Treatment of contracts in insolvency cases
Table of Contents
Understanding the specific details of a contract and the relevant insolvency laws is crucial for navigating the legal complexities of insolvency and contracts. The insolvency framework dictates how contracts in insolvency cases are treated affecting the enforceability and termination of agreements. This article analyses a contract’s clauses and the insolvency laws applicable in the insolvency or liquidation proceedings in this regard.
Types of Contracts Typically Affected in Insolvency
There are different types of contracts that are involved in the insolvency process:
Executory Contracts:
These are contracts in insolvency cases where obligations from both parties are yet to be performed, such as service agreements or lease agreements. In insolvency, the treatment of executory contracts can be complex, with the liquidator potentially choosing to assume or reject them. If the liquidator rejects the contract, the other party may have a claim for damages.
Supply and Vendor Agreements:
These contracts include provisions for closeout, netting, offset, and collateral arrangement related to financial transactions, thereby they are used for long-term supply arrangements. Insolvency laws provide special protections for financial contracts in insolvency cases, allowing for the exercise of netting and offset provisions, even if they would otherwise be considered unenforceable under general contract law.
Leases and Real Estate contracts in insolvency cases:
Commercial leases, subleases, and asset-use agreements can be impacted during insolvency, leading to either continuity or termination depending on the specific circumstances. The termination of these agreements is crucial for maintaining the viability of the debtor company and maximising the value of its assets during the insolvency resolution process.
Employment and Consulting Contracts:
During a corporate insolvency resolution process (CIRP), employment and consulting contracts in insolvency cases are generally treated with a focus on preserving the company as a “going concern”. This means that the interim resolution professional (IRP) or resolution professional (RP) may seek to compel performance of these contracts if they are deemed essential for the company’s continued operation. However, they can also disclaim contracts deemed non-essential, which may lead to termination.
Legal Framework under the IBC
The Insolvency and Bankruptcy Code, 2016 govern the treatment of contracts in insolvency cases , especially:
Section 14 – Moratorium on Enforcement of Contracts:
Section 14 of the IBC establishes a moratorium, or a temporary halt, on the enforcement of contracts in insolvency cases and other actions against a corporate debtor. This provision provides for a complete moratorium against any action to foreclosure, recover or enforce any security interest, or recover possession of any property by the owner or lessor during CIRP. For instance, section 14(2A) empowers the RP to prevent the termination of contracts that are considered “critical” to the operations of the corporate debtor as a going concern.
Section 20 – Corporate Debtor to Continue as a Going Concern:
This section outlines the management of a corporate debtor’s operations as a “going concern”. The IRP is tasked with preserving the value of the corporate debtor’s assets and ensuring the continuation of its operations. This includes actively managing the business, including entering contracts, raising interim finance, and issuing instructions to personnel to keep the company operational.
Section 30 and Section 31 – Resolution Plan and its Binding Effect:
Sections 30 and 31 govern the resolution plan process, particularly regarding its approval and binding effect on contracts. The resolution plan can provide for continuation, modification, or rejection of contracts, that is binding on all stakeholders, including contractual counterparties.
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Role of Resolution Professional
The RP plays a crucial role in managing contracts during the insolvency process, as they represent the corporate debtor in dealing with third parties and amending or modifying existing contracts to facilitate resolution:
Evaluation of Onerous or Burdensome Contracts:
The RP has the discretion to recommend termination if the contract is not commercially viable. The RP evaluates the contact’s potential to contribute to the turnaround of the company and whether it hinders or benefits the overall resolution strategy.
Renegotiation or Assignment of Contracts:
The RP, as the custodian of the corporate debtor’s assets, may choose to assign certain contracts to a successful resolution applicant. This allows the applicant to take over the debtor’s obligations and rights under the contract. However, it is necessary to obtain consent from counterparties in many cases.
Judicial Interpretation and Case Law
In the Binani Industries Case, the National Company Law Appellate Tribunal (NCLAT) addressed the termination of contracts during the insolvency resolution process. The NLCAT’s decision highlighted the primary objective of the IBC is to facilitate resolution, not to obstruct it. It also deemed resolution plans discriminatory if they treated similarly-placed financial and operational and creditors differently. The NCLT in Reliance Commercial v. Ved Cellulose Ltd., has held implications for contract termination clauses triggered by insolvency, as the initiation of CIRP under the IBC may lead to the suspension or modification of existing contracts. Further, the NCLT ruled that only the Committee of Creditors (CoC) approved changes would hold.
Read more : Common Misconceptions About the IBC
Treatment of Ipso Facto Clauses
The inclusion of ipso facto clauses in contracts is an important element to consider in insolvency:
What are Ipso Facto Clauses?
An “ipso facto clause” is a contractual provision that allows a party to terminate a contract or modify its terms automatically upon the occurrence of a specific event, such as the other party’s insolvency or bankruptcy. These clauses are designed to provide a safeguard for one party against potential financial harm if the other party faces financial difficulties.
Indian Legal Position:
The IBC does not explicitly prohibit ipso facto clauses, like the U.S. Bankruptcy Code. While section 14(2) of the IBC prevents the termination of essential services during the CIRP, and section 14(2A) allows for the termination there is a default in payment to the supplier. The Supreme Court has also addressed the issue in cases like Gujarat Urja Vikas, but ultimately left the decision on the validity of ipso facto clauses to the legislature.
Contractual Rights vs. Resolution Objectives
Balancing Creditor Rights and Commercial Continuity:
The IBC recognises the importance of protecting creditor rights during insolvency and facilitates the continuation of viable business during insolvency. It aims to balance the interests of both creditors and debtors. While creditors are given the right to recover their dues, the system also allows for debtors to potentially restructure and continue operating, provided they can demonstrate a viable plan.
Essential Contracts vs. Redundant Agreements:
Essential contracts, like those for utilities or critical supplies may be deemed crucial for the continued operation of the business, allowing them to be continued even during insolvency. Redundant agreements, on the other hand, may be terminated or have their obligations reduced to free up assets for creditors or to streamline operations.
Treatment in Liquidation Scenario
In insolvency processes, contracts are generally terminated, unless they are deemed necessary for asset preservation or realisation. Counterparties are then relegated to the status of claimants in the process, with their legal recourse significantly limited. The IBC has section 14 for a moratorium on proceedings against the insolvent company, including the termination of contracts, to facilitate the resolution process and protect assets. Their primary recourse is to participate in CIRP and submit their claims, hoping to recover their losses alongside other creditors.
Conclusion
Contracts that are vital to the company’s operations or could contribute to its recovery are generally preserved, while those that are onerous or hinder the resolution process may be rejected. The IBC has specific provisions regarding the treatment of contracts, namely, sections 14, 30 or 31. However, the NCLT may set aside terminations if they would jeopardise the debtor’s operations or violate the moratorium under IBC. It is the responsibility of RPs and CoCs to assess the strategic value of contracts to balance stakeholder interests. The NCLT and other courts have played a critical role in interpreting the IBC’s provisions related to contracts, particularly the scope of the moratorium and the treatment of executory contracts.
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