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Ipso facto Termination in India: Valid or Invalid?

On March 8, 2021, Hon’ble Supreme Court delivered a judgement highlighting the need for the Legislature to provide clarity on the validity of ipso facto clauses in India in the context of insolvency laws. The Hon’ble Court, being well aware of its remit, adopted a ‘workable formula’, applicable only in the given factual matrix, to address the issue in question and did not encroach the legislature’s role in formulating a policy with respect thereto. In fact, the Hon’ble Court has put forth a series of questions for consideration before the lawmakers regarding the validity of ipso facto clauses.

The dispute in the matter Gujarat Urja Vikas Nigam Ltd. v. Mr. Amit Gupta & Ors. [C.A. No. 9241/2019] (Captioned Case) revolved around the notice of termination dated May 1, 2019 issued by Gujarat Urja Vikas Nigam Limited (Appellant) for terminating the Power Purchase Agreement (PPA) entered into between the Appellant and Astonfield Solar (Gujarat) Private Limited (Corporate Debtor/CD), on account of initiation of Corporate Insolvency Resolution Process (CIRP) of the Corporate Debtor, pursuant to the order of National Company Law Tribunal (NCLT) dated November 20, 2018.

On May 31, 2019, NCLT restrained the Appellant from terminating the PPA and National Company Law Appellate Tribunal (NCLAT) further upheld NCLT’s decision and stated that the Appellant cannot terminate the PPA on the sole ground of initiation of CIRP. An appeal was filed against this order of the NCLAT and while arriving at the judgement, the Hon’ble Court considered, inter alia, the issue of validity of ipso facto clauses in the context of insolvency laws. The said issue is crucial, particularly because it has highlighted the conflict between autonomy of the parties to contract vis-à-vis ensuring that the corporate debtor remains as a ‘going concern’ throughout the insolvency process.

An effective insolvency regime is central to a positive financial and business sentiment towards an economy and focuses on plugging the gaps that hinder the central process of keeping a corporate debtor a ‘going concern’ during the CIRP. Maintaining the status of a corporate debtor as a going concern becomes especially difficult due to invocation of certain contractual obligations that were agreed to by the corporate debtor before the initiation of CIRP.

One such clause being an ipso facto clause – a contractual provision, typically present in all contracts, that allows a party to terminate the contract with its counterparty due to the occurrence of a financial distress, which can include filing an application for insolvency, initiation of insolvency, financial restructuring and so on, and in the context of the Captioned Case refers to initiation of CIRP.

Such ipso facto clauses become a contentious legal issue in light of the two opposing considerations – on one hand, upholding ipso facto clauses make the objective of IBC redundant by allowing the counterparty to terminate the agreement, thus reducing the asset of the corporate debtor and making it difficult to run the corporate debtor as a ‘going concern’; whereas, on the other hand, restricting enforcement of such clauses forces the counter party to continue an unviable contract with the corporate debtor, which contravenes the sanctity of enforcing contractual remedies.

An overview of the position that various international organizations as well as jurisdictions take on this issue will help inform our perspective on balancing two equally important objectives. To begin with, international organizations like the UNCITRAL and the World Bank’s recommendation are in favour of insolvency laws overriding ipso facto clauses, and where any negative impact must be balanced by providing compensation to the creditors who have suffered loss for continuing performance. The supranational organization, European Union, too is of the view that the creditors should not be allowed to terminate contracts based on ipso facto clauses when the defaulter is undergoing restructuring.

Further, in the United States, there is a statutory prohibition in enforcing ipso facto clauses in executory contracts and unexpired leases since 1979. However, it is allowed in certain financial arrangements like swap agreements, securities, forwarding, etc. Similar to the United States, France, Austria, and Germany have introduced statutory provisions to invalidate termination based on ipso facto clauses during the insolvency proceedings in the years 2014, 2020 and 2021, respectively.

Countries like Australia and Singapore too have introduced amendments, in the year 2018 and 2020, respectively, to its insolvency regimes to invalidate termination based on ipso facto clauses on the ground of insolvency; and such amendments have a prospective application. Greece, being one of the exceptions, has a statutory provision that upholds termination based on ipso facto clauses.

In addition to statutory provisions, common law countries like the United Kingdom and Canada follow the principle of ‘Anti-Deprivation Rule’ (ADR), which seeks to prevent the debtor’s asset from being reduced before it becomes subject to the insolvency process. However, certain judgements have clarified the scope of ADR and held that in cases of complex financial instruments and as far as possible, ADR should not be applicable on bonafide commercial transactions; and courts should give effect to such contractual terms, except in the case of a blatant attempt to deprive a party of property in the event of liquidation.

However, recently UK has amended its Insolvency Act in June 2020 to introduce provisions that are similar to the moratorium provision under Section 14 of the Insolvency and Bankruptcy Code, 2016 (IBC). The statutory laws of Canada invalidate ipso facto clauses in both commercial and consumer restructurings and are intended to protect consumer debtors from the deleterious consequences of provisions that trigger upon bankruptcy.

Looking at the global insolvency and restructuring scenario, with the exception of Greece, it can be gauged that across foreign jurisdictions, enforcement of ipso facto clauses on the grounds of initiation of insolvency is restricted during an insolvency or restructuring process, with varying degree of exceptions.

In India, the committee headed by J. J. Irani in 2005 took note of the UNCITRAL guide on insolvency regime and supported the idea of invalidation of ipso facto clauses to preserve the corporate debtor’s assets from being diluted during the insolvency process, subject to exceptions. However, this recommendation did not find any legislative embodiment. The Report of the Bankruptcy Law Reforms Committee, pursuant to which IBC was enacted, recognized the requirement of a ‘calm period’, in the form of moratorium, where interests of the creditors are protected without disrupting the running of the enterprise.

In December 2018, invalidation of ipso facto clauses was also observed in a report issued by Vidhi Centre for Legal Policy, which notes that IBC does not per se prohibit operation of ipso facto clauses during insolvency proceedings, however, Section 14 of the IBC provides for a limited exception in prohibiting the termination, suspension or interruption of specified essential goods or services.

Recently, explanation to Section 14(1) of the IBC was introduced through the Insolvency and Bankruptcy Code (Amendment) Act, 2020, which prohibited termination of any license, permit, registration, quota, concession, clearance, or any similar grant or right given by a governmental authority or statutory regulator on the grounds of insolvency, as long as there is no default in payment of current dues.

The legislative intent behind this amendment was looked into in the Report of the Insolvency Law Committee (ILC) dated February 20, 2020, which observed the importance of keeping the corporate debtor as a ‘going concern’ during the moratorium period imposed under the IBC, and how termination of certain Government licenses and permits during CIRP based on ipso facto clauses made the imposition of moratorium ineffective. Therefore, ILC suggested addition of the explanation to Section 14(1) of the IBC "to avoid any scope for ambiguity" and to make the legislative intent precise and clear.

In the Captioned Case, the Hon’ble Court upheld NCLAT’s order and held that NCLT could exercise its residuary powers to restrict the Appellant from terminating the PPA on the sole ground of initiation of CIRP of the Corporate Debtor. This view was taken considering the Appellant was the only purchaser of the electricity generated by the Corporate Debtor and how crucial the PPA was to keep the Corporate Debtor as a ‘going concern’.

However, the Hon’ble Court emphasized that a court cannot intervene to set aside valid terminations, which would merely dilute the value of a corporate debtor, and the present reasoning is limited to the unique factual matrix of the Captioned case and should not be used as a precedent in future cases to justify a court’s interference in enforcement of any contractual terms agreed between the parties.

It is apparent that since the inception of IBC, the courts have time and again taken a view to uphold the objective of IBC, which is to revive the corporate debtor and operate it as a going concern. As observed across multiple foreign jurisdictions, termination based on ipso facto clauses solely on the grounds of insolvency is restricted as it is in direct contravention to the object of insolvency laws.

Having said that, there are uncertainties that plague the insolvency process, for instance unending delays, non-availability of assets, lack of expertise in running the business by resolution professionals, and lack of clarity on the classification of suppliers, a definite timeline or visibility on the process, which create major hurdles in balancing the objectives of the IBC vis-à-vis rights of the counterparties.

Freedom of contract
is an important facet of growing economy and it is extremely important to ensure that the counterparties are not made to suffer owing to such challenges or made to continue in an unviable proposition.

While the global precedents and the decision in the Captioned Case clearly suggest invalidation of ipso facto clauses only in an insolvency scenario and not when the termination is on account of deficiency of service, until the Legislature brings in any amendment to tie in the loose ends, the question of validity of ipso facto clauses must be decided by the judiciary based on the facts of each case.

However, given the expertise and bandwidth of NCLT, it may not be the appropriate forum to adjudicate on this issue. The Supreme Court’s appeal to the Legislature to engage in a dialogue to provide its legislative vision on the issue of validity of ipso facto clauses hints at the complexity of this issue at hand and the need for a balanced and effective solution which can be achieved after carefully considering not just the objectives of the IBC but also the rights of the counterparties. Accordingly, the questions raised by the Hon’ble Court must be answered logically and strictly in the context of the Indian economy.

Written By:
  1. Mr.Ketan Mukhija, Partner, Link Legal and
  2. Ms.Karishma Singh, Associate, Link Legal
Disclaimer
The contents of this update are for general information and discussion only and is not intended for any solicitation of work. This update should not be relied upon as a legal advice or opinion.

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