No contract, no arbitration agreement? The separability principle explained

In DHL Project & Chartering Ltd v Gemini Ocean Shipping Co. Ltd [2022] EWCA 1555, the Court of Appeal considered whether an arbitration agreement was binding on the parties in circumstances where a pre-condition to the effectiveness of the contract had not been satisfied. In dismissing the application to set aside the arbitral award for lack of jurisdiction under s67 of the English Act (the Act), the Court provided useful guidance on the correct forum for disputes concerning both the formation of contracts and their validity.

Background

We summarised the background to this case in our previous post here. In short, the case concerned a vessel called the "Newcastle Express". The Owner and Charterer were negotiating the terms of a proposed charter for a voyage from Newcastle in Australia to Zhoushan in China with a cargo of coal. The Owner planned to have the vessel inspected and approved on 2 September 2020. However, approval was not forthcoming by that date and the Charterer decided to release the vessel and arrange a substitute.

Where the main terms for a charterparty have been agreed but the parties have yet to enter into contractual relations, this is generally referred to by shipowners, charterers and chartering brokers as an agreement on 'subjects' or 'subs' - an expression which signals that there are pre-conditions to the contract which remain outstanding. The conclusion of a binding contract in respect of such an agreement is seen as dependent on the agreement of the relevant party or parties to 'lift' (i.e. remove) the subjects. It was common ground here that the Charterer had not "lifted the subject" of the "shippers/receivers approval".

The Owner considered that a binding charterparty containing an arbitration clause had been concluded, and that the Charterer's release of the vessel was a repudiation of the contract. The Owner therefore commenced an arbitration against the Charterer. The arbitration never came to the attention of the Charterer's management, so the Charterer did not participate. The arbitrator found in favour of the Owner on the basis that the Charterer's release of the vessel was not reasonable.

The Charterer brought a s67 application challenging the award on the ground that the arbitrator had no substantive jurisdiction. In the alternative, the Charterer also issued an application for leave to appeal on a point of law under s69.

Mr Justice Jacobs held that the arbitrator had no jurisdiction, because the effect of the "subject" clause was that no binding contract was concluded until the "subject" was lifted. He reasoned that just as when agreement is reached "subject to contract", the common practice in the chartering market of a vessel being "fixed on subjects" has the effect of negating any intention to enter contractual relations until the "subjects" are "lifted". However, he granted leave to appeal in relation to both the s67 and s69 applications.

On appeal, the Owner submitted that the judge had failed to give proper effect to the separability principle, and that his judgment had created "an unprincipled and regrettable precedent which is antithetical to the modern "one-stop" dispute resolution presumption".  The Owner also argued that the question of whether the vessel had been approved had nothing to do with, and therefore could not "impeach", the arbitration clause.

Decision

The Court of Appeal concluded that the "subject" in this case was a pre-condition of the contract, the purpose of which was to prevent a binding contract from coming into existence. What mattered was whether the Charterer had communicated to the Owner that the "subject" had been lifted, which it had not.

On the question of separability of the arbitration clause, the judge drew a distinction between disputes concerning (i) "contract formation", such as whether there had been valid offer and acceptance and intention to create legal relations and (ii) "contract validity", where the parties did agree to arbitration, but one party is contending that the agreement is invalidated, which generally trigger consideration of separability.

Where the issue is one of "contract formation", it will generally "impeach" the arbitration clause because there is no binding arbitration agreement in the first place. In contrast, arguments of "contract validity" require consideration of whether the ground of invalidity "impeaches" the arbitration clause. Arguments of invalidity will not necessarily impeach the arbitration agreement, and indeed, they will be presumed not to do so unless they relate directly to the arbitration agreement. The Court of Appeal gave the example of an allegation that an agent exceeded their authority by entering into an agreement – in that case it would have to be shown that the agent had no authority to enter into the arbitration agreement as well as the matrix contract in order to impeach the arbitration clause.

The doctrine of separability "serves the narrow though vital purpose of ensuring that any challenge that the main contract is valid does not, in itself, affect the validity of the arbitration agreement". The relevant question is whether the parties did or did not negotiate and conclude a valid agreement to arbitrate their disputes even if they did not conclude the underlying contract. This still requires the usual contract formation rules to be satisfied. Whilst in most cases, defects in contract formation are likely to impeach the arbitration clause, there will still be instances where parties have reached a valid and binding agreement on an arbitration clause but not the underlying contract.

In this case, which concerned "contract formation", there was no valid arbitration agreement and the High Court had been right to set aside the award for lack of jurisdiction. All that the parties had agreed was that if a binding contract was concluded, then that contract would contain an arbitration clause. The Court of Appeal added that the one-stop presumption in Fiona Trust could not apply here, as that presumption had nothing to do with whether the parties had concluded a contract (including a contract to arbitrate) in the first place.

Comment

This case provides useful guidance on disputes about the validity of the underlying contract where that contract contains an arbitration clause. The Court of Appeal has helpfully clarified that as a matter of English law, where it is found that the parties have not entered into a binding agreement in the first place, the arbitration agreement will generally not be binding either. Where a party argues that an arbitration clause is not binding because there is no contract, it may fall to the courts to determine the issue, unless, as the Court of Appeal commented, the parties can reach an ad hoc agreement to submit that issue to arbitration, without prejudice to whether that agreement is necessary. Otherwise, there is a risk that even if the tribunal determines that a contract has been formed and that it has jurisdiction (as in this case), the party who has relied on the arbitration clause may face a s67 challenge which nullifies the findings of the arbitral tribunal.

In light of this judgment, parties negotiating term sheets that are "subject to contract" should be advised that their arbitration clause may not be binding unless the parties specifically agree to be bound by the arbitration clause prior to entry into the main contract. For that arbitration agreement to be binding, it must comply with ordinary contract formation requirements.

For more information, please contact David Nitek, Partner, Liz Kantor, Professional Support Lawyer, or your usual Herbert Smith Freehills contact.