Lawyers. Latin. Legalese. The world seems to be veering away from jargon in contract drafting and general parlance, but we would like to make a humble exception in today’s Bridge Legal piece (a shoutout to one of our followers for requesting this analysis is in order). Ipso Facto – a phrase that simply means, ‘by that very fact’, finds itself to be the focus of India’s Supreme Court in yet another interesting decision that has wide implications for contracts countrywide.    

Contracts 101 or Why Is This Relevant?

Chances are that you have had the (potentially horrendous) opportunity to review a contract that impacts your business (if you are a lawyer, Business’ business is your business (this is our last alliteration, we promise), so it’s safe to say that contracts for review eventually translate into your own business). Like any other relationship, one cannot be too wise when it comes to understanding when termination of an arrangement is possible and more importantly, when it isn’t – typically nested under a nasty heading titled ‘Termination’, we cannot stress enough how important such clauses and the words in them are to every contractual business arrangement.

The ‘term’, or tenure (or tenor, if you’re into Finance) of a contract is closely linked to termination rights in the sense that an exercise of termination results in a contractual arrangement coming to an end prematurely, i.e., prior to the term completing. Some contracts list out situations in which either party may terminate a contract and others list out specific conditions under which a particular party can terminate the contract in question.

The ‘term’, or tenure (or tenor, if you’re into Finance) of a contract is closely linked to termination rights in the sense that an exercise of termination results in a contractual arrangement coming to an end prematurely, i.e., prior to the term completing.

Sure, but What Does This Have to Do With ‘Ipso Facto’?

Ipso Facto clauses are very relevant to termination clauses in contracts since certain acts and facts, simply by virtue of occurring, can lead to one (or more) party(ies) having the right to terminate the contract in question. Our case today deals with a specific type of ipso facto clause, namely that linked to an insolvency or bankruptcy event.

Contracts typically state that a party may terminate a contract if the other party (termed as the ‘counterparty’) becomes insolvent or subject to a ‘bankruptcy event’.  In India, the law and procedure governing bankruptcy is contained in the Indian Bankruptcy Code of 2016, a legislation that completely contains Indian law pertaining to bankruptcy and insolvency. Bankruptcy events that can lead to the termination of a contract almost always link to the initiation of, in India, what is known as a ‘Corporate Insolvency Resolution Process’ – the process of an insolvency tribunal admitting and considering a case of insolvency under the Insolvency and Bankruptcy Code of 2016.

Simply put, the principle is that if you enter into a contract and the counterparty is obligated to pay you for your products and / or services, the fact that the counterparty becomes subject to an insolvency process should be reason enough for you to terminate the contract since you may or may not get paid (the counterparty no longer has the capacity to pay you) for keeping up your end of the contractual bargain. The converse applies as well, being subject to an insolvency event yourself could also, ipso facto, lead to the termination of your contract with a counterparty since it would be aware that your capacity to pay would be in question.

Ipso Facto clauses are very relevant to termination clauses in contracts since certain acts and facts, simply by virtue of occurring, can lead to one (or more) party(ies) having the right to terminate the contract in question.

Seems Fair Enough – Why Did India’s Highest Court Need to Step In?

Ipso Facto clauses when linked to insolvency / bankruptcy are problematic, to say the least. Businesses stay alive when profitable and being profitable involves being able to enter into contractual arrangements – on the other hand, the primary objective of any insolvency legislation or process is to get a company (we don’t cover individuals in our bankruptcy laws yet) back on its feet. It’s a lot like going to a doctor when you are sick, but also losing your employment and pay by virtue of being sick in the first place; you have no money to pay the doctor and get better because you can’t earn money since you’re sick.

A lot of countries, including the United States and the United Kingdom understand this conundrum and have laws in place to deal with this problem of contracts being terminatable by virtue of (or ipso facto) the counterparty going insolvent, but India has no such laws in place yet. While the Supreme Court of India represents the highest echelon of the judicial system in the country, it cannot implement or change laws – that power rests with the Legislature.

It’s a lot like going to a doctor when you are sick, but also losing your employment and pay by virtue of being sick in the first place; you have no money to pay the doctor and get better because you can’t earn money since you’re sick.

So What Did the Supreme Court Do, Exactly?

Here’s the good part – the Supreme Court merely upheld and protected what the appellate tribunal under the Insolvency and Bankruptcy Code of 2016 (let’s call this the IBC) held in the first place (called the National Company Law Appellate Tribunal or ‘NCLAT’, it judges cases that are appealed from the National Company Law Tribunal or ‘NCLT’, the tribunal immediately subordinate to it), while fine tuning it. The NCLT and NCLAT derive their power from the IBC, which in turn is a product of the Legislature.

The NCLAT in this particular case prevented the termination of a contract vital to the business of a particular company merely because one of the parties to the contract became subject to insolvency proceedings; the rationale of the NCLAT goes back to our doctor analogy (the NCLAT is the doctor, by the way) – how could it allow the termination of a contract vital to the business of the sick company when terminating it would lead to certain death? The IBC most certainly tries to prevent such corporate death (termed liquidation) and the objective of setting up NCLTs and NCLATs is to ensure that companies that are insolvent get better (termed functioning as a ‘going concern’).

The Supreme Court understood this and upheld the decision of the NCLAT to prevent termination of the contract by prioritising this need to keep companies alive as going concerns. If counterparties get the right to terminate contracts merely (or ipso facto) because bankruptcy proceedings are initiated, it could lead to a situation wherein a lot of companies simply cease to function, severely impacting the economy and people’s livelihoods.

The NCLAT in this particular case prevented the termination of a contract vital to the business of a particular company merely because one of the parties to the contract became subject to insolvency proceedings.

Does This Mean That Contracts Cannot Be Terminated on the Basis of Insolvency or Bankruptcy Events?

No.

So What Does This Decision Mean, Then?

The case at hand involved a situation wherein the entire business of a company was based on a specific contract – the termination of the contract would certainly mean that the company would, in corporate terms, die.

If you are a service provider of any sort, it goes without saying that if you do include such ipso facto termination clauses linked to insolvency / bankruptcy events in your contracts, it’s quite likely that you may be prevented from terminating your contract with your customer if the customer’s business is inherently linked with your services to keep it alive (such services may even be classified as ‘essential services’ under the IBC and you may be statutorily mandated to continue providing said services with no assurance of getting fully paid).

The decision at hand effectively confirms that the NCLT or NCLAT set up under India’s IBC can prevent the enforcement of termination clauses linked to insolvency / bankruptcy events under the abovementioned situations, and that is some serious food for thought for lawyers, in-house counsel and businessmen alike.