Analysing the Unenforceability of Ipso Facto Clauses During Insolvency Process
[Abhishek is a student at National University of Advanced Legal Studies, Kochi.]
Ipso facto clauses are provisions in a contract that allow termination of the contract merely upon the insolvency of one of the contracting parties. Recently, the National Company Law Appellate Tribunal (NCLAT) in Gujarat Urja Vikas Nigam Limited v. Yes Bank Limited and Another has held that a purchaser cannot terminate an agreement merely because the supplier is undergoing insolvency/liquidation process. The tribunal ruled that ipso facto clauses which provide for such termination are unenforceable if they affect the viability of the corporate debtor as a going concern. In this post, the author seeks to analyse the need to restrict the enforceability of ipso facto clauses during insolvency and liquidation process.
Under the relevant power purchase agreement (PPA), the appellant was a purchaser of power from the corporate debtor who owned the power plant. The appellant relying, inter alia, on clause 9.2.1(e), contended that on account of the corporate debtor’s liquidation, they had the right to terminate the PPA. On the other hand, the respondent, who had a security interest over the power plant, contended that such termination will impact the value of the power plant and will, in turn, offend the object of maximisation of assets.
The NCLAT accepting the arguments of the respondent held that the ipso facto termination clause in the PPA is unenforceable during the insolvency process. The tribunal ruled that enforcing such clauses will go against the object of the Insolvency and Bankruptcy Code 2016 (Code) and will be in breach of Section 14(1)(b) of the Code. It was held that allowing termination of the agreement will have an impact on the asset value of the power plant. Further, relying on Astonfield Solar (Gujarat) Private Ltd v. Gujarat Urja Vikas Nigam Limited, it was held that the provisions of the Code will override any ‘instrument’ on account of Section 238 of the Code. The term ‘instrument’ was interpreted to include any agreement, including that creates rights and liabilities of the parties.
Therefore, the ruling of the NCLAT indicates that agreements containing ipso facto termination clauses are unenforceable if they are in breach of the object of maximisation of value of the assets.
While the NCLAT is right in its decision, the justifications for restricting the enforceability of ipso facto clauses needs further discussion. Also, the law as it stands is unclear, and there is a need to have a new provision inserted in the Code to completely restrict enforcement of such clauses.
Is Restricting Freedom of Contract Justified?
It is evident that allowing insolvency law to override ipso facto clauses goes against the pre-insolvency entitlements agreed upon by the parties. This interference with the freedom of contract requires a meaningful justification. It has been held in Indian Steel and Wire Products Limited v. State of Madras that freedom of contract is not an absolute right and can be restricted in light of economic compulsions. Further, in Delhi Transport Corporation v. D.T.C. Mazdoor Congress and Others, it was held that freedom of contract is subject to the economic interest of the community at large.
It is pertinent to note that one of the most important objectives of insolvency law is to maximise the value of assets for the benefit of all parties and the economy in general. To protect this objective, a restriction on the enforcement of ipso facto clauses is necessary. The UNCITRAL Legislative Guide on Insolvency Law recognises the overriding effect of insolvency laws over ipso facto clauses to keep the business of the debtor together and maximise the value of assets. Similarly, the US Bankruptcy Code invalidates ipso facto clauses that prevent debtors from performing beneficial contracts on account of pending bankruptcy proceedings. Further, Australia, the United Kingdom and Singapore have brought in legislative changes to render ipso facto clauses unenforceable during insolvency proceedings.
The NCLAT rightly observed that the object of the Code is to boost economic growth and protect national wealth. Allowing enforcement of such clauses would subvert the purpose of a moratorium and threatens the existence of the corporate debtor as a going concern. Therefore, the interference with the freedom of contract by restricting the enforcement of an ipso facto clause is justified.
Amending the Code to Provide Clarity
The decision in light of Section 238 of the Code suggests that all ipso facto termination clauses are unenforceable during insolvency. However, there is no express provision in the Code that speaks about the unenforceability of all ipso facto clauses. While the Report of the Insolvency Law Committee recognised the unenforceability ipso facto clauses, it recommended legislative changes only with respect to termination of licenses, permits and quotas, concessions, registrations, and other grants issued by the government authorities. These recommendations were inserted by amending Section 14 vide the Insolvency and Bankruptcy Code (Amendment) Act 2020. The Code and the committee report are silent on the question of enforceability of ipso facto clauses in other executory contracts. To avoid ambiguity, the author suggests insertion of a new provision on the lines of § 365 of the US Bankruptcy Code to expressly render all ipso facto clauses unenforceable during the insolvency and liquidation process.
Further, if the legislature deems fit certain exceptions may be allowed to enforce ipso facto clauses. For instance, an ipso facto clause may be enforced during the insolvency process if the party faces significant financial hardship in continuing the contract with the corporate debtor. Similar exceptions have been recognised under Section 440 of Singapore’s Insolvency, Restructuring and Dissolution Act and Section 233B (1)(5) of UK’s Corporate Insolvency and Governance Act 2020. Such exceptions will help in balancing the objectives of the Code and the contractual stipulations agreed upon by the parties.
If a contract is allowed to be terminated merely on the ground of insolvency or liquidation, it will significantly affect the value of the corporate debtor and negate the object of the Code. To preserve the economic interest of the stakeholders, and to achieve the object of economic growth, the restriction on ipso facto clauses is justified. However, the judgment of the NCLAT is only in reference to PPAs, and the law pertaining to other executory contracts containing ipso facto clauses in unclear. Therefore, taking a cue from the legislations in the UK, Singapore, and Australia, the Code needs to be amended to restrict the enforceability of ipso facto termination clauses.