However, before the tender could be finally accepted by the Board, the appellant withdrew from the process. As a result, the respondent claimed damages from the appellant and sought the appointment of an arbitrator for adjudication of disputes.

The appellant contested the claim of the respondent by stating that no valid arbitration agreement existed, as the parties were in the negotiating stage and the material provisions of the contract were not settled. The stand of the respondent is that the agreement was entered into force when the respondent sent a counterproposal to the appellant and appellant had not returned the proposal, therefore, it was argued that the appellant, despite not signing it, acted on it, implying indirect acceptance and thus concluded contract came into existence. However, the Supreme Court observed that material changes to certain clauses of the contract by the respondent, would significantly impact the determination of concluded contract between the parties. The draft agreement sent by the respondent to the appellant was merely a counterproposal, and without the appellant’s express consent, it could not be said that appellant understood the agreement in the same manner as the respondent did. Therefore, in the absence of consensus ad idem on the material terms of the contract, no concluded contract emerged; and consequently, no arbitration agreement could be said to exist between the parties.

Validity of arbitration clauses in the draft agreements

While determining the existence of arbitration agreement between the parties, the Calcutta High Court in Orissa Stevedores Ltd. v. Orissa Mineral Development Co. Ltd.⁹, deals with an interesting question, wherein the petitioner sought to enforce the arbitration agreement by stating that modification suggested by it in the draft agreement did not alter the arbitration clause and therefore the arbitration clause is deemed to have been accepted between the parties. As per the facts of the case, the respondent shared a draft agreement with the petitioner for finalisation so that a formal agreement could be executed between the parties. However, the petitioner suggested a modification to one of the minor terms of the draft agreement without questioning the arbitration clause contained therein and as a result, a formal agreement could not be executed between the parties. Later, after performing a substantial part of the contract, the dispute arose between the parties, and petitioner invoked the arbitration clause contained in the draft agreement.

The Calcutta High Court observed that:

15. … if it is held that the modification suggested did not affect the arbitration clause and as such the arbitration clause is deemed to have been accepted, there would be a serious problem.¹⁰

The Court observed that there was an exchange of letters, which serves as a record of the draft agreement having been exchanged between the parties. However, it cannot be said there exists a valid arbitration agreement between them. When the petitioner suggested modifications to the draft agreement, it effectively sent a counterproposal to the respondent rather than accepting the terms of the draft agreement as sent by the respondent. The Court further clarified that without proper agreement, the arbitrator could not ascertain whether the modifications suggested by one party to another were accepted or rejected by the parties and whether the original draft agreement was final.

Another reason for rejecting the petitioner’s suggestion could be that, despite the presence of an unaltered arbitration clause in the draft agreement, the parties cannot be compelled to arbitrate based on clauses that were never discussed or agreed upon between the parties. The incorporation or modification of the clauses in the draft agreement could serve as a safeguard or provide a strategic advantage to one party and may be detrimental to the interests of another party in the event of arbitration. Therefore, without the absolute and unqualified acceptance to these clauses there cannot be said to have an agreement between the parties to go to arbitration. The draft agreement that was sent by the respondent to the petitioner was the proposal, when the petitioner suggested modification, however insignificant, there was no absolute or unqualified acceptance by the petitioner of the proposal contained in the draft agreement. However, the petitioner made a counterproposal and suggested new agreement which clearly shows that the parties were not at ad idem on the draft agreement and therefore no arbitration agreement can be said to exist between the parties.

Conclusion

At the heart of arbitration lies the concept of meeting of minds without it, arbitration ceases to be a chosen mechanism and instead becomes an imposed mechanism. Courts must therefore go beyond the mere presence of an arbitration clause in a draft agreement and rather ascertain whether there was an absolute and unqualified acceptance of the arbitration agreement by the parties. As the saying goes, “A prelude to a contract should not be confused with the contract itself”. The stage of negotiation, including the exchange of draft agreements, is an antecedent step and does not amount to an unequivocal acceptance of arbitration terms. The essential features of an enforceable arbitration agreement include a definite commitment instead of mere option to arbitrate, with a clear and mutual intent of the parties. Thus, if there is no concluded arbitration agreement, courts should not force parties into arbitration simply because a draft agreement has an arbitration clause in it.