The High Court of Judicature at Allahabad has ruled that an arbitral tribunal lacks the legal authority to award compound interest, or interest upon interest, unless the underlying contract explicitly provides for such a calculation. This decision, delivered by a division bench of Chief Justice Arun Bhansali and Justice Jaspreet Singh, marks a significant clarification regarding how arbitral awards must be structured in commercial disputes where the contract remains silent on interest mechanisms.

The ruling arose from an appeal filed by the State of Uttar Pradesh against M/s Apex Construction Company regarding a project for the widening and strengthening of the Raya-Math Road in District Mathura. The dispute, which had seen years of litigation, centered on the final payment due to the construction company. While the arbitral tribunal had previously found the construction company entitled to an award of approximately ₹1.56 crore, the tribunal had also ordered the State to pay 14% interest, compounded annually, on this sum from September 2009 until the date of actual payment.

In its judgment, the division bench emphasized that arbitral tribunals must operate strictly within the bounds defined by the parties' agreement. The Court observed, "The Arbitral Tribunal is a creature of the contract and it is bound to act within the four corners of the contract." Finding that the contract in question made no provision for compound interest , the bench determined that the tribunal’s decision to apply annual rests —effectively capitalizing the interest—was a jurisdictional error .

The legal conflict originated in 2008 when the Public Works Department of Uttar Pradesh awarded the contract to the respondent. Following the completion of the work, the contractor sought additional payments, leading to a long-standing dispute over whether the road had been completed to standard specifications. When the matter reached arbitration in 2015, the tribunal rejected the State’s counterclaim regarding substandard materials but ultimately granted the contractor compound interest, citing its general power under Section 31(7) of the Arbitration and Conciliation Act, 1996.

The State challenged the award under Section 34 of the Act, arguing that the tribunal had exceeded its mandate by awarding compound interest, which contravened the provisions of the Interest Act, 1978. When the commercial court dismissed the State’s petition, the matter was brought before the High Court in an appeal under Section 37.

The High Court meticulously analyzed the interplay between Section 31(7) of the Arbitration and Conciliation Act and Section 3 of the Interest Act. It noted that while the former allows for the inclusion of interest in the "sum" awarded for both pre-reference and post-award periods, it does not provide an open-ended license to compound those figures. The Court held that in the absence of a specific stipulation in the contract, the imposition of interest upon interest is legally impermissible.

In clarifying the limits of an arbitrator's discretion, the bench stated, "In the banking industry generally a lending bank may add the interest every quarter or annually but that is only a methodology of charging interest, but nevertheless it still remains under the umbrella of compound interest ." By drawing this distinction, the Court reinforced the principle that the technical methods used by commercial banks do not automatically validate an arbitrator's decision to compound interest in construction contracts.

The Court also addressed the scope of its own power to modify the arbitral award. Drawing on the precedent set by the Supreme Court in recent constitutional bench rulings, the bench affirmed that courts may intervene to modify an award specifically regarding interest, provided the modification does not require re-adjudication of the substantive findings of fact.

"Only severable awards are amenable to modification; a composite or indivisible arbitral award cannot be modified," the Court noted, citing established guardrails for judicial intervention. Because the finding on the principal amount owed was factually sound and severable from the error regarding interest calculation, the bench concluded that the entire award did not need to be set aside.

Consequently, the High Court modified the arbitral award to rectify the interest calculation. The construction company remains entitled to the principal sum of ₹1,56,79,034.65, but this amount will now attract simple interest at 14% per annum from September 1, 2009, until the date of the claim petition in 2016. Any amount crystallized as of January 31, 2016, will then carry 14% per annum simple interest until the date of actual recovery. Furthermore, the court maintained the original provision for the deduction of ₹1,39,619 from the total award, as originally recommended in technical reports, alongside simple interest.

The ruling serves as a vital reminder to parties and practitioners that the standard of "reasonableness" in Section 31(7) of the Arbitration Act does not override the fundamental prohibition against compound interest in the absence of a contractual agreement. The decision effectively preserves the integrity of the original findings while curbing the financial impact of compounded interest on public exchequers. The matter concluded with the High Court affirming the award's substantive findings but restricting the accrual of interest, thereby standardizing the calculation to simple interest rates for the duration of the protracted dispute. The construction company and the state authorities are now directed to calculate the final dues based on this simple interest methodology, ensuring compliance with the modified order.