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Validity of Ipso Facto clauses in Indian Insolvency Regime - An Analysis
The extent to which contractual arrangements between commercial parties can or should be disrupted as a result of one of the contracting parties entering the insolvency process is a question that frequently arises in insolvency law at present. Ipso facto clauses have been a divisive topic of debate because they demonstrate the need for a balance between contractual relationships and insolvency rules. These clauses have the potential to obstruct the Insolvency and Bankruptcy Code 2016 (IBC) objective as well of saving corporate debtors through the restructuring process. It's crucial to understand what ipso facto provisions are and how they apply to the insolvency regime before looking at the observation of the courts on this issue.
Ipso Facto clauses are contractual provisions that allow one party to terminate or modify a contract if the other fails to meet its obligations. The defaults might include things like the start of insolvency proceedings, the appointment of an insolvency administrator, non-payment of dues, or non-performance of a contract and very many more things. The goal of ipso facto provisions is primarily to protect one party from financial damage in the event that the other party defaults. However, these clauses have created scenarios in which they represent a barrier to the defaulting party's successful insolvency case. Yet, the significance of these ipso facto clauses which provide parties with flexibility throughout the creation of a contract should not be overlooked. And therefore, the purpose of this article is to describe the current state of ipso facto clauses under the Insolvency and Bankruptcy Code and in other jurisdictions following that, through this article, we can even understand the balance between the ipso facto clauses and IBC with a help of landmark case which was decided recently.
Validity of ipso facto clauses
Ipso facto clauses are contractual provisions which allow a party to terminate the contract with its counterparty due to the occurrence of an event of default. In the context of IBC, in some of these ipso facto clauses, the event of default includes events such as applying for insolvency, commencement of insolvency proceedings, or appointment of insolvency representative, etc. The Supreme Court after a detailed perusal of laws in different jurisdictions refrained to resolve the question of the validity/ invalidity of ipso facto clause in the present case as it raises complex issues of legal policy and balancing between contractual freedom on the one hand and corporate rescue on the other. Rather, the SC urged the legislature to provide concrete guidance on this issue in order to solve the conundrum.
Basically, when an ipso facto clause allows one party to cancel a contract due to the insolvency of another, the corporate debtor suffers greatly if the terminated contract was critical to the corporate debtor’s ability to function as a “going concern”. As a result, maintaining some essential contracts during the Corporate Insolvency Resolution Process seems to be critical which results in the necessity of unambiguous laws for governing the ipso facto clauses.
On looking at the position under Insolvency and Bankruptcy Code, 2016 (IBC) with regards to the ipso facto clauses, it’s seen that in contrast to its predecessors, the IBC does not specifically invalidate ipso facto clauses but during an insolvency proceeding, however, as per section 14(2) of the IBC, it prohibits the suspension, termination, or interruption of essential products or services to the corporate debtor. Furthermore, as per section 14(2-A) of the code, it clarifies that the supply of essential goods or services that the interim resolution professional or the resolution professional consider being critical for the protection and preservation of corporate debtors’ value and the continuation of the corporate debtors’ operations as a going concern shall not be affected during the moratorium period. Thus, section 14(2A) also contains an exception that allows for termination if dues are not paid to the supplier.
As a result, the IBC rules are confined to the protection of contracts involving essential products or services. However, the Adjudicating Authorities have regularly invoked section 238 of the code, which gives way to the IBC an overriding effect over other instruments in the event of inconsistency to invalidate the ipso facto clauses.
This conflict can be very well understood through the case of Gujarat Urja Vikas Nigam Limited v. Amit Gupta and Others, REED 2021 SC 03533, popularly known as the Gujarat Urja Vikas case which was decided very recently in the month of March this year. Through this one case, we can know what was examined by the Supreme Court's ruling in the case of Gujarat Urja Vikas, and the many factors considered when deciding whether ipso facto clause validity limits should be incorporated into the IBC.
Before getting into the observations directly made in this particular case, a gist of the facts is required to be known to further understand the whole subject matter. To begin with as we know a novel situation arose in this particular case on the validity of the ipso facto clause and this case when we see was concerned with the stay on termination of a Power Purchase Agreement (PPA) signed between Gujarat Urja Vikas Nigam Ltd., who is the Appellant and the corporate debtor. Here, the Appellant is the sole purchaser of power generated by the corporate debtor. However, when the insolvency proceedings of the corporate debtor commenced, the appellant had terminated the PPA. So, the question of law here was whether the termination of the PPA, which was the heart of the corporate debtor’s business, could be stayed by the Court under the bankruptcy code or not. The National Company Law Tribunal (NCLT) and National Company Law Appellate Tribunal (NCLAT) had stayed the termination of the PPA on the ground that the PPA is an ‘instrument’ under Section 238 of IBC and therefore, can be overridden by the code, therefore, both the tribunals stated that the termination of the PPA will frustrate the objective of the Code. There were two points here for the Supreme Court to examine when the case was appealed. First, whether the NCLT has jurisdiction to settle a contractual dispute between the corporate debtor and the Appellant under Section 60(5) of the IBC, and second, whether the PPA was properly terminated by the Appellant.
The Supreme Court held that the NCLT and the NCLAT had jurisdiction under Section 60(5) to adjudicate contractual issues arising out of or related to the insolvency action because the PPA was terminated due to the corporate debtor's corporate insolvency resolution process, the NCLT had the jurisdiction to determine whether the PPA was legally terminated. The Supreme Court, on the other hand, had also clarified that those contractual problems that were unrelated to the bankruptcy action may not be addressed by the NCLT, and that the resolution professional would have to take such sorts of disputes to the appropriate body for resolution.
In simple terms, the apex court had supported the NCLAT's decision on the PPA's termination but made it clear that it was not ruling on the general validity of ipso facto terms under the IBC at all. Instead, the Court decided based on the facts of the case and the importance of the PPA to the corporate debtor's operations. The Court noted that the PPA was the corporate debtor's sole contract and that the PPA's terms prohibited the corporate debtor from supplying electricity to third parties. As a result, terminating the PPA would result in the corporate debtor's demise, which was manifestly contrary to the IBC's purpose and would obstruct the requirement to keep the corporate debtor operating as a going concern during the insolvency resolution proceedings.
The validity of the Ipso facto clauses under the Bankruptcy code can be very clearly understood through this case as the Supreme Court's decision in Gujarat Urja Vikas raises the broader issue of contractual obligations' enforceability or non-enforceability during the insolvency process. And it is to be noted here that as per section 14(2) of the code, it currently prevents third parties from ceasing to provide essential services to the corporate debtor once the insolvency process has begun and the moratorium has taken effect. Furthermore, section 14(2A) of the code, which was enacted in December 2019, also states that the supply of critical services, which here refers to the services that are critical to the business but do not fall under the category of essentials, cannot be stopped as long as the corporate debtor makes payments for these supplies for the current period, even if payment defaults in the past period.
Moreover, the licenses, government grants, and permits required for the conduct of the corporate debtor's business are a final category mentioned in the explanation to section 14(1) of the code, and they cannot be terminated when the Corporate Insolvency Resolution Process (CIRP) begins as long as the corporate debtor has not defaulted on the current payments required to keep the licenses or permits active during the moratorium and all of these requirements are designed to increase the likelihood of the corporate debtor's revival by guaranteeing that its business can continue to operate even during the CIRP. The contracts for loans, guarantees, and other sorts of financial agreements, as well as contracts with the corporate debtor's clients for the provision of goods or services, are not included in the foregoing types of contracts and the Section 14 with regards to the moratorium, prohibits the beginning or continuation of any legal proceedings for the recovery of debt, including security enforcement measures, is generally used to deal with financing contracts. The customer contracts or contracts in which a corporate debtor provides goods or services to a counterparty, such as the PPA in the case of Gujarat Urja Vikas as we see, is left. The other question that comes up is whether it is possible for a counterparty that receives goods or services from a corporate debtor to terminate their contract because the corporate debtor is in the midst of a CIRP. To answer this with reference to the case law being discussed, we see that the legitimacy of ipso facto terms under the IBC may be the most important consideration.
The treatment of ipso facto clauses is one area of insolvency law where states differ greatly. Given the opposing interests at stake, most governments have adopted restrictions on the enforcement of ipso facto provisions rather than an outright ban. The United States Bankruptcy Code, under Section 365(e) for example, prohibits the enforcement of ipso facto clauses in executory contracts and unexpired leases but has permitted their enforcement in other kinds of contracts, such as derivatives and in the United Kingdom, by contrast, the ipso facto clauses have largely been upheld if they are part of a bona fide commercial transaction. There has, however, been a recent amendment through the introduction of Section 233B of the UK Insolvency and Governance Act that invalidates ipso facto clauses where a supplier can terminate supplying goods to a party in insolvency.
Similarly, here, if the IBC were to be amended to clarify the validity of ipso facto clauses in contracts as the Supreme Court suggests in the case of Gujarat Urja Vikas it would be critical to strike a balance between the need to facilitate a successful resolution and the need to protect the contractual counterparties' interests.
As first, any restriction on the enforcement of ipso facto terms should make it clear that it would not preclude counterparties from terminating a contract for reasons other than bankruptcy during the CIRP and if a counterparty, for example, chooses to terminate a contract because a corporate debtor fails to produce goods or make payments in line with the contract's terms, it should be allowed to do so during CIRP. Secondly, any limitation on the enforcement of ipso facto clauses would have to be considered in terms of time. There may be a compelling reason not to allow contracts that are fundamental to the debtor's business to be terminated on the grounds of insolvency during the CIRP, while the debtor's revival is a possibility but on the other hand, it may be prudent to lift any hold on the implementation of ipso facto clauses during the liquidation process, as keeping the debtor as a continuing concern is no longer important.
Therefore, we can come to an understanding by now that the sort of contract in question, as well as its importance to the corporate debtor's business, would be critical to first look into as many organisations working on infrastructure projects rely significantly on one or a few contracts, usually with a government or quasi-government agency. In such situations, allowing the counterparty to terminate the contract on grounds of insolvency would rule out any prospect of a resolution, as the Supreme Court in Gujarat Urja Vikas had noted.
The government has avoided including any sector-specific rules in the IBC to yet, but the reality of these corporate structures cannot be overlooked if the IBC is to be a useful dispute resolution mechanism for the infrastructure sector as similar to section 14(2A) on the provision of critical services to the corporate debtor, it may be advantageous to limit the termination of contracts critical to the corporate debtor's business simply on the basis of insolvency. And, until the legislature clarifies the position on ipso facto clauses, the courts and tribunals should follow the Supreme Court's lead in the case of Gujarat Urja Vikas and assess the facts of the case at hand, as well as the effect of termination on the corporate debtor before coming to a decision.
Looking at the global insolvency and restructuring scenario, and the decision in the case clearly suggestswe see that the invalidation of ipso facto clauses only in an insolvency scenario and not when the termination is on account of deficiency of service until then the legitimacy of ipso facto clauses is decided by the judiciary based on the facts of each case, regardless of whether the legislature introduces any amendments to tie up the loose end. The Supreme Court's request that the legislature should engage in a dialogue in order to provide its legislative vision on the issue of ipso facto clauses' validity hints at the complexity of the issue at hand and the need for a balanced and effective solution that can be achieved by carefully considering not only the Insolvency and Bankruptcy Code’s objectives but also the counterparties' rights.
To sum it up all, while ipso facto terms should be invalidated, it is preferable to offer counterparties with appropriate safeguards that protect their interests under the bankruptcy code as this will ensure that neither corporate debtor nor the terminating party suffers in the hands of inequitable law which favours one of them entirely. And therefore, the termination of a contract based on other non-insolvency defaults such as non-payment of dues, non-performance of contract etc. should not be restrained. The Hon’ble Supreme court too in the case of Gujarat Urja Case made this clear. To conclude, it is understood by now that a complete prohibition on the use of ipso facto clauses to end a contract during insolvency proceedings will invade on party autonomy in an unreasonable manner and the counterparty would be trapped in an unfavourabledeal that would have a negative impact on its own financial situation as well. As a result, the parliament should recognise the need for balanced legislation in order to avoid similar arbitrary judgments in future, and provide a clear provision under the Insolvency and Bankruptcy Code regarding the certainty and balance contractual rights with IBC as it is an absolute necessity. And with reference to the case law discussed in this article, we see that in the appeal the apex court had upheld the decision of NCLT and NCLAT and pointed out the object of moratorium under Section 14 of the Code, which is “to see that there is no depletion of a corporate debtor's assets during the insolvency resolution process so that it can be kept running as a going concern during this time, thus maximizing value for all stakeholders” and observed that the life of the corporate debtor was completely dependent on the PPA and termination of the same would have led to corporate death of the corporate debtor and like mentioned, clear legislation regarding the legality of ipso facto terms under the IBC is required. The Apex Court has observed that the desirability of Parliament providing its legislative voice on the broader validity of ipso facto clauses. Lack of a legislative vision on the issue of validity of ipso facto clauses will lead to confusion and reduced commercial clarity.