The Delhi High Court Discusses the Effect of Novation on an Arbitration Clause in the Original Contract

The Delhi High Court recently in the case of B.L. Kashyap and Sons Limited vs. Mist Avenue Private Limited1 held that when a new contract novates the original contract, the arbitration clause would also stand extinguished by virtue of the new agreement. This decision is based on the principle of novation of a contract which is enshrined in Section 62 of the Indian Contract Act, 1872. The Section states that “if the parties to a contract agree to substitute a new contract for it, or to rescind or alter it, the original contract, need not be performed.”

In this case, B.L. Kashyap and Sons Limited filed a petition under Section 34 of the Arbitration and Conciliation Act, 1996 (“Act“) seeking to set aside an arbitral award rendered by a sole arbitrator on January 7, 2019. The disputes first arose under a Construction Contract executed between the parties in August 2014 (“Construction Contract“). Such disputes were resolved mutually between the parties and the parties entered into a Memorandum of Understanding (“MOU“) in October 2014 to record the settlement terms. It is relevant to note that while the Construction Contract contained an arbitration clause, the MOU did not. The MOU merely provided that the petitioner was entitled to claim all dues under the Construction Contract and “file any legal measures” for this purpose.

According to the MOU, the Construction Contract would be considered fully satisfied when the petitioner handed over all the assets and consumables listed therein, and Mist Avenue Private Limited paid the final settled dues of Rs. 1,32,00,000/- under the Construction Contract. The parties also agreed to cancel the Construction Contract and enter into a new contract based on a cost-plus basis, with Mist Avenue Private Limited making an advance payment of Rs. 1,50,00,000/- in instalments. When the respondent failed to pay the entire amount, the petitioner invoked the arbitration clause under the Construction Contract. The respondent raised a preliminary objection as to the arbitrability of the disputes on the basis of the execution of the MOU. The arbitrator concluded that the MOU amounted to novation of the Construction Contract and, therefore, the arbitral tribunal lacked jurisdiction to entertain disputes under the arbitration clause in the Construction Contract. The arbitrator further determined that even if the terms of the MOU were breached, the Construction Contract could not be revived. The petitioner challenged this arbitral award before the Delhi High Court.

The Delhi High Court examined whether an arbitration clause survives a supervening agreement between the parties. After discussing various judgements, the following observations were made:

(i) An arbitration clause contained in an agreement which is void ab initio cannot be enforced as the contract itself never legally came into existence.

(ii) A validly executed contract can also be extinguished by a subsequent agreement between the parties.

(iii) If the original contract remains in existence, for the purposes of disputes in connection with issues of repudiation, frustration, breach, etc., the arbitration clause contained therein continues to operate for those purposes.

(iv) Where the new contract constitutes a wholesale novation of the original contract, the arbitration clause would also stand extinguished by virtue of the new agreement.

The interpretation of the MOU by the arbitrator was discussed in the judgement. The arbitrator observed that ‘legal measures’ as stated in the MOU, did not specify that the previous contract cancelled hitherto would automatically revive and come into operation. There was no specific mention that the parties would get their disputes under the MOU settled through arbitration. There was an express understanding incorporated in the MOU whereby both the parties had categorically agreed to cancel the previous original agreement. The arbitrator held that though the original contract was validly executed, the parties decided to put an end to it as if it never existed and substituted a new contract for it, solely governing their rights and liabilities. In such a situation, the original contract is extinguished by the substituted one and the arbitration clause of the original one perishes with it.

The Delhi High Court agreed with the interpretation of the terms of the MOU by the arbitrator and stated that such interpretation was plausible and did not call for any interference under Section 34 of the Act. While the MOU records the terms upon which the Construction Contract will stand fully satisfied, this does not lead to an invariable conclusion that the Construction Contract would stand revived, if those terms were not fulfilled. The MOU stated that it was executed to cancel the Construction Contract, which contained the arbitration clause. Therefore, the Construction Contract was novated by the execution of the MOU. The Court relied on two Supreme Court judgments2 to hold that the arbitration clause in an agreement would perish with its novation. Consequently, the petition was dismissed, and the arbitral award was upheld.

Parties seeking to novate a contract, through execution of a new contract, such as a memorandum of understanding or a settlement agreement, must bear in mind that if the parties would like to retain the right to refer a dispute to arbitration the novated contract must also contain an arbitration clause. Upon novation of a contract the rights under the original contract are extinguished and parties should therefore ensure that all essential provisions are incorporated or reproduced in the novated contract.

1 O.M.P. (Comm) 190/2019

2 Union of India vs. Kishorilal Gupta & Bros, AIR 1959 SC 1362 and Lata Construction vs. Rameshchandra Ramniklal Shah (Dr), (2000) 1 SCC 586.