What is the effect of illegality of a contract on an arbitration clause within that same contract? To the extent that the contract is unenforceable, does this also render the arbitration clause invalid?

The answer to this query has substantial repercussions because a tribunal’s jurisdiction depends on the validity of the arbitration agreement that it is constituted under. Where the arbitration agreement is invalid, an arbitral award rendered can be challenged (see Article V(1)(a) of the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards 1958; see also Article 34(2)(a) of the UNCITRAL Model Law).

In the case of Beijing Jianlong Heavy Industry Group v Golden Ocean Group Ltd & Ors [2013] EWHC 1063 (Comm), the claimant (respondent in various arbitrations) made an application under Section 67 of the UK Arbitration Act 1996 to challenge the awards on the basis that the tribunal lacked substantive jurisdiction. The sole legal issue was this: “[i]f an English law guarantee is (or, as in this case, is assumed to be) unenforceable because it involves the commission in a foreign country of acts that are unlawful under local law is its provision for London arbitration also unenforceable?” (see paragraph [1]). For the purposes of the application, it was accepted by parties that, on the assumed facts, the underlying contracts in question were “unenforceable because they were entered into as part of a scheme the object or intention of which was to procure the carrying out of illegal acts in China” (see paragraph [16]).

The English High Court held that the arbitration clause was enforceable on the basis that “[t]he policy and purpose of the rule which invalidates the Guarantees does not strike down the arbitration provisions” (see paragraph [41]). To uphold the clause would be “respecting the parties’ choice and providing a one stop process“, which the High Court considered to be “powerful commercial factors” which should apply “to this otherwise very conventional charterparty guarantee case” (see paragraph [46]).

The Law

An English law contract “will not be enforceable where performance of that contract is forbidden by the law of the place where it must be performed (the lex loci solutionis)” (see paragraph [18]).

Furthermore, an English law contract “will not be enforceable if the common intention of the parties was to perform in a foreign friendly country some act which is illegal under the law of that country” (see paragraph [19]). In other words, even where the terms of the English law contract strictly do not contemplate performance of obligations that are illegal in the foreign country, but where “the real object and intention of the parties, at the time of the contract” is the commission of some sort of unlawful act, the English courts will not enforce that contract. This further principle was established by the English Court of Appeal case of Foster v Driscoll [1929] 1 KB 470 (approved by the House of Lords in Regazzoni v KC Sethia [1958] AC 301).

However, an arbitration agreement is separable (and separate) from the underlying contract (see Fiona Trust & Holding Corporation v. Privalov [2007] UKHL 50, [2007] 4 All ER 951). This is further provided for in Section 7 of the UK Arbitration Act 1996 which states,

“Unless otherwise agreed by the parties, an arbitration agreement which forms or was intended to form part of another agreement (whether or not in writing) shall not be regarded as invalid, non-existent or ineffective because that other agreement is invalid, or did not come into existence or has become ineffective, and it shall for that purpose be treated as a distinct agreement”.

The Claimant’s Arguments

As a result, the claimant sought to argue that the arbitration agreement was itself “impeached” and not simply as a consequence of the invalidity of the underlying contract (see paragraph [32]).

“(1) “The inclusion of an agreement providing for arbitration in London substantially improves the chances of a full recovery by the Defendants under the Guarantees by:

i. Preventing the issue of the validity of the Guarantees coming before the Chinese courts (who would, applying the mandatory provisions of Chinese law, refuse to enforce the Guarantees).

ii. Permitting the Defendants to have the validity of the Guarantees determined instead by an English arbitral tribunal applying English law.

(2) On the assumed facts, the Arbitration Agreements therefore served an important purpose: they enabled the parties to circumvent the applicable provisions of Chinese law by preventing the validity of the Guarantee coming before the Chinese courts. This was the sole purpose for which they were entered into.

(3) The Arbitration Agreements are therefore directly impeached by the principle in Foster v. Driscoll: they were themselves entered into as a separate but at the same time integral part of a scheme the object or intention of which was to procure the carrying out of illegal acts in China.”

Decision of the High Court

The High Court disagreed with the claimant and upheld the arbitration clause.

First, the learned judge considered that upholding the arbitration clause and allowing the dispute to proceed to arbitration would not undermine the principle in Foster v Driscoll (see paragraph [38] and [39]). In this respect, the High Court considered that the principle did not extend to arbitration clauses (see paragraph [40]),

“…While it is correct that the majority [in Foster v Driscoll] wished to give the parties no assistance in their dispute resolution (“The Courts of this country ought not to entertain actions of this character…. Sankey LJ at 515), there was no arbitration clause before the court and, if there had been, the law applied to it would not have been that of today. The nature and function of an arbitration clause is distinct and different from that of other contractual provisions- see the observations of Lord Macmillan and Lord Wright in Heyman v Darwins referred to by Hoffmann LJ in Harbour at 469. The effect of Foster v Driscoll is not as I see it simply to “sweep away” (as it was put by the Claimant before the arbitrators) the arbitration provisions. …”

Second, the High Court acknowledged that the choice of English law before an arbitral tribunal was less favourable to the claimant than the use of Chinese law before the Chinese courts. However, this point was irrelevant and was “certainly not a reason for seeing the arbitration provisions as impeached” (see paragraph [42]).

Third, such cases of (alleged) illegality had to be examined on their own facts (see paragraph [44]). In this respect, this was not an obvious or “palpable” case for striking down the arbitration clause because (a) it involved illegality under a foreign (Chinese) law and (b) it was not a case where the parties were “arbitrating disputes about the spoils of crimes” (see paragraph [33]).

Finally, the “bad motives or intentions” behind the choice of arbitration “to conceal wrongdoing” did not change the legal position for the separability of the arbitration clause from the underlying contract. The High Court also noted that “there [was] no public policy [under Chinese law] requiring the exposure of criminals for punishment” (see paragraph [45]).

Conclusion

The doctrine of separability (or severability) of the arbitration clause from the underlying contract is well-established as part of international commercial arbitration (see for example, Article 23(1) of the UNCITRAL Arbitration Rules). Parties should be aware that even where the underlying contract is void and unenforceable for illegality, that by itself does not necessarily render the arbitration clause itself unenforceable. What was critical in the High Court’s judgment was its view that an arbitration clause and a foreign governing law did not impugn the dispute resolution mechanism and would be upheld.