Introduction:

While arbitration is touted as an economically feasible means of dispute resolution, the practical realities reveal otherwise. Parties often have to bear huge costs, including arbitrators’ fees, advocates’ fees, tribunal’s expenses etc.Consequently, micro, small and medium enterprises often find themselves at a disadvantage wheninvolved in disputes against enormous entities. This is where arbitration, envisaged under the Micro, Small and Medium Enterprises Development Act, 2006^[1] (“MSMED Act”), gains importance. Under Section 18 of the MSMED Act,^[2] MSMEs can opt for a statutory arbitration mechanism, whereby, arbitrators appointed under the MSMED Act would adjudicate the dispute. Moreover, the arbitral fees is stipulated by the state MSME councils, which are substantially lesser than the fees that would accrue under ad hoc or institutional arbitration. This helps the concerned MSME take advantage of the benefits of arbitration even when working with a shoestring budget for agitating disputes. 

However, there are implied limitations in the category of disputes which can be submitted before MSME arbitration. Recently, the courts around the country have clarified whether disputes arising out of ‘Works Contracts’ would be amenable to MSME arbitration. In this piece, we are going to explore the concept of ‘Works Contract’, whether they are arbitrable to MSME arbitrations and how the law stands today.

‘Works Contract’: What does the law say?

The term ‘works’ tends to give the false impression that ‘construction contracts’ can be used interchangeably with ‘Works Contracts’ or that they are one and the same thing. However, such conclusions are far from the truth, at least in law. Although there are a limited number of statutes which define this term, a comprehensive definition can be found in the Central Goods and Services Tax Act, 2017 (hereinafter, ‘CGST Act’)^[3]:

“‘works contract’ includes any agreement for carrying out for cash, deferred payment or other valuable consideration, the building, construction, manufacture, processing, fabrication, erection, installation, fitting out, improvement, modification, repair or commissioning of any movable or immovable property.”

The aforesaid definition may establish some clarity; however, it is pertinent to analyze how the courts have interpreted this term. In K. Raheja^[4], the Supreme Court was interpreting the definition of ‘Works Contract’ as under the Karnataka Sales Tax Act, 1957, which is pari materia to the one provided in the CGST Act. The Supreme Court observed that the said definition was “very wide” and is not restricted to works contract normally understood, which stood affirmed in Larsen & Toubro v. State of Karnataka.^[5]

Perhaps the most significant decision dealing with ‘works contract’ is Kone Elevators v. State of TN^[6] wherein the Constitution Bench laid down notable criteria for deciding the nature of a ‘Works Contract’:

• the works contract is indivisible but, by legal fiction, is divided into two parts, one for the sale of goods, and the other for the supply of labour and services;
• the concept of the “dominant nature test” or, the “degree of intention test” or the “overwhelming component test” for treating a contract as a works contract is not applicable;
• once the characteristics of the works contract are met within a contract and entered into between the parties, any additional obligation incorporated in the contract would not change the nature of the contract.

Notably, the Supreme Court^[7] also expounded on how one could differentiate between a contract for sale and a works contract. It said that the main object of the contract would be a determining factor in eliciting the nature of the transaction. In this regard, it observed:

“5. […] Therefore, in judging whether the contract is for a ‘sale’ or for ‘work and labour’, the essence of the contract or the reality of the transaction as a whole has to be taken into consideration. The predominant object of the contract, the circumstances of the case and the custom of the trade provide a guide in deciding whether transaction is a ‘sale’ or a ‘works contract’. […]”

From the aforementioned, it emerges that a ‘works contract’ has features of both-supply of goods and services and is thus, a composite contract. The dominant nature, i.e., whether there are more elements of goods or services present in the contract does not denude the contract of its nature of being a ‘works contract’. Although it may be divisible in fiction, without these elements, the ‘works contract’ would not exist. Further, one must considerthe substance and not the form to determine whether the contract falls within the definition of a ‘works contract’ or a supply contract simpliciter.

Works Contract and MSMED Act: Is the misfit a settled law?

Before delving intoarbitration, it is necessary to understand the background of the relationship MSMED Act and Works Contract. For the development of MSMEs, MSME Public Procurement Policies by the State have sought to give preference to these industries. This preference typically takes the form of awarding contracts to MSMEs. This raises a question – what would happen if an MSME is given preference in awarding of works contracts?

In Shree Gee^[8], the Hon’ble Delhi High Court consideredthe same question, wherein, the Indian Oil Corporation gave preference to an MSME by applying a clause in the Notice Inviting Tender, which contained such preference. The Hon’ble High Court analysed MSME Procurement Policy, 2012 and the related documents and concluded  that it would not be applicable to a works contract. It quashed the awarding of the contract and directed that it be awarded to the petitioner, subject to terms.

A similar question came before a division bench of the Allahabad High Court in Rahul Singh^[9], which ruled that a works contract does not fall within the ambit of the MSMED Act. Another significant decision in this regard was P.L. Adke^[10] of the Hon’ble Bombay High Court, which arose out of an order passed under Section 9 of the Arbitration and Conciliation Act, 1996 (“Arbitration Act”)^[11], which was rejected by the concerned District Court. The Appellant herein was an entity which received a Work Order from the Respondent. It was the case of the Appellant that monies payable under the Work Order were not disbursed to it despite the Appellant performing the work. Further, the Appellant contended that itwould fall within the definition of ‘seller’ and conversely, the Respondent would fall within the definition of ‘buyer’ under the MSMED Act. Therefore, the Appellant had sought to invoke statutory arbitration under the MSMED Act. However, the Bombay High Court dismissed the appeal relying on the decisions of Shree Gee^[12] and Rahul Singh^[13], that MSMED Act could not have been invoked in the instant scenario. It referred to the decisions of the Larsen & Toubro^[14] and Kone Elevators^[15] to establish that the Work Order was under the scope of definition of ‘Works Contract’ and therefore, arbitration could not have been invoked under the MSMED Act^[16]. The judgment in PL Adke^[17] was challenged before the Hon’ble Supreme Court and the judgment was reserved vide Order dated 15.02.2022.^[18] However, it is notable that the Supreme Court has not stayed the operation of the judgment, which means that it is good in law. As will be elucidated in the succeeding section, High Courts have successively relied on PL Adke to render their own findings on the issue.

Works Contracts and MSMED Arbitration: Can arbitration be invoked?

The basis for this article emanates out of the judgment of the Bombay High Court in National Textile Corporation Ltd. v. Elixir Engineering Pvt. Ltd. & Anr.^[19] The Petitioner filed a petition under Section 34 of the Arbitration Act^[20] challenging the awards passed by the Facilitation Council for being without jurisdiction. In the instant case, Respondent No. 1 was the successful bidder in the tender floated by the Petitioner for “design, fabrication, erection, testing and commissioning of piping systems for steam, condensate, compressed air, roof/soft water, warm water return/LPG/CNG and thermic fluid at Achalpur, Amravati in Maharashtra.”

Respondent No. 1 was not satisfied with the payments received under the contract and made an application to the MSMED Facilitation Council. The Facilitation Council partially accepted the claims of Respondent No. 1 and ordered certain payments to be made to it. Although the Petitioner had raised contentions regarding jurisdiction before the Facilitation Council, the award went against the Petitioner. Subsequently, the Petitioner filed a petition under Section 34 before the Bombay High Court.

The Hon’ble Court took note of the decision in PL Adke and held the following:

“34. […] Therefore, following the judgment in the case of M/s. P. L. Adke v. Wardha Municipal Corporation/Council, it is held that the provisions of the MSMED Act could not have been invoked by Respondent No. 1. This clearly shows that the initiation of the statutory arbitration under the provisions of the MSMED Act on the part of Respondent No. 1 in the context of contracts in question before the Facilitation Council, was a stillborn exercise and that the Facilitation Council could not have exercised jurisdiction to conduct the arbitration proceedings. This renders the impugned awards without jurisdiction. As this aspect goes to the very root of the matter, the Petitioner has made out ground under Section 34 of the Arbitration Act, although the scope for interference in an arbitral award has been narrowed down after the amendment of the Arbitration Act in the year 2015 and the clarification of the position of law by the Supreme Court in the case of Ssangyong Engineering & Construction Co., Ltd. v. The National Highways Authority of India (supra). The lack of jurisdiction in the Facilitation Council to conduct the arbitration proceedings renders the impugned awards patently illegal.”

(emphasis supplied)

The Bombay High Court set aside the award on the ground that since the contract in question was a ‘Works Contract’ and hence, the Facilitation Council could not have exercised its jurisdiction.

The Hon’ble Delhi High Court was presented with another scenario in Tata Power Company Ltd. v. Genesis Engineering Company.^[21] In the instant case, owing to certain disputes arising between the parties pursuant to a work order issued to the Respondent, the Petitioner had issued a Notice invoking Arbitration under Section 21 of the Arbitration Act^[22], nominating an arbitrator. However, the Respondent did comply with the notice and, in turn, approached the Facilitation Council under the MSMED Act^[23]. This ledto the Petitioner approaching the Delhi High Court under Section 11 of the Arbitration Act^[24].

Before the High Court, the Respondent contended that since it has already approached the Facilitation Council and the Petitioner has also joined the proceedings therein, the present Section 11^[25] should be rejected. Per contra, the Petitioner contended that the work order fell under the definition of ‘Works Contract’ and disputes qua the same cannot be agitated before the Facilitation Council. While analyzing the Contract and placing reliance on the judgments reproduced in this article, the High Court allowed the Section 11 petition and observed:

“24. In view of the aforesaid judgments and the nature of Works Order awarded to Respondent clearly establishes that the Work Orders in question are essentially Works Contract. It is a settled principle of law that dispute/claims arising from Works Contract are not amenable to the jurisdiction of Facilitation Council constituted under the MSME Act. It is evident that the Work Orders under question qualify as Work Contracts, therefore, the Respondent is not entitled to take the benefit of provisions of MSME Act and to assail the maintainability of the instant proceedings.

26. […] In view of the same, this Court is inclined to refer the disputes and differences arising between the parties to arbitration, by appointing a sole arbitrator.”

(emphasis supplied)

Conclusion: A caveat to MSMEs

As put forward earlier, registration as an MSMED Act is a beneficial legislation aimed at providing inter alia efficient and feasible modes of dispute resolution. However, MSMEs faced with a situation involving elements of works contracts should be wary of the substance of their contract. Although it is only the High Courts which have held that such contracts will not be amenable to the MSMED Act, the conclusions are being accepted across jurisdictions all around the country. Hence, this interpretation has been painted with the colour of the settled law. Although the Supreme Court’s decision in PL Adke is awaited and the same may change the current position, practitioners and MSMEs should exercise restraint and analyze their position qua their contracts before approaching the Facilitation Council.

[1] Micro, Small and Medium Enterprises Development Act, 2006,  No. 27, Acts of Parliament, 2006 (India).

[2] Micro, Small and Medium Enterprises Development Act, 2006,  § 18, No. 27, Acts of Parliament, 2006 (India).

[3] Central Goods and Services Tax Act, 2017, No. 12, Acts of Parliament, 2017 (India).

.

[4] K. Raheja v. State of Karnataka, (2005) 5 SCC 162.

[5] Larsen & Toubro v. State of Karnataka, (2014) 1 SCC 708.

[6] Kone Elevators v. State of TN, (2014) 7 SCC 1.

[7] Ibid.

[8] Shree Gee v. Union of India, (2015) 224 DLT 445.

[9] Rahul Singh v. Union of India & Ors., (2017) 122 ALR 65.

[10] PL Adke v. Wardha Municipal Corporation, MANU/MH/2179/2021.

[11] Arbitration and Conciliation Act, 1996,  § 9, No. 26, Acts of Parliament, 1996 (India).

[12] Shree Gee v. Union of India, (2015) 224 DLT 445.

[13] Rahul Singh v. Union of India & Ors., (2017) 122 ALR 65.

[14] Larsen & Toubro v. State of Karnataka, (2014) 1 SCC 708.

[15] Kone Elevators v. State of TN, (2014) 7 SCC 1.

[16] Micro, Small and Medium Enterprises Development Act, 2006,  No. 27, Acts of Parliament, 2006 (India).

[17]  PL Adke v. Wardha Municipal Corporation, MANU/MH/2179/2021.

[18] SLP (C) No. 7674/2021.

[19] National Textile Corporation Ltd. v. Elixir Engineering Pvt. Ltd. & Anr., 2023 SCC OnLine Bom 653.

[20] Arbitration and Conciliation Act, 1996,  § 34, No. 26, Acts of Parliament, 1996 (India).

[21] Tata Power Company Ltd. v. Genesis Engineering Company, 2023 SCC OnLine Del 2366.

[22]  Arbitration and Conciliation Act, 1996,  § 21, No. 26, Acts of Parliament, 1996 (India).

[23] Micro, Small and Medium Enterprises Development Act, 2006,  No. 27, Acts of Parliament, 2006 (India).

[24]  Arbitration and Conciliation Act, 1996,  § 11, No. 26, Acts of Parliament, 1996 (India).

[25] Ibid.