Ipso Facto Clauses and the IBC
A question that often arises in insolvency law is the extent to which contractual agreements between commercial parties can or should be disrupted on account of one of the parties to the contract entering into the insolvency process. At play is the tension between respecting the sanctity of contractual commitments, on the one hand, and the need for insolvency law to facilitate a successful resolution process for the debtor, on the other hand. If enforcing a particular contract would be highly detrimental to the business of the insolvent debtor and significantly reduce the likelihood of its successful resolution, can insolvency law provide that such a contract cannot/ need not be enforced? This tension is manifested in the debate around the enforcement of ipso facto clauses in contracts, an issue that was considered by the Supreme Court in its decision in Gujarat Urja Vikas Nigam Limited v. Mr. Amit Gupta & Ors. (“Gujarat Urja Vikas”) in March of this year.
Ipso facto clauses are clauses in commercial contracts that permit a party to terminate the contract on the occurrence of certain pre-defined insolvency related events of the counterparty. While a number of jurisdictions have restrictions (with exceptions and carve outs) on the enforcement of ipso facto clauses in certain contexts, the Insolvency and Bankruptcy Code, 2016 (“IBC”) is largely silent on this question. In Gujarat Urja Vikas, the Supreme Court did not pronounce on the validity of ipso facto clauses in general, concluding quite rightly that this was an issue for the legislature to decide.
This blog post looks at the Court’s decision in Gujarat Urja Vikas and the various considerations involved in determining whether restrictions on the validity of ipso facto clauses should be built into the IBC.
Supreme Court’s Ruling in Gujarat Urja Vikas:
In Gujarat Urja Vikas, the corporate debtor, Astonfield Solar Gujarat Private Limited, had entered into a power purchase agreement (“PPA”) with Gujarat Urja Vikas Nigam Limited (the “Appellant”) for the supply of solar power to the Appellant. An insolvency application against the corporate debtor was admitted in November 2018 and, in May 2019, the Appellant sought to terminate the PPA on the grounds that the commencement of the corporate insolvency resolution process (“CIRP”) constituted an event of default under the PPA. The resolution professional applied to the National Company Law Tribunal (“NCLT”) seeking a stay on termination of the PPA in light of the fact that the PPA was the sole contract of the corporate debtor and termination would affect the corporate debtor’s status as a going concern. The NCLT passed an order restraining the Appellant from terminating the PPA, a decision that was confirmed by the National Company Law Appellate Tribunal (“NCLAT”).
On appeal to the Supreme Court, there were two issues for the Court’s consideration. First, whether the NCLT had jurisdiction under Section 60(5) of the IBC to resolve a contractual dispute between the corporate debtor and the Appellant and, second, whether the PPA was validly terminated by the Appellant. On the question of jurisdiction, the Supreme Court held that the NCLT (or NCLAT) had jurisdiction under Section 60(5) to adjudicate on contractual disputes that arose out of, or related to, the insolvency proceeding. In this case, as the PPA was terminated because of the CIRP of the corporate debtor, the NCLT had jurisdiction to consider if the PPA had been validly terminated. On the other hand, the Supreme Court clarified that contractual disputes that did not relate to the insolvency proceeding could not be considered by the NCLT and that the resolution professional would have to approach the relevant authority for the resolution of such disputes.
On the issue of termination of the PPA itself, the Supreme Court upheld the decision of the NCLAT, but made clear that it was not ruling on the general validity of ipso facto clauses under the IBC. Instead, the Court based its decision on the specific facts of the case, and the centrality of the PPA to the business of the corporate debtor. The Court pointed out that the PPA was the sole contract of the corporate debtor and that the terms of the PPA itself prevented the corporate debtor from supplying electricity to third parties. As a consequence, termination of the PPA would sound the death knell of the corporate debtor, which was clearly contrary to the purpose of the IBC and would come in the way of the requirement to maintain the corporate debtor as a going concern during the CIRP.
Validity of the Ipso Facto Clauses under the IBC:
The Supreme Court’s ruling in Gujarat Urja Vikas brings up the larger issue of the enforceability (or non-enforceability) of contractual obligations during the CIRP. Currently, Section 14(2) of the IBC prohibits third parties from stopping the supply of essential services to the corporate debtor once the CIRP is commenced and the moratorium comes into effect. In addition, Section 14(2A), which was introduced through an amendment to the IBC in December 2019, provides that the supply of critical services (i.e., services that are critical to the business, but don’t 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 there have been payment defaults in past periods). A final category referred to in the explanation to Section 14(1) are licenses, government grants and permits required for the conduct of the corporate debtor’s business, which again cannot be terminated upon commencement of the CIRP as long the corporate debtor has not defaulted on the current payments required for continuation of the licenses or permits during the moratorium. All these provisions are aimed at increasing the likelihood of revival of the corporate debtor, by ensuring that its business can be run as a going concern during the CIRP.
Missing from the above types of contracts are, most notably, contracts for loans, guarantees and other types of financing arrangements, and contracts with the corporate debtor’s customers for the provision of goods or services. Financing contracts are largely dealt with through the Section 14 moratorium, which suspends initiation or continuation of any legal proceedings for the recovery of debt, including security enforcement actions. That leaves customer contracts or contracts where the corporate debtor is supplying goods or services to a counterparty, such as the PPA in Gujarat Urja Vikas. Can a counterparty that is the recipient of goods or services from the corporate debtor choose to terminate its contract because the corporate debtor is undergoing a CIRP? The validity of ipso facto clauses under the IBC may be most relevant in this context.
The treatment of ipso facto clauses is one area of insolvency law that varies significantly across jurisdictions. However, given the competing interests at stake, most jurisdictions have enacted restrictions (rather than an outright ban) on the enforcement of ipso facto clauses. 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. In the United Kingdom, by contrast, 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.
If there were to be a legislative change to the IBC to clarify the validity of ipso facto clauses in contracts (as the Supreme Court in Gujarat Urja Vikas has suggested), it would be critical to balance the need to facilitate a successful resolution with the need to protect the interests of contractual counterparties. First, any restriction on the enforcement of ipso facto clauses should make very clear that it would not prevent counterparties from terminating a contract during the CIRP for reasons other than insolvency. If, for example, a counterparty chooses to terminate a contract because the corporate debtor fails to supply the goods or to make payments in accordance with the contractual terms, it should be allowed to do so during the CIRP. Second, the time period for any restriction on the enforcement of ipso facto clauses would need to be considered. During the CIRP, when revival of the debtor is a possibility, there may be a strong reason to not allow contracts that are critical to the debtor’s business to be terminated on grounds of insolvency. On the other hand, during the liquidation process, it may be prudent to lift any stay on the enforcement of ipso facto clauses as maintaining the debtor as a going concern is no longer important.
Finally, the type of contract involved and its centrality to the corporate debtor’s business would also be a crucial factor. It is the case that many companies pursuing infrastructure projects are heavily dependent on one or a handful of contracts, typically with a governmental or quasi-governmental authority. 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 noted. The Government has, to date, shied away from introducing any sector specific provisions in the IBC, but the reality of these business structures cannot be ignored if the IBC were to be a meaningful resolution tool for the infrastructure sector. Similar to Section 14(2A) on the supply of critical services to the corporate debtor, it may be worthwhile restricting the termination of contracts critical to the corporate debtor’s business solely on grounds of insolvency.
Until the legislature clarifies the position on ipso facto clauses, courts and tribunals would do well to adopt a similar line of reasoning as the Supreme Court in Gujarat Urja Vikas and consider the specific factual matrix of the case at hand and the effect of termination on the corporate debtor.
† Aparna Ravi is a Partner at Samvad Partners. The views expressed here are personal.