Supreme Court: Need Law to Clarify Validity of 'Ipso Facto' Contractual Clauses in relation to Insolvency

Supreme Court: Need Law to Clarify Validity of 'Ipso Facto' Contractual Clauses in relation to Insolvency

The Supreme Court (SC) on 8 March 2021, in the case titled Gujarat Urja Vikas Nigam Limited (Appellant) v. Amit Gupta (Respondents) has observed that there is a lack of a legislative voice on the issue of validity/invalidity of ipso facto clauses relating to insolvency will lead to confusion and reduced commercial clarity.

The SC bench consisting of Justices DY Chandrachud and MR Shah upheld the order of the National Company Law Tribunal (NCLT) and noted that clarification is needed through law regarding the validity of ipso facto clauses (contractual provisions which allow a party (terminating party) to terminate the contract with its counterparty (debtor) due to the occurrence of an 'event of default'.

The factual background of the case is that the Power Purchase Agreement (PPA) was signed on 30 April 2010 as per the PPA, the appellant has to purchase all the power generated by the Corporate Debtor.

The NCLT admitted a petition filed by the Corporate Debtor (Respondent) under Section 10 of the Insolvency and Bankruptcy Code (Code) and commenced the Corporate Insolvency Resolution Process (CIRP).

In May 2019, the appellant had issued termination notices to the respondent mentioning that as per Article 9.2.1(e) of the PPA, the Corporate Debtor undergoing the CIRP under the Code amounts to an 'event of default'. As per Article 9.2.1(a) of the PPA, there was a default in the operation and maintenance of the Plant.

The appellant rejected the reply sent by the respondent to it and stated that they will terminate the PPA under Articles 9.2.1(e) and 9.3.1 since the Corporate Debtor is under CIRP.

The corporate debtor moved to the NCLT for seeking an injunction restraining the appellant from terminating the PPA. The NCLT issued its final order restraining the appellant from terminating the PPA and setting aside the First Notice.

The SC bench made the following observations while referring to laws followed in international and multilateral organizations-

(i) "Many jurisdictions follow the US model of legislatively invalidating ipso facto clauses. Interestingly, this shift has been far more prominent in the last decade even though the US Bankruptcy Code has had this position since 1979;

(ii) Some of the recent jurisdictions to follow the US model, such as Australia and Singapore, invalidate ipso facto clauses prospectively, i.e., ipso facto clauses contained in the contracts entered into before the laws came into effect will not be invalidated;

(iii) The UK, through the CIGA, only invalidates ipso facto clauses in supplier contracts, which is similar to the effect of Section 14(2) of the Code.

(iv) Greece is one of the few countries which legislatively upholds ipso facto clauses;

(v) The position of law in the Republic of Korea is unclear due to contradictory judicial decisions, which has prompted demands for legislative clarity. This highlights the growing commercial importance of legislative clarity in this area;

(vi) Generally, even where ipso facto clauses are invalidated, it does not affect the termination rights of the terminating party based on other events of default in the contract;

(vii) Some nations which invalidate ipso facto clauses, such as Austria, Canada, Singapore, and UK (limited to supplier contracts), provide for an exception based on hardship being caused to the terminating party. This hardship is to be determined by the courts; and

(viii) Even in nations which legislatively invalidate ipso facto clauses, there are often contrasting judicial decisions in relation to the scope of their invalidation."

The Top Court while dealing with the instant matter also noted that in India ipso facto clauses are invalid in-

- Government licenses, permits, registrations, quotas, concessions, clearances or a similar grant or right given by the Central Government, State Government, local authority, sectoral regulator, or any other authority constituted under any other law for the time being in force, in accordance with the Explanation to Section 14(1);

- Contracts where the counter-party supplies essential/critical goods and services to the Corporate Debtor, within the meaning of Sections 14(2) and 14(2A).

The bench added that there exists no clear position regarding the validity of ipso facto clauses in other contracts, from the bare text of the Code.

The Top Court further added that many complex questions will arise while dealing with the issue of the validity or invalidity of ipso facto clauses. It stated that the following questions may arise in this regard-

1. "The extent of invalidation of ipso facto clauses, i.e., termination solely based on an insolvency event' (filing of an application for commencement of CIRP, the commencement of CIRP, the appointment of RP, et al) within the Code will be invalid;

2. Whether the invalidation is absolute or conditional during the insolvency process?

3. What kinds of contracts should be exempt from this invalidation?

4. What should be the nature of the exceptions to the invalidation of ipso facto clauses to preserve the interests of the terminating party?

5. Whether the invalidation should happen prospectively or retrospectively?

6. What safeguard will be required to ensure that parties do not circumvent the invalidation?"

The Apex Court stated that it is not dealing with the issue of the validity or invalidity of ipso facto clauses exhaustively in the instant case. It added, "Rather, what we can do is an appeal in earnest to the legislature to provide concrete guidance on this issue since the lack of a legislative voice on the issue will lead to confusion and reduced commercial clarity."

The SC clarified that "The Court is at its heart, an institution which responds to concrete cases brought before it. It is not within its province to engraft into law its views as to what constitutes good policy. This is a matter falling within the Legislature's remit."

It added that "Equally when presented with a novel question on which the legislature has not yet made up its mind, we do not think this Court can sit with folded hands and simply pass the buck onto the Legislature. In such an event, the Court can adopt an interpretation a workable formula that furthers the broad goals of the concerned legislation, while leaving it up to the legislature to formulate a comprehensive and well-considered solution to the underlying problem."

The Top Court further stated that "To aid the legislature in this exercise, this Court can put forth its best thinking as to the relevant considerations at play, the position of law obtaining in other relevant jurisdictions and the possible pitfalls that may have to be avoided. It is through the instrumentality of an inter-institutional dialogue that the doctrine of separation of powers can be operationalized in a nuanced fashion. It is in this way that the Court can tread the middle path between abdication and usurpation."