[Priyal Jain is a fourth-year student at Hidayatullah National Law University, Raipur]
Ipso facto clauses have become a contentious topic for discussion as they manifest the necessity for a balance between contractual relations and Insolvency laws. These clauses have the capability of frustrating the objective of the Insolvency and Bankruptcy Code 2016 (IBC or Code) i.e. the rescue of corporate debtors (CD) through the restructuring process. But the importance of these ipso facto clauses which offer freedom to parties during the formation of a contract cannot be denied. Thus, this article aims to explain the status quo concerning ipso facto clauses under IBC as well as other jurisdictions. Subsequently, this article tries to put forth a possible way forward for India to achieve a much-required balance between ipso facto clauses and IBC.
Ipso Facto Clauses
Ipso Facto clauses are contractual clauses that allow a party to terminate or modify a contract in case of a default. Such defaults may be specified situations such as commencement of insolvency proceedings, appointment of insolvency administrator, non-payment of dues, non-performance of a contract etc. The purpose of ipso facto clauses is to provide a safe harbour to one party from financial loss in case of default by the other party. However, these clauses have raised situations in which they become a hindrance in a successful insolvency proceeding of the defaulting party.
In cases where an ipso facto clause allows termination of a contract by one party by the reason of another party’s insolvency proceedings, the CD suffers immensely if that terminated contract was essential in order for it to function as a ‘going concern’. Thus, the continuance of some essential contracts during the Corporate Insolvency Resolution Process (CIRP) becomes crucial. This leads to the necessity of unambiguous laws for governing ipso facto clauses.
Position under IBC concerning Ipso Facto Clauses
Unlike its predecessors, IBC till date does not explicitly invalidate ipso facto clauses entirely. However, Section 14(2) of the IBC does not allow for the suspension, termination or interruption of the supply of essential goods or services to the CD during an insolvency proceeding. Also, Section 14(2-A) of the IBC clarifies that the supply of such essential goods or services, which the interim RP or RP considers to be critical for: (i) protection and perseverance of CD’s value and; (ii) keeping the operations of CD as a going concern, shall not be affected during the period of moratorium. Section 14(2-A) comes with an exception that allows termination in case of non-payment of dues to the supplier.
Thus, IBC provisions are limited to the protection of those contracts which are in relation to essential goods or services. However, Section 238 of the Code, which provides for the overriding effect of IBC over other instruments in case of inconsistency, has been relied upon frequently by Adjudicating Authorities in cases such as Gujarat Urja, Tata Consultancy and GRIDCO to invalidate ipso facto clauses.
The Gujarat Urja Case
A novel situation which needed determination of validity of ipso facto clauses under IBC arose in Gujarat Urja Vikas Nigam Ltd. v. Amit Gupta and ors. This case was concerned with the stay on termination of a Power Purchase Agreement (PPA) signed between Gujarat Urja Vikas Nigam Ltd. (Appellant) and the CD. The Appellant is the sole purchaser of power generated by the CD. However, when the insolvency proceedings of the CD commenced, the appellant terminated the PPA.
The question of law was whether the termination of the PPA, which was the heart of the CD’s business, could be stayed by the Court under IBC or not. The National Company Law Tribunal (NCLT) and National Company Law Appellate Tribunal (NCLAT) stayed the termination of the PPA on the ground that the PPA is an ‘instrument’ under Section 238 of IBC and therefore, overridden by the Code. Both the tribunals stated that the termination of the PPA will frustrate the objective of the Code.
The appeal went to Supreme Court which 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”. In the present case, the life of the CD was completely dependent on the PPA and termination of the same would have led to corporate death of the CD. Further, the court also expressed the need for express legislation with respect to the validity of ipso facto clauses under IBC.
Stance of Different jurisdictions
Restricting the enforcement of ipso facto clauses is surely an important step for protection of a CD and its stakeholders. Absence of a proper mechanism under IBC to deal with such clauses has led the Adjudicating Authorities to read between the lines in order to stay the termination of contract for keeping CD alive. Therefore, the need for legislation is inevitable.
Every insolvency regime faces such a situation where the question of prioritizing contractual autonomy over insolvency code is raised and the views concerning this are quite contrasting all around the world. For example, United States (US) law prioritizes US Bankruptcy Code 1979 (US Code) over party autonomy. As per Section 365(e) of the US Code, an executory contract or an unexpired lease (barring few exceptions) is not capable of termination solely on the basis of insolvency of the CD. Similar approach has been followed by France and Austria. Contrastingly, the United Kingdom (UK) law is inclined towards party autonomy. UK insolvency regime follows common law ‘Anti Deprivation rule’ which does not invalidate ipso facto clauses if the contract was entered with a bonafide intention. Further, Section 233B of the UK Insolvency Act 1986 which was recently added by Corporate Insolvency and Governance Act 2020 invalidates only those clauses which relate to the termination or suspension of supply of essential goods and services to CD. Greece has even provided complete validity to ipso facto clauses through legislation.
Possible Way Forward for India
It seems that the NCLT and NCLAT have stayed the termination of contracts even in cases where non-insolvency default has occurred. Therefore, in order to avoid similar arbitrary judgments in future, a clear provision under IBC to provide certainty and balance contractual rights with IBC is an absolute necessity. The author believes it is desirable that while invalidating ipso facto clauses, various safeguards are provided to counterparty that protect its interests under IBC. This will ensure that neither CD nor the terminating party suffer in the hands of inequitable law which favours one of them entirely. These safeguards may include following:
A provision may be made for a conditional stay rather than a complete stay on termination of a contract. A stay on termination should operate unless the Committee of Creditors makes a beneficial arrangement for counterparty such as payment on an ongoing basis or prioritizing the payment as CIRP cost in the resolution plan.
An exception of significant financial hardships just like in Canada and Singapore may be added. However, a tough test for proving this ‘significant financial hardship’ has been adopted in a Canadian case of the Toronto Dominion Bank, according to which, the determination of ‘significant financial hardship’ must be objective which shows the prejudicial nature of the ongoing contract quantitatively.
The termination of a contract based on other non-insolvency default such as non-payment of dues, non-performance of contract etc. should not be restrained. Even the SC in Gujarat Urja Case made this clear.
In conclusion, a complete restraint on the use of ipso facto clauses to terminate a contract during insolvency proceedings will lead to unreasonable encroachment of party autonomy. Counterparty would be locked into an unfavourable contract which will even affect its own financial condition. Therefore, a need for balanced legislation should be acknowledged by the parliament.