Conundrum of Going Concern and Ipso Facto Clause

Introduction

Very often in the contracts, we come across the provisions allowing one party (terminating party) to terminate the contract if the other party (corporate debtor) enters into some form of insolvency resolution process i.e. event of default, which relates to the filing of an application for commencement of insolvency against the corporate debtor, commencement of insolvency proceedings or liquidation proceedings (ipso facto clause). A glimpse of the triggering point of “ipso facto clause” is as under:

Filing of an application for insolvency resolution process or admission of such application or any demand notice from any financial creditor or operational creditor; and
In case of any proceeding filed under Insolvency and Bankruptcy Code, 20161 (I&B Code), the same is not discharged or dismissed within 7 days of the institution or presentation thereof.

At times, in addition to termination of a contract, the ipso facto clause also provides for enforcement of a security, suspension of further credit or cessation of supply of goods or services as well.

The raison d’être for the I&B Code is (i) reorganisation and insolvency resolution of corporate debtor “as a going concern”; (ii) maximisation of value of the assets; (iii) promote entrepreneurship; (iv) balancing interest of all stakeholders; and (v) to avoid multiplicity of statutes and fora. The I&B Code being the beneficial legislation has an inbuilt mechanism to achieve the aforesaid objectives.

While analysing the myriad questions surrounding “ipso facto clause”, the aforesaid objectives cannot be looked through a narrow prism to restrict the same only to corporate insolvency resolution process (CIRP), but would subsume the liquidation proceedings as well. Hence, the scrutiny being undertaken hereunder is deemed to cover not only CIRP but liquidation proceedings as well.

Though the Supreme Court of India in Gujarat Urja Vikas Nigam Ltd. v. Amit Gupta2., dealt with validity/invalidity of “ipso facto clause”, it chose not to elucidate exhaustively on its invalidity and extent thereof. The Supreme Court framed a list of questions3 (being the substantial question of law) which arose while considering the validity/invalidity of “ipso facto clause” and left the same unanswered.

Having regard to the aforesaid objectives, we endeavour to answer the myriad complex questions (being not exhaustive in nature) framed by the Court in the following manner:

Invalidity of ipso facto clause causing termination solely based on an “insolvency event” (filing of an application for commencement of CIRP, commencement of CIRP/liquidation et al.); and
Exceptions to the invalidity of ipso facto clause and safeguards to prevent the parties from circumventing the invalidation.

While pondering upon the invalidity/validity of ipso facto, it is pertinent to keep in mind the key observations made by the Supreme Court in Gujarat Urja4:

the going concern status of a corporate debtor would be negated by a termination of its sole contract, on the basis of an ipso facto clause;5
termination of the contract will have the consequence of cutting the legs out from under the CIRP;6 and
insolvency law cannot afford to be inward-looking7.

Invalidity of ipso facto clause

At the outset, we introduce the “doctrine of pro-corporate debtor as going concern bias” which sets out the contours of invalidity of the ipso facto clause. Such doctrine originates from the provisions of the I&B Code (more particularly Section 148) read with the objectives of the I&B Code as envisaged in the Preamble primarily being (i) maximisation of the value of the assets; (ii) keep the corporate debtor continues as a going concern9; and (iii) balance the interest of all the stakeholders.

One may argue that the “doctrine of pro-corporate debtor as going concern bias” may not be in position to resolve the tension between the rights of a corporate debtor during the CIRP (including liquidation) as against the contractual right of the terminating party and sanctity of the contract. Though at first blush, such argument appears to be attractive but deserve to be brushed aside.

In order to ensure that the I&B Code achieves the aforesaid objectives, the legislature in its wisdom incorporated various provisions which make serious inroad in the contractual freedom of the parties. Pertinently, the reference is drawn to de jure implementation of provisions such as Section 14 dealing with moratorium (though limited in nature and reason thereof being addressed) and binding nature of approved resolution plan. Such objectives have been further sought to be achieved by the Court with enunciation of doctrine of clean slate i.e. hydra head should not be popping out during implementation of the resolution plan to ensure that the corporate debtor as acquired by the resolution applicant continues as a going concern and the resolution applicant is not saddled with unforeseen claims and/or liabilities.

Section 14 prohibits termination or suspension of “essential goods or services” only during the moratorium period. Section 14(2-A) and Explanation to Section 14(1) was added by the legislature to ensure that the corporate debtor continues as a going concern and to prevent the corporate debtor from suffering hardship due to termination solely on ground of insolvency.

It is well settled that the legislative intent behind moratorium under Section 14 is to keep the corporate debtor’s assets together and ensure orderly completion of the process of resolution for the maximisation of the value of all stakeholders, till the time creditors take a view on the resolution of default. Moreover, this is to provide a breathing space to the corporate debtor, preparation time to shed unprofitable activities and onerous contracts wherever required.10

Though Section 14 provides for moratorium, it is restricted only during CIRP period. The catch here is that the ipso facto clause is rendered invalid only “till the moratorium period” and does not cover liquidation. The concept of keeping the corporate debtor as a going concern applies even at the stage of liquidation. Secondly, such moratorium protects only those contracts in which the corporate debtor receives essential goods or services and does not extend to cover those key contracts11 wherein the corporate debtor supplies goods and/or renders services. Thus, the object of the I&B Code is not being preserved in its essence and spirit.

We cannot remain oblivious to the fact that in order to ensure that the corporate debtor does not commit default in relation to essential goods and services as presently envisaged under Section 14 being non-payment of dues, it is a sine qua non that the corporate debtor must have the liberty and in fact, the right to be more precisely put, to generate revenue by providing goods and services under the key contracts. This is exactly the point at which the “doctrine of pro-corporate debtor as a going concern bias” comes into picture to protect such right of the corporate debtor. Needless to say that non-protection of such right has the tendency to render Section 14 as inherently contradictory, making the provision as futile and nugatory.

In relation to the Explanation to Section 14(1), the Insolvency Law Committee Report of 2020 noted that12:

termination of grants/government contract on account of ipso facto clause is in contravention of the purpose underlying the moratorium; and
corporate debtor’s business would lose value and would not be able to possibly resolve corporate debtor as a going concern.

There is no reason to presume that termination/suspension of the non-government contract would not cause loss to the value of corporate debtor and resultantly, ensure that it does not continue as a going concern. In addition, such termination would also obliterate the enterprise value of the corporate debtor. Ipso facto clause is antithesis to the primary focus of the I&B Code i.e. revival and continuation by preserving the assets of the corporate debtor and its resolution as a going concern during CIRP/liquidation. The validation of the ipso facto clause deprives the corporate debtor of the contingent interest arising out of or incidental to the property.

We cannot lose sight of the fact that termination owing to ipso facto clause hinders restructuring plan/liquidation and further causes insurmountable hurdles for the corporate debtor in meeting its obligations. Such termination would create a hurdle in the successful recovery of the corporate debtor since it significantly diminishes the chances of successful recovery and undermine the resolution process and even the liquidation.13

“Doctrine of pro-corporate debtor as a going concern bias” is in line with the law of various jurisdictions such as United States,14 France, Germany,15 Canada,16 Australia and Singapore, which invalidates the ipso facto clause that terminate the contract solely on ground of filing of insolvency proceeding or commencement thereof. However, termination rights referring to breach of the contract remain valid due to event of default. The same approach has been adopted by the EU Directives.17We outline a mechanism under “Exception and Safeguards” to ensure that the terminating party does not adopt camouflaged approach for terminating the contract.

We find it pertinent to mention two judgments – Belmont Park Investments Pty Ltd. v. BNY Corporate Trustee Services Ltd.18 by the UK Supreme Court (UKSC) and Chandos Construction Ltd. v. Deloitte Restructuring Inc.,19 by the Supreme Court of Canada (SCC), both dealing with validity/invalidity of the ipso facto clause.

The UKSC upheld the ipso facto clause on the ground that the complex commercial contracts/transaction entered in good faith between the parties which contained ipso facto clause would not violate the anti-deprivation rule which nullifies intentional or inevitable evasion of the debtor’s property.

Belmont Park20 was pronounced by the UKSC prior to the 2020 Amendment whereby the UK Insolvency Act, 1986 was amended by the Corporate Insolvency and Governance Act, 2020 to introduce Section 233-B of the UK Insolvency Act, 1986 which invalidates ipso facto clauses. However, the amendment covers only contracts where the corporate debtor is being supplied goods and services to and not vice versa, which is similar to Section 14(2) of the I&B Code.

With great humility, we state that the UKSC failed to appreciate that ipso facto clause is aimed at debtors and the anti-deprivation rule, by contrast, protects creditors.21 The SCC in Chandos22 correctly relied on the “effects-based test” to explain the anti-deprivation rule and held that any clause which had the “effect” of removing a debtor’s estate would be invalid as against the anti-deprivation rule.

In other words, if the termination of contract by virtue of ipso facto clause results into loss of enterprise value of the corporate debtor, which adversely affects its status as a going concern, the same shall be invalid.

Logical sequitur of the aforesaid is that validation of ipso facto clause in relation to non-government contract i.e. a contract between two private entities, would ensure that the corporate debtor does not continue as a going concern, which would in turn render the aforesaid objective of the I&B Code as a nullity.

Exceptions and safeguards

Having concluded that ipso facto clause would be invalid, while we further examine the extent of such invalidation i.e. whether the invalidation is conditional or absolute, we are of view that in order to achieve the objective of the I&B Code, the ipso facto clause, irrespective of the date on which the same was incorporated in the contract ought to be treated invalid with retrospective effect and such invalidity shall not depend upon introduction of amendment (which would be nothing more than a clarificatory amendment).

The United Nations Commissions on International Trade Law (UNCITRAL) Guide23 which indicates that national insolvency law overrides such ipso facto clauses, with limited exceptions, since the performance of contract is crucial for CIRP.24 The UNCITRAL Guide was created with the intent that it would be used as a reference for enacting laws and regulations or reviewing the adequacy of existing laws and regulations.

The EU Directive states that mere reference to the negotiations on a restructuring plan or stay or any similar event connected to stay should not be a sufficient ground to terminate an essential contract.25 Further, the World Bank26 suggests a balanced approach which is to override ipso facto clause but subject to special exceptions.

The J.J. Irani Expert Committee Report on Company Law in 200527 also recommended on similar lines of the World Bank and UNCITRAL Guidelines. It stated that it is imperative to enhance the value of the assets while keeping the curve of liabilities flat. The Committee also recommended to put a conditional stay on the operation of ipso facto clause from the date of admission of the insolvency application. It also explained that putting an absolute stay would harm the contractual freedom of the supplier by compelling him to perform the obligations contrary to his commercial interests.

The aforesaid recommendation was never incorporated expressly by the legislature while enacting the I&B Code. Some countries like Austria, Canada while invalidating ipso facto clause, carve an exception of “hardship being caused to terminating party”. Such hardship is determined by the court.

An absolute invalidation of ipso facto clause would put the terminating party into the insolvency events. Therefore, the ipso facto clause which provides for termination solely on the ground of insolvency events shall be invalid, whereas if the clause provides for termination on the ground other than insolvency events shall be valid. We cannot shut our eyes to mischief played by the terminating party while terminating the contract on the ground other than insolvency events, hence, interim resolution professional (IRP)/ resolution professional (RP), as the case may be, should with the consent of committee of creditor or liquidator in consultation with Stakeholder Committee, decide which contracts fall within the contours of the key contracts and which do not. Accordingly, it shall ensure that such key contracts are performed to keep the corporate debtor as a going concern and for protection of all the stakeholders.

In case of any dispute or terminating party being aggrieved by aforesaid decision or in case being aggrieved by camouflaged termination, the IRP/RP/liquidator, should approach adjudicating authority under Section 60(5) of the I&B Code28 since the adjudicating authority is conferred with power to dispose of “any question of priorities or any question of law or facts arising out of or in relation to the insolvency resolution or liquidation proceedings of the corporate debtor under the Code”.

Recently, the Supreme Court in Tata Consultancy Services Ltd. v. Vishal Ghisulal Jain29 dealing with the order passed by adjudicating authority under Section 60(5) of the I&B Code as affirmed by the National Company Law Appellate Tribunal injuncting termination of contract, held that even if the contractual dispute arises in relation to the insolvency, a party can be restrained from terminating the contract only if it is central to the success of the CIRP. Crucially, the termination of the contract should result in the corporate death of the corporate debtor. The Court cautioned that the NCLT does not have any residuary jurisdiction to entertain the present contractual dispute which has arisen dehors the insolvency of the corporate debtor.

Though the Supreme Court has clarified the position of law, however, it appears to have missed that the jurisdiction under Section 60(5) ought not to be looked through such a microscopic prism that the application can be entertained only if threshold of corporate death is satisfied. This approach is not only contrary to the aforesaid objectives of the I&B Code but also obliterates the legislative underlying the essence of “going concern” in relation to CIRP as well as liquidation and “maximisation of asset”. It would otherwise further lead to multiplicity of proceedings before various fora. Therefore, every attempt ought to be made to thwart the prospect of stakeholders engaging in multiple litigations, resulting into unwarranted undue delay. Delays are also a cause of concern because the liquidation value depletes rapidly, irrespective of the imposition of a moratorium, and a delayed liquidation is harmful to the value of the corporate debtor, the recovery rate of the Committee of Creditors and consequentially, the economy at large.30

While deciding the application, the adjudicating authority may refer to the following non-exhaustive grounds to prima facie determine the validity of the ipso facto clause—

Nature of the contract;
Necessity to protect the corporate debtor as a going concern and the counter party;
Any compelling, commercial, social or public interest to protect the rights of the counter party; and
Such other allied relevant factors which it deems fit and reasonable.

In order to implement the aforesaid, the I&B Code would require a clarificatory amendment, which should be worded in such a manner that it does not affect the terminating rights due to non-performance or non-payment or any such other similar rights.

Conclusion

As per the Doing Business Report 202031, countries such as Singapore, United States, Australia, Germany which invalidate ipso facto clause conditionally or completely fall within top 25 ranking in ease of doing business rankings. Whereas, India stands at 63rd ranking, these rankings are arrived at by taking into account inter alia the extent of the enforcement of contracts and insolvency resolution in a particular country.

Though India has made significant progress in insolvency resolution bracket, it is still far behind in the contract performance bracket. Furthermore, insolvency resolution dehors the contract performance would not be in position to sustain the aforesaid year 2020 ranking. Therefore, invalidation of ipso facto clause guaranteeing performance of the contract is a sine qua non to ensure ease of doing business in India.

The basis for invalidating ipso facto clause is not only to keep the key contracts alive and protect the interests of the stakeholders by keeping the company as a going concern but also to make our mark globally and to increase our ease of doing business rankings. Hence, our laws cannot afford to be inward-looking, which necessitates the clarificatory amendment to I&B Code and the same may be worded in the following manner:

Statement of Object and Reasons:

It is noticed that the contract generally confers an unconditional right on the party other than the corporate debtor to terminate, accelerate or modify the contract to the detriment of the corporate debtor solely on the ground of filing of an application for commencement of CIRP, commencement of CIRP/liquidation et al. The same has tendency to hinder status of corporate debtor as a going concern and eventually, the corporate insolvency resolution process or liquidation process of the corporate debtor would not be successful as envisaged by the Insolvency and Bankruptcy Code, 2016.
Though Section 14 of the I&B Code provides for limited moratorium to protect the corporate debtor for achieving the objective of the I&B Code, it is felt that the legislature needs to clarify that the said provision read with the objective of the I&B Code invalidate the clauses which terminate or accelerate or impose any other penalty leading to termination of the contract.
It is the duty of IRP/RP to preserve the corporate debtor as a going concern and similar duty is casted upon Liquidator (to ensure that liquidation as a going concern be achieved). The IRP/RP or Liquidator, as the case may be, is required to take immediate custody and control of all the assets of the corporate debtor, including the business records.
Interim resolution professional or resolution professional or Liquidator or terminating party, as the case may, would be in position to approach the adjudicating authority through an application under Section 60(5) of the I&B Code for adjudication, establishing that continuation of the contract is or is not essential for successful corporate insolvency resolution process and/or the liquidation, as the case may be, of the corporate debtor.
The Bill seeks to achieve the aforesaid objectives.

Amendment Provision

Notwithstanding anything contained in an agreement or contract executed between the parties, party other than corporate debtor shall have no right to terminate or suspend or accelerate or modify to the detriment of the corporate debtor any right or obligation arising out of such agreement, solely by reason of:

filing of an application under the I&B Code against the corporate debtor before the adjudicating authority; or
commencement of corporate insolvency proceedings or liquidation against corporate debtor:

Provided that interim resolution professional or resolution professional, as the case may be, with the consent of the Committee of Creditor or Liquidator in consultation with Stakeholders Committee, as the case may be, shall decide the key contracts which are essential to keep the corporate debtor as a going concern and shall ensure performance of such contract:

Provided further that the party other than corporate debtor or interim resolution professional or resolution professional or Liquidator, as the case may be, shall approach the adjudicating authority under Section 60(5) for adjudication of any dispute in relation to ipso facto clause. The adjudicating authority shall decide whether the continuation of the contract is essential for successful corporate insolvency resolution process and/or the liquidation, as the case may be, of the corporate debtor, after taking into account the following factors:

Nature of the contract;
Necessity to protect the corporate debtor as a going concern and the counter party;
Any compelling, commercial, social or public interest to protect the rights of the counter party; and
Such other allied relevant factors which it deems fit and reasonable.

*(2016-2021) National Law University, Odisha. Currently working as in-house counsel at an Indian Conglomerate. Author can be reached at nishita23agrawal2@gmail.com.

**(2009-2014) National Law University, Odisha. Currently working as in-house counsel at an Indian Conglomerate. Author can be reached at anuragnluo@gmail.com.

1 Insolvency and Bankruptcy Code, 2016.

2 (2021) 7 SCC 209.

3 Gujarat Urja Vikas Nigam Ltd. v. Amit Gupta, (2021) 7 SCC 209, 300-301, para 146.

4 (2021) 7 SCC 209.

5 Gujarat Urja Vikas Nigam Ltd. v. Amit Gupta, (2021) 7 SCC 209, 305-306, para 163.

6 Gujarat Urja Vikas Nigam Ltd. v. Amit Gupta, (2021) 7 SCC 209, 304, para 158.

7 Gujarat Urja Vikas Nigam Ltd. v. Amit Gupta, (2021) 7 SCC 209, 273-274, para 92.

8 Insolvency and Bankruptcy Code, 2016, S. 14.

9Going concern refers to a situation where the corporate debtor would be functional as it would have been prior to the initiation of the CIRP, other than the restrictions put by the Code. However, going concern in case of liquidation sale implies only transfer of assets and not liabilities. The liabilities of the corporate debtor are settled as per the waterfall mechanism under S. 53 of the I&B Code and thus, assets are transferred without any encumbrance or charge to the purchaser. [Gaurav Jain v. Sanjay Gupta, IA No. 2264 of 2020 in CP (IB) No. 1239/MB/2018, order dated 9-3-2021 (NCLT Mumbai)].

10 P. Mohanraj v. Shah Bros. ISPAT (P) Ltd., (2021) 6 SCC 258.

11EU Directive 2019/1023 of the European Parliament and of the Council of 20-6-2019, Art. 7–The key contracts are those contracts which are necessary for the continuation of the day-to-day operations of the business like relating to supply, the suspension of which would lead to the corporate debtor’s activities coming to a standstill.

12Report of Insolvency Law Committee dated 20-2-2020, available at <http://www.mca.gov.in/Ministry/pdf/ICLReport_05032020.pdf>, accessed 21-11-2021.

13EU Directive 2019/1023 of the European Parliament and of the Council of 20-6-2019 on Preventive Restructuring Framework, on Discharge of Debt and Disqualifications and, on Measures to Increase the Efficiency of Procedure Concerning Restructuring, Insolvency and Discharge ofDebt, and amending Directive (EU) 2017/1132 (Directive on Restructuring and Insolvency).

14United States Bankruptcy Code, 1979, S. 365(e).

1515-11-2012, the 9^th Senate of the Federal Supreme Court of Germany.

16Ss. 65.1, 66.34 and 84.2 of the Bankruptcy & Insolvency Act, and Companies’ Creditors Arrangement Act.

17EU Directive 2019/1023 of the European Parliament and of the Council of 20-6-2019 on Preventive Restructuring Framework, on Discharge of Debt and Disqualifications and, on Measures to Increase the Efficiency of Procedure Concerning Restructuring, Insolvency and Discharge of Debt, and amending Directive (EU) 2017/1132 (Directive on Restructuring and Insolvency).

18 (2012) 1 AC 383 : (2011) 3 WLR 521.

19 2020 SCC 25 (Canada SC).

20 (2012) 1 AC 383 : (2011) 3 WLR 521.

21 2020 SCC 25, para 118 (Canada SC).

22 2020 SCC 25 (Canada SC).

23UNCITRAL, Legislative Guide on Insolvency Law, available at <https://uncitral.un.org/sites/uncitral.un.org/files/media-documents/uncitral/en/05-80722_ebook.pdf>, accessed on 21-11-2021.

24 Gujarat Urja¸ (2021) 7 SCC 209,275-276, para 94.

25EU Directive 2019/1023 of the European Parliament and of the Council of 20-6-2019.

26World Bank, Principles for Effective Insolvency and Creditor/Debtor Regimes, 2016, available at <http://pubdocs.worldbank.org/en/919511468425523509/ICR-Principles-Insolvency-Creditor-Debtor-Regimes-2016.pdf>, accessed on 21-11-2021.

27J.J. Irani Expert Committee of Company Law Report, 2005 available at <https://ibbi.gov.in/uploads/resources/May%202005,%20J.%20J.%20Irani%20Report%20of%20the%20Expert%20Committee%20on%20Company%20Law.pdf>, accessed on21-11-2021.

28 Insolvency and Bankruptcy Code, 2016, S. 60(5).

29 2021 SCC OnLine SC 1113.