Validity Of Ipso Facto Clauses In Employment Contracts

This 2^nd article in our 2-part series on 'Employment Contracts vis-à-vis CIRP' examines the validity of ipso facto clauses which permit employees to terminate their employment on the occurrence of an insolvency event; and acknowledges the duelling priorities of upholding contractual freedom and ensuring that the debtor remains a 'going concern'.

In Gujarat Urja Vikas Nigam v Amit Gupta,¹ the Supreme Court of India defined ipso facto clauses as "...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". In the context of insolvency law, in some of these ipso facto clauses, the "event of default" includes applying for insolvency, commencement of insolvency proceedings, appointment of insolvency representative, et al..."

Parties often retain the right to unconditionally terminate contracts – through ipso facto clauses – if a counterparty faces insolvency issues so as to mitigate against situations where an insolvency event impacts the counterparty's ability to perform its obligations. In India, ipso facto clauses are also often included in licences granted by sectoral regulators, and regulators may, therefore, terminate the licences on the occurrence of an insolvency event.

While ipso facto clauses are increasingly common, enforceability of these stipulations is a matter of interest especially in the context of insolvency.

Indian Jurisprudence

Although ipso facto clauses are founded on the principle of contractual autonomy, Section 14(2A) of the Insolvency and Bankruptcy Code, 2016 (IBC) and the decision in Gujarat Urja have curtailed this autonomy by restricting the operation of such clauses in contracts for the supply of critical goods or services to a corporate debtor as they are at odds with the objective of the IBC – i.e. the survival, and successful resolution, of corporate debtors.

To the extent that Indian legislation has expressly permitted the termination, or suspension, of contracts on the ground of insolvency, the right to terminate, or seek suspension, has vested with the party undergoing insolvency. Illustratively: (i) under the erstwhile Companies Act, 1956 (1956 Act), a liquidator could, with permission from the tribunal, disclaim certain contracts, including unprofitable contracts, to which the company being wound up was a party, thereby releasing it from the attendant rights and liabilities;² and (ii) under the Sick Industrial Companies (Special Provisions) Act, 1985 – which preceded, and was repealed by, the IBC – the Board for Industrial and Financial Reconstruction could suspend the operation of contracts³ to which the sick industrial company was a party for a defined period.⁴

In 2005, the Report of the J.J. Irani Expert Committee on Company Law (2005) (Expert Committee) recommended that unless there was a compelling commercial, public or social interest,⁵ on the commencement of insolvency, the enforcement of unperformed contracts which would otherwise automatically terminate upon insolvency should be stayed as "...such interference / overriding powers would assist in achieving the objectives of the insolvency process...".⁶

Thereafter, in 2018, the Vidhi Centre for Legal Policy recommended that there be a conditional stay on the operation of ipso facto clauses from the insolvency commencement date, as "...a complete stay on the operation of ipso facto clauses would constitute a serious restraint on the freedom of contract and would effectively compel suppliers to perform contracts even when such an action is against their commercial interests...".⁷

The IBC has only suspended the termination of the following during the moratorium period: (i) contracts for the supply of essential goods or services,⁸ and, or, critical supplies; and (ii) licences, registrations and grants from regulators provided current dues are being paid.

Judicial Precedent

In 2021, the Supreme Court⁹ acknowledged that there is no settled position regarding the validity of ipso facto clauses. Given that the Legislature had not addressed the validity of ipso facto clauses, the Supreme Court observed that an argument could be made that, generally, ipso facto clauses forming part of a valid contract were enforceable. The only exception to this was where the IBC invalidated ipso facto clauses to prevent the: (i) disruption of supplies of essential or critical goods and services provided the corporate debtor pays all current dues; and (ii) suspension or termination of government licences, grants, etc., provided there is no default in payment of current dues.

The Court appealed to the Legislature to provide concreate guidance on the issue to provide commercial clarity. Specifically, the Court felt there was a need to determine:

1. The extent to which the IBC would invalidate ipso facto clauses;
2. Whether the invalidation of ipso facto clauses during the corporate insolvency resolution process (CIRP) is absolute or conditional;
3. Whether certain types of contracts should be exempt from this invalidation;
4. 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 be prospective or retrospective;
6. The safeguards required to ensure that parties do not circumvent the invalidation.

International Jurisprudence

The 2004 United Nations Commission on International Trade Law Guide on Insolvency Law acknowledges the inherent tension between upholding contractual freedom and fulfilling the objective of insolvency law, and recommends that insolvency regimes invalidate ipso facto clauses. In fact, it goes a step further and recommends empowering insolvency representatives to reinstate contracts where creditors have pre-emptively terminated contracts on some other ground before the commencement of insolvency proceedings.

In Gujarat Urja, the Supreme Court has analysed international jurisprudence on ipso facto clauses at some length. The United States of America has invalidated ipso facto clauses in executory contracts and unexpired leases.¹⁰ However, ipso facto clauses are permitted in contracts for loans and other debt financing or financial accommodations to, or for the benefit of, the debtor, or to issue a security of the debtor.

Other developed nations such as France,¹¹ Austria,¹² Singapore,¹³ Australia¹⁴ and Canada¹⁵ have broadly incorporated similar provisions invalidating ipso facto clauses. However, the position in the Republic of Korea¹⁶ is unclear on account of conflicting judicial decisions, and Greece¹⁷ has by and large upheld the validity of ipso facto clauses.

The position in the United Kingdom, where insolvency is governed by both statute and common law doctrine, is more nuanced. The common law rule of 'anti-deprivation' invalidates any contractual provision which has the effect of depriving the insolvent's estate of any right, property, or benefit, by the very fact (hence, ipso facto) of the entity becoming insolvent. Section 233B¹⁸ of the Insolvency Act 1986 partially invalidates ipso facto clauses where a supplier can cease to supply goods¹⁹ to a party in insolvency (but not vice-versa) unless the continuation of the contract would cause hardship to the supplier.²⁰

Ipso Facto Clauses in Indian Employment Contracts

While, in India, employment contracts of mid and lower-level employees do not often include ipso facto clauses, the possibility of such clauses being included in the employment contracts of senior management and executives cannot be ruled out – especially where the employer is on the verge of insolvency. In fact, insolvency events may trigger 'golden parachute' clauses in the employment contracts of senior executives;²¹ however, corporate debtors may want to enforce employment contracts of such key personnel during the moratorium in order to ensure that it functions as a going concern. In certain cases, companies undergoing CIRP have only chosen to retain a small number of senior management and executives,²² an effort which could fail if their employment contracts include ipso facto clauses.

In any event, an employment contract is a personal contract and cannot be specifically enforced against the will of the employee per Section 14 of the Specific Relief Act, 1963. In our opinion, this principle would extend to employment contracts with employers who have been admitted into insolvency, and therefore, while a RP or liquidator may challenge any payment to an employee (not being wages or statutory dues) during the moratorium period; they should be incapable of compelling an employee to continue to provide services to the corporate debtor.

The uncertainty surrounding the operation of ipso facto clauses is likely to continue in the absence of legislative intervention. To that end, the Legislature may consider:

1. mandating a conditional stay on contracts for the supply of essential and, or, critical goods and services, rather than a complete stay, on the operation of ipso facto clauses during CIRP. This stay should operate so long as the committee of creditors approves the payment of current dues on an ongoing basis or as part of CIRP costs in the resolution plan;²³
2. adding an exception to Section 14(2A) of the IBC which would permit a supplier of critical services to terminate their services, with the leave of the Tribunal, where the supplier would suffer undue hardship if the contract were to continue irrespective of whether the corporate debtor is paying current dues; and, or,
3. clarifying whether the provisions of Section 14(2A) of the IBC apply to contracts of personal service.

Originally published on 23 January 2024

Footnotes

1. (2021) 7 SCC 209

2. Section 333 of the Companies Act, 2013 and Regulation 10 of the Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016 confer similar powers.

3. Or rights or liabilities arising from them.

4. Under the Sick Industrial Companies (Special Provisions) Act, 1985, a declaration suspending the operation of contracts or the rights and liabilities arising out of them could be made for up to 2 years initially, and 1 year at a time, provided that the total suspension period did not exceed 7 years. This "...merely kept [the contracts] in abeyance so as toenable the [Board for Industrial and Financial Reconstruction] to pass an appropriate order, inter alia, for revival of a sick company for the purpose of giving effect to the purport and object for whichthe laws relating to corporate insolvency have been enacted...",[4] and, therefore, was not akin to an ipso facto clause.

5. Report of the J.J. Irani Expert Committee on Company Law (2005), para 13.5 6 on page 97.

6. ibid. on page 97.

7. Vidhi Centre for Legal Policy, "Insolvency and Bankruptcy Code - The journey so far and the road ahead", December 2018, on page 34.

8. i.e. electricity, water, telecommunication and information technology services.

9. In Gujarat Urja.

10. Section 365(e) US Bankruptcy Code, 1979.

11. Article L622-13 of the Commercial Code, 2014.

12. Section 25b (2) of the Austrian Insolvency Code.

13. Section 440 of the Insolvency, Restructuring and Dissolution Act, 2018.

14. Section 415D of the Corporations Act, 2001.

15. Section 65.1 of the Bankruptcy & Insolvency Act, 1985.

16. Article 119(1) of the Debtor Rehabilitation and Bankruptcy Act of Korea, 2017.

17. Article 32 of the Bankruptcy Code, 2020.

18. Introduced by the UK Insolvency and Governance Act, 2020 w.e.f. 26 June 2020.

19. Irrespective of whether such goods are critical or essential to the survival of the insolvent debtor.

20. Prior to the insertion of Section 233B of the Insolvency Act 1986, the UK Supreme Court had held that ipso facto clauses in commercial contracts did not violate the anti-deprivation rule. See Belmont Park Investments PTY Ltd. V BNY Corporate Trustee Services Ltd., (2011) UKSC 38.

21. We have not commented on whether or not a golden parachute is an avoidable contract in terms of Sections 43-51 of the IBC.

22. In Jet Aircraft Maintenance Engineers Welfare Association v. Ashish Chhawchharia, 2022 SCC OnLine NCLAT 418, the RP decided to retain only 50 employees to form part of the Asset Protection Team, who were given the option to resign and seek re-employment by the corporate debtor on fresh employment terms.

23. Supra note 8.

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