Analysing “Law” under Section 23 of the Contract Act

   

NO CONTRACT FOR UNLAWFUL CONSIDERATION OR OBJECT — BUT WHAT IS LAW?

The Contract Act, 1872 (“the Contract Act”) does not profess to be a complete code dealing with contracts law¹. The Indian courts, however, have held the Contract Act to be exhaustive in relation to a particular subject to the extent it deals with that subject². Though, what does one do when the Contract Act itself looks to incorporate all laws in force while considering the enforceability of contracts without as much as defining the ambit or scope of law?

A contract is a legally enforceable agreement. Section 10 of the Contract Act mandates that agreements for an unlawful consideration or an unlawful object are not “contracts” and thus not enforceable. While the words “lawful” or “unlawful” are not defined in the Contract Act, Section 23 provides that a consideration or object is unlawful if it is, inter alia, “forbidden by law” or would “defeat the provisions of any law”. Again, the word “law” has not been defined in the Contract Act.

This article is an exploration of what amounts to “law” under Section 23 of the Contract Act in an attempt to analyse the restrictions while contracting in India. It is specifically examined whether agreements contrary to delegated legislation like rules, regulations, notifications, and circulars are unenforceable in India due to Section 23 of the Contract Act.

“LAW” DEFINED

Clause (3)(a) of Article 13 of the Constitution of India (“the Constitution”), defines the word “law” to include “any Ordinance, order, bye-law, rule, regulation, notification, custom or usage having in the territory of India the force of law”. This is a non-exhaustive definition, with the word “include” used to enlarge the scope of the subsequent words and phrases. However, the definition of clause (3)(a) of Article 13 is arguably relevant only for the purposes of Article 13 and does not have any “relevance in deciding a question whether an agreement is void and is not enforceable in law”³.

The Supreme Court, while examining what constitutes “law” for the purposes of Article 19, relied on Article 13(3)(a) to hold that there is no distinction between law made by the legislature and subordinate legislation for placing restriction on the exercise of fundamental rights under Article 19(1)⁴. Similarly, Article 366(10) defines “existing law” to mean “any law, Ordinance, order, bye-law, rule or regulation” for the purposes of interpreting the Constitution. Notably, the words “notification, custom or usage” are absent in Article 366(10). While the definitions and interpretation of “law” under the Constitution are useful guides to interpret what may amount to “law” under Section 23 of the Contract Act, one need not belabour on the constitutional provisions due to the General Clauses Act, 1897 (“the General Clauses Act”).

Section 3(29) of the General Clauses Act defines “Indian law” to mean any Act, Ordinance, Regulation, rule, order, bye-law or other instrument which before the commencement of the Constitution, had the force of law in any Province of India or part thereof, or thereafter has the force of law….

The definition of “Indian law” is applicable to all Central statutes made after the commencement of the General Clauses Act. This definition is also arguably not directly applicable to Section 23 of the Contract Act since the Contract Act is prior to the General Clauses Act. Therefore, one must look to precedents to determine the scope of the word “law” used in Section 23 of the Contract Act.

INTERPRETING “LAW” UNDER THE CONTRACT ACT

The narrow interpretation of the word “law” in Section 23 of the Contract Act limits it to the provisions set out in a legislative enactment. The Supreme Court, in Union of India v. L.S.N. Murthy³, limited the word “law” in the expression “defeat the provisions of any law” in Section 23 of the Contract Act “to the expressed terms of an Act of the legislature”. Going by this narrow interpretation, courts may enforce contractual terms contrary to rules and notifications since the rules are not express terms of legislative Acts or statutes. Notably, the directions under question in L.S.N. Murthy case³ were in a Letter from the Ministry of Defence. The Supreme Court held that the letter may be an instruction to the officers of the Ministry of Defence but was not an Act of the legislature [SCC Para 21].

The Supreme Court, in its recent judgment in G.T. Girish v. Y. Subba Raju⁵, gave much needed clarity on this narrow interpretation taken in L.S.N. Murthy case³. One of the issues before the Supreme Court in G.T. Girish case⁵ was whether an agreement to sell was contrary to Section 23 of the Contract Act, if it was contrary to or prohibited in the statutory rules, namely, the Bangalore Rules of Allotment, 1972. The respondent, relying on L.S.N Murthy case³, contended that there is no “law” as understood under Section 23 of the Contract Act which would be defeated by the agreement since the restriction was only in the rules.

Rejecting the request to refer the matter to a larger Bench, the Supreme Court distinguished L.S.N. Murthy case³ observing that it pertained to a letter and not with statutory rules. The Supreme Court in G.T. Girish case⁵ further observed that the Court in L.S.N. Murthy case³ had failed to notice the judgment of a three-Judge Bench in Gherulal Parakh v. Mahadeodas Maiya⁶.

The Supreme Court in the G.T. Girish case⁵ held that Section 23 of the Contract Act contemplates law, in all its forms, being immunised from encroachment and infringement by a contract. While a contract expressly or impliedly prohibited by “law” would not be enforced by courts, rules or orders under authority derived from the legislature are species of subordinate legislation and will be “law”. A statutory rule, which is law within the meaning of Article 13 of the Constitution, would be law under Section 23 of the Contract Act.

Interestingly, a Full Bench of the Allahabad High Court held⁷ that: (Abdul Hameed case⁷, SCC OnLine All para 14)

14. … the term “law” includes an order by a competent authority having the force of law. Consequently, where any agreement is forbidden by an order of the competent authority having the force of law, it shall be an agreement forbidden by law as contemplated by Section 23 of the Contract Act.

The Allahabad High Court drew inference from Section 3(29) of the General Clauses Act and Articles 13(3)(a) and 366(10) of the Constitution to conclude that “law” must include “not only an Act and Ordinance but also Regulations, rule, order, bye-law or other instrument which has the force of law”.

Thus, “law” for determining the enforceability of contracts under Section 23 of the Contract Act includes all forms of subordinate legislation deriving authority from statutory provisions. Will this, therefore, include not just statutory rules but also notifications, circulars, or orders issued by an authority exercising powers delegated by statute?

EXTENT OF DELEGATED LEGISLATION AS “LAW” UNDER THE CONTRACTS ACT

It is trite that rules made under a statute, particularly those which are placed before the legislature, must be treated for all purposes of construction or obligations, exactly as if they were in that statute and will have the same effect as if they were contained in the statute⁸. The directions are incorporated and become part of the statute itself⁹.

Going a step further, the Supreme Court has held circulars and directions which have a statutory force ought to be read as supplement to the provisions of the statute¹⁰. The Supreme Court held that a statutory order issued by the Central Government under the Essential Commodities Act, 1955 was “law” within the meaning of Article 13 while analysing the validity of the order¹¹.

In line with these judgments, it appears that any direction drawing force from statute will be “law” under Section 23 of the Contract Act.

INVALIDITY OF CONTRACTS DUE TO LEVY OF PENALTY

Another crucial factor to consider is that statutes generally provide for a penalty in case of non-compliance of notifications, circulars, and directions issued by the designated authority exercising delegated power. Penalties are necessary to ensure compliance with the directions of the authority empowered under any statute and imply a prohibition. The Supreme Court observed that agreements are void if their performance, though not prohibited in the statute, would result in a penalty:“[i]n every case where a statute inflicts a penalty for doing an act, though the act be not prohibited, yet the thing is unlawful, because it is not intended that a statute would inflict a penalty for a lawful act”¹².

A contract is void if prohibited by a statute under a penalty, even without express declaration that the contract is void, because such a penalty implies a prohibition¹³. Thus, it is arguable that contracts contrary to directions of statutory authorities while exercising delegated powers are unenforceable under Section 23 of the Contract Act since they are likely to result in the levy of a penalty. However, the Supreme Court came to a different conclusion in the case of B.O.I. Finance Ltd. v. Custodian¹⁴.

The contracts in question before the Supreme Court in the B.O.I. Finance case¹⁴ pertained to sale, purchase, and buy-back of unlisted securities between banks and third parties. It was contended that the contracts in question were ready-forward transactions contrary to the provisions of the Banking Regulation Act, 1949 and the Securities Contracts (Regulation) Act, 1956. RBI had issued confidential circulars prohibiting banks from entering into buy-back arrangements of such unapproved securities. The Supreme Court observed that RBI’s circulars set out a binding prohibition on banks and penalty may be levied on non-compliant banks under Section 46 of the Banking Regulation Act, 1949. However, the Supreme Court held that the contracts in question could not be invalidated since they were between banks and third parties who could have been unaware of RBI’s confidential circulars¹⁴.

On the other hand, the Supreme Court in Asha John Divianathan v. Vikram Malhotra¹⁵, held that transactions which required RBI’s prior permission would be unlawful until the permission is received. In this case, Section 31 of the Foreign Exchange Regulation Act, 1973 (“FERA”) required prior general or special permission from RBI to transfer or dispose of immovable property situated in India by sale or mortgage by a person who is not a citizen of India. The Supreme Court opined that such transfer cannot be given effect to until RBI’s permission is received and a person contravening this requirement may be visited with penalty under Section 50 of FERA¹⁵.

CONCLUSION

Under Section 23 of the Contract Act, courts can refuse enforcement of contracts which are contrary not just to express or implied statutory provisions but to any delegated rules, regulations, notifications, circulars, or directions having statutory force.

In addition, contracts which are not unlawful but their performance may result in an unlawful act or consequence are also hit by Section 23. For instance, Section 144 of the Companies Act, 2013 provides that a company’s statutory auditor cannot provide certain services like internal audit, investment advisory services, and management services to the said company or its holding/subsidiary company. While contracts for provision of non-audit services by qualified chartered accounts by themselves are not illegal, there is a clear prohibition in law on auditors rendering non-audit services to companies where they are conducting the statutory audit. While chartered accounts contravening Section 144 are separately liable for misconduct by the regulator i.e. ICAI, courts are likely to hold that contracts for non-audit services between companies and their statutory auditors are unlawful under Section 23 of the Contract Act.

On similar lines, performance of a contract resulting in levy of penalty prescribed by statute will render the contract unlawful under Section 23. However, there are notable exceptions to this rule. It, therefore, becomes necessary to determine whether a contract will be enforceable based on the facts of each case. The Supreme Court has held that what is to be seen is whether the illegality goes so much to the root of the matter that the claimant cannot bring his action without relying upon the illegal transaction into which he had entered¹⁶. Indicating that courts may also consider equities while deciding on the contractual disputes, the Supreme Court observed that when both parties are confederates in the fraud, courts will have to find out which approach would be less injurious to public interest¹⁷.

In addition, contractual clauses requiring compliance with “applicable law” are common and one must bear the wider interpretation of Section 23 in mind while entering into contracts. There is no material difference between the expressions “existing law”, “law in force”, and “Indian law”¹⁸. Therefore, parties must remain alive to applicable laws and subordinate legislation while determining their rights and obligations under any contract, particularly since subordinate legislation can override existing contracts¹⁹.

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