Contractual Interpretation in Arbitration: Balancing Business Intent and Judicial Oversight

Tushar Verma and Ayush Bajpai[1]

INTRODUCTION

The core objective of commercial dispute resolution is to resolve business conflicts efficiently and fairly. However, the first line of defense against such disputes is a well-drafted contract i.e. clear, precise, and comprehensive. The fundamental principle in contract drafting is that no provision should be assumed, implied, or left to interpretation without explicit articulation. Disputes often arise when parties interpret the same clause in different ways, leading to conflicts that require formal resolution. This article critically examines the evolving application of the doctrine of implied terms within the framework of Indian commercial arbitration. Further, it analyses recent judicial developments and proposes a balanced approach that upholds the sanctity of contractual interpretation while preserving the autonomy of arbitral proceedings.

Henceforth, it becomes essential to consider certain principles that form the basis of the interpretation of a commercial contract. This article seeks to examine the following key issues (a) the extent to which arbitral tribunals may imply terms into commercial contracts, (b) the legal standards governing such implication, and (c) whether judicial oversight is warranted where tribunals apply these standards incorrectly or arbitrarily.

The answer to the above inquiry is rooted in a fundamental principle: courts and tribunals may only imply a term in a contract when the express terms are absent, ambiguous, or fail to align with commercial business sense. In such circumstances, tribunals and courts often invoke principles such as the Business Efficacy Test and the Officious Bystander Test to interpret contractual terms and imply provisions necessary to give effect to the intended commercial transaction between the parties. However, any interpretation by the courts or tribunals must remain consistent with the express terms of the contract, ensuring that no distortion or unintended modification occurs.

Principle Surrounding Contractual Interpretation:

A. Business Efficacy Doctrine:

The Contracting Parties often mistakenly assume that the express terms of a contract will always prevail. However, even a well-drafted commercial contract may contain gaps or inconsistencies. Despite Even in the presence of such omissions, the courts and Tribunals proactively strive to achieve a business common sense that gives effect to the intended transaction envisioned at the outset of the contract. In such cases, courts and tribunals often endeavour to ensure that the contract operates effectively and aligns with the parties' commercial intent i.e. the principle for Business Efficacy. This principle allows the interpretation of unstated contractual terms that reasonable businesspersons would have intended to include from the outset, and the objective is to ensure that the contract functions effectively, without placing an undue burden on either party in unforeseen circumstances.

Under this doctrine, the question is not what the actual parties subjectively intended but what a reasonable person in their position would have agreed upon at the time of contracting. A key precedent is The Moorcock (1889) 14 PD 64, where Bowen L.J. held that courts may imply terms necessary for the effective execution of the contract. Further, recently Hon’ble Apex Court, in Nabha Power v. Punjab State Power Corporation & Satya Jain v. Anis Ahmed Rushdie, reaffirmed this principle, emphasizing “that commercial contracts should be interpreted in line with the presumed intent of rational businesspersons”. For e.g., a retailer contracts with a supplier to purchase perishable goods but the contract doesn’t specify refrigerated transport. The supplier delivers in a regular truck, causing spoilage and financial loss. The retailer argues for an implied term that goods must be transported properly. Applying business efficacy, a court may imply this term, as both parties must have intended the goods to arrive in a saleable condition.

To uphold the presumed intention of the parties while ensuring that courts and tribunals do not imply terms in a manner that undermines the transaction's intended efficacy which the parties would have intended at all events, the Apex Court in Nabha Power (Supra) established a structured approach for implying contractual terms, known as the Five-Prong (Penta) Test. This test, later followed in Investors Compensation Scheme Ltd. v. West Bromwich Building Society andAttorney General of Belize v. Belize Telecom Ltd., requires that an implied term: (1) be reasonable and equitable, (2) be necessary for business efficacy, (3) be one both parties would have agreed to (Officious Bystander Test), (4) be capable of clear expression, and (5) not contradict any express contract provision.

B. The Officious Bystander Test

Drafting a commercial contract is a complex and technical task that demands the expertise of skilled legal professionals from both sides. Given the intricacies involved, it is often impractical to explicitly include every possible term within the contract. However, certain terms are so inherently understood in the context of business transactions that courts and tribunals have the authority to imply them when necessary. These implied terms reflect what any reasonable third party would naturally assume to be part of the agreement, thereby ensuring fairness and practicality in the interpretation of the contract. Hence, another widely applied test in contractual interpretation is the Officious Bystander Test, first articulated in Shirlaw v Southern Foundries wherein LJ Mackinnon quoted “If, while the parties were making their bargain, an officious bystander were to suggest some express provision for it in the agreement, they would testily suppress him with a common ‘Oh, of course.”. Henceforth, the same was reinforced in Nabha Power (Supra). The essence of this test is that if an uninvolved but knowledgeable third party were to suggest an omitted contractual term during negotiations, both parties would instinctively respond, "Oh, of course!"

However, the principles governing the implication of terms in a contract must be carefully balanced against the principle of party autonomy. In some instances, such implied terms may conflict with the express provisions of the contract—particularly in cross-border arbitration. Cases such as Terre Neuve Sarl v Yewdale and Etihad Airways PJSC v Flotherillustrate the complexities involved in determining commercial expectations and assessing business efficacy in international commercial agreements.

For instance, consider a scenario where a chef leases a commercial kitchen from a landlord, but the contract does not explicitly mention a functioning ventilation system. After taking possession, the chef discovers that the ventilation is defective, rendering the space unsafe for cooking. The landlord refuses to make repairs, arguing that the contract contains no such obligation. In interpreting the agreement, a court would assess Firstly, whether the need for a ventilation system was foreseeable to both parties at the time of contracting. Secondly, whether the ventilation was so essential and obvious that its inclusion could be presumed i.e. officious bystander test (if, during negotiations, an outsider had asked, “Shouldn’t the kitchen have proper ventilation?”, both parties would likely have replied, “Of course!”), Lastly, the court would evaluate whether the absence of such a system defeats the commercial purpose of the contract—invoking the business efficacy test. If all these questions are answered in the affirmative, the court would likely imply the term and rule in favour of the chef.

Furthermore, the Courts have applied this reasoning in cases such as Enercon (India) Ltd. v. Enercon GMBH whereinthe tribunal implied terms to clarify the supply agreement’s functional intent, with the court subsequently upholding this interpretation under the narrow scope of judicial review to reinforce business efficacy and address contractual omissions.In the majority of cases, the two above-discussed principles operate in tandem, as the primary objective of implying a term is to reflect the true intent of the parties at the time of contracting and to uphold the efficiency & purpose of business transaction.

Contractual Interpretation in Arbitration: Balancing Intent and Judicial Restraint:

In arbitration proceedings, party autonomy is paramount. However, the question of whether arbitral tribunals can or should imply terms into a contract raises complex legal and doctrinal challenges. As discussed above, the interplay between the business efficacy principle and the officious bystander test plays a crucial role in interpreting commercial agreements. These principles help tribunals resolve ambiguities by identifying terms that reflect the parties’ shared intentions, thereby preserving commercial purpose without compromising the parties’ autonomy.

In this context, the judiciary has consistently emphasized that arbitral tribunals must adhere to the contractual framework when resolving disputes. As in Associate Builders v. Delhi Development Authority it was held, that an arbitral tribunal must resolve disputes strictly within the terms of the contract. Failure to do so renders the award patently illegal. However, a tribunal’s reasonable interpretation of a contract cannot be overturned merely on the possibility of alternative view on facts and interpretation, and the courts can exercise their jurisdiction only to evaluate the tribunals reasoning on the ground of perversity and arbitrariness. Similarly, in Vestas Wind Technology India Pvt. Ltd. v. Inox Renewables Ltd., the Bombay High Court upheld an arbitral award applying business efficacy principles to contractual interpretation.

However, the doctrine of Error Within Jurisdiction limits judicial intervention in the Tribunal’s decisions. While the interpretation of contractual terms falls within the arbitrator’s domain, courts will not interfere unless the arbitrator exceeds their jurisdiction or interprets the contract in an unreasonable and arbitrary manner. This issue was examined by the Delhi High Court in Reliance Industries v. GAIL (India) Ltd., where the court held that the principle of Business Efficacy Test cannot be applied by an appellate court u/s 37 of the Commercial Courts Act for interpretation of contractual terms. As the Hon’ble court emphasized that such proceedings have a very narrow scope and do not allow for reassessment of evidence or substitution of judicial opinion over the arbitral tribunal’s findings.

Conclusion 

This article establishes that whenever a dispute arises, courts and arbitral tribunals are empowered to interpret and, where necessary, imply terms to give effect to the true intent of the contract. Foundational principles such as the officious bystander test and the business efficacy doctrine serve as essential tools to ensure that such interpretations are both just and equitable. However, the exercise of this power demands careful judicial restraint and doctrinal precision to avoid encroaching upon party autonomy and the foundational principles of arbitration.

Recent judicial trend, as seen in cases like Vestas Wind Technology India Pvt. Ltd. (Supra), M/S Adani Power (Mundra) Ltd. Vs. Gujarat Electricity Regulatory Commission & Ors, & Nabha Power(Supra) highlights the judiciary’s increasing reliance on these doctrines to uphold commercial reasonableness. While the doctrine of “error within jurisdiction” limits judicial interference u/s 34 & 37 of the Act, courts can still set aside awards that are arbitrary or unreasonable.

Further, as contracts are increasingly drafted using AI, interpretation becomes more complex. While AI reduces human error, it also obscures the human intent and reasonableness that traditionally guide contract formation. This makes the application of principles for interpretation more challenging. Additionally, varying arbitration frameworks such as those for cross border arbitration, MSMEs and PSUs require context-specific approaches, rather than a uniform standard. Thus, only a principled and restrained application of interpretative doctrines can ensure that arbitration remains an effective, party-centric method for resolving modern commercial disputes.

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[1] Tushar Verma and Ayush Bajpai are fourth-year B.A. LL.B. (Hons.) students at Dr. Ram Manohar Lohiya National Law University, Lucknow. They have a keen interest in commercial arbitration and contract law, actively engaging in research and writing on related topics. Their academic journey has involved contributing to legal research projects and participating in seminars and workshops focused on dispute resolution and contract interpretation.