Arbitration Agreement Does Not Extend To Guarantee Agreement If Not Stated Explicitly

While loan agreements and guarantee agreements are frequently intertwined and often executed concurrently in transactions involving financial institutions, it is crucial to recognize their legal distinction. This differentiation is particularly pertinent when addressing arbitration clauses.

Thus, the question of whether an arbitration clause in a loan agreement extends to guarantors when the Guarantee Agreement does not explicitly contain such a clause is a significant legal issue, and the article examines this issue by utilising several key points from judgements to illustrate the legal principles at play.

Relevant Definitions :

• Section 2(1)(h) and Section 2(3)(h) of The Arbitration And Conciliation Act, 1996 defines party as:

“party” means a party to an arbitration agreement”

“(3) This Part shall not affect any other law for the time being in force by virtue of which certain disputes may not be submitted to arbitration”

• Section 7(5) of the The Arbitration And Conciliation Act, 1996 states that:

“ The reference in a contract to a document containing an arbitration clause constitutes an arbitration agreement if the contract is in writing and the reference is such as to make that arbitration clause part of the contract.”

• RBI states that NFBC ( Non-Banking Financial Company) is :

“ A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of immovable property. A non-banking institution which is a company and has principal business of receiving deposits under any scheme or arrangement in one lump sum or in installments by way of contributions or in any other manner, is also a non-banking financial company (Residuary non-banking company).”

• In Inox Wind Ltd. v. Thermo Cables Ltd. (2018) 2 SCC 519 elaborated on the terms “single contract” and “two contract” :

In a "single contract" scenario, the court highlighted that the parties to the document being referenced are the same as those in the main contract. This means that any terms or clauses, including arbitration clauses, referenced in such a document are considered part of the main contract. For instance, if the parties in the loan agreement and guarantee agreement are the same, then it will constitute a "single contract" scenario.

On the other hand, in a "two contract" scenario, the court explained that if at least one party to the referenced document is different from those in the main contract, it constitutes a two contract case. For instance, in such a scenario, the parties to the Loan Agreement and the Deeds of Guarantee differ, i.e., separate parties exist in the main agreement (loan agreement ) and guarantee is assured through a third party in the guarantee agreement. This distinction is important because it affects whether the terms of the referenced document can be considered binding on the parties.

Background:

In the past, typically, when financial institutions made agreements, when a loan agreement contained an arbitration clause, it was commonly accepted that this condition also applied to the guarantee agreement. In other words, according to Section 7(5) of the Arbitration and Conciliation Act, 1996, the arbitration clause was considered to be incorporated into the Deeds of Guarantee in lieu of Loan Agreement. This was because the loan and the guarantee were viewed as a single, interconnected transaction, making their performance closely linked. For instance, agreements were generally read, like in the case of Habas Sinai Ve Tibbi Gazlar Isthisal Endustri AS v Sometal SAL [2010] EWHC 29 (Comm), the court considered whether general wording in a contract could incorporate an arbitration clause from another contract between the parties. The court held that in this instance, general words of incorporation were sufficient to include the arbitration clause without needing to specifically refer to it. This is in contrast to the recent stand which requires specific reading of the guarantee agreement. In other words, the guarantee agreement must clearly include an arbitration agreement, otherwise it will be assumed that no arbitration agreement exists. This stricter test of incorporation of an arbitration clause is applied so that the guarantor is not at a disadvantage.

Applicability of Section 7(5):

For an arbitration clause to be enforceable under Section7(5) of the The Arbitration And Conciliation Act, 1996, reference made in the primary agreement must be clear and explicit, making the arbitration clause a part of the contract. This understanding of the section can be derived from M/S Intech Capital Ltd. V. M/S Shikhir Plast India Pvt Ltd. & Ors. DIAC/6864B/09-23 which states that an arbitration clause in a loan agreement does not automatically apply to guarantors if it is not explicitly included in the guarantee agreement, i.e, for an arbitration clause to be applicable under Section 7(5) of the Arbitration Act, the reference made in the guarantee agreement must be such that it unambiguously makes the arbitration clause a part of the contract.

Further, when a party who has signed an agreement tries to enforce arbitration on a non-signatory party, it is crucial to exercise caution. The idea was effectively emphasised in the case of STCI Finance Ltd. v. Shreyas Kirti Lal Dishi & Anr. 2020 SCC OnLine Del 100, where the Hon'ble High Court acknowledged the several situations in which the issue arises. The scope of Arbitration agreements have been expanded by courts to encompass individuals or entities who were not-signatories to the agreement, particularly when non-signatories are making a claim that is connected to or derived from a signatory. In such situations, individuals or entities who have not signed an arbitration agreement can legally require those who have signed it to engage in arbitration. This is because the signatories' agreement to arbitration is implicit in the claim made by the non-signatories. In contrast, when a party who has signed a contract attempts to impose arbitration on a party who has not signed the contract, the situation becomes inherently distinct and more intricate. This is because it necessitates clear and indisputable proof that the non-signatory has willingly consented to participate in arbitration. The primary matter at hand is the agreement of both parties, which is achieved when a non-signatory willingly pursues arbitration, so satisfying the requirement of mutual consent. Enforcing arbitration on a party that did not sign the agreement requires a decisive and unambiguous determination by the courts that the non-signatory has explicitly consented to participate in the arbitration proceedings.

Distinction Between Loan Agreement and Guarantee Agreements

A fundamental principle established in M.R. Engineers and Contractors Pvt. Ltd. v. Som DattBuilders Ltd. (2009) 7 SCC 696 elucidates the distinct nature of loan and guarantee agreements. The court reiterated that these agreements are separate and independent contracts and are not dependent on each other. By highlighting an important distinction between the agreements, the Hon'ble Supreme Court held that the arbitration clause does not automatically extend from the main contract (Loan Agreement) to the subcontract (Guarantee Agreement) by making a bare reference of the terms and conditions of the main contract within a subcontract, an unambiguous reference must exist. In other words, in order for the arbitration clause to be incorporated and applicable to the guarantee holder within the guarantee agreement, the reference of such arbitration clause must be made in the said guarantee agreement and must explicitly indicate an intention to do so.

Further, in the same case, the court considered whether a general reference to the loan agreement in the guarantee contract was sufficient to include an arbitration clause. The court ruled that a mere reference to the arbitration clause is insufficient; it must be unambiguous and unequivocal.

Lastly, M/S Intech Capital Ltd. V. M/S Shikhir Plast India Pvt Ltd. & Ors DIAC/6864B/09-23 reiterated the view of the Inox judgement and stated that where ‘two contract’ scenario exists between parties and third parties, in such a case explicit mention of arbitration clause is required in the Guarantee agreement to hold the guarantor liable under the said agreement.

Conclusion

There still remains a lack of awareness on this matter, thus it is important to know that in two contract scenarios explicit arbitration agreement must exist in the contract for it to be liable. These judgements discussed above emphasise the importance of inserting arbitration terms specifically in all relevant agreements if the objective is to bind all parties to arbitration. The legal principle is clear: parties cannot be forced to arbitrate disputes unless they expressly agree to do so in the relevant contract. Thus, for binding a guarantor as under Guarantee Agreement, an explicit arbitration clause must exist.

Section 7(5) of the Arbitration Act is also relevant in this case. It states that a reference in a contract to a document containing an arbitration clause establishes an arbitration agreement only if the reference is explicit and includes the arbitration clause as part of the contract. This ensures that parties are only bound by arbitration if they explicitly agree to it.

However, there still remains a lack of awareness on this matter. Therefore, it is important to know that in “two contracts” cases, an explicit arbitration clause must be present in the guaranteed agreement to hold the guarantor liable to arbitration.

The author is an Advocate.

[The opinions expressed in this article are those of the author. Verdictum does not assume any responsibility or liability for the contents of the article.]