Termination of Contracts During Corporate Insolvency Resolution Process: Part I

The commencement of corporate insolvency resolution process under the Insolvency and Bankruptcy Code (“Code”) results in a moratorium, inter alia, on any coercive action against the assets of the corporate debtor. The moratorium is aimed at ensuring that the corporate debtor continues as a going concern, which in turn enhances the possibility of revival of the corporate debtor. The nature and extent of the moratorium is stipulated in Section 14 of the Code. An important issue that arises in this context is the effect of the moratorium on the corporate debtor’s contractual obligations, particularly the right of a counter party to terminate a contract entered into with the corporate debtor. In this three-part series, I examine the legality of termination of contracts by counter-parties during the corporate insolvency resolution process (“CIRP”). Part I lays down the relevant statutory framework prior to the amendments introduced by the Insolvency and Bankruptcy Code (Ordinance), 2019; Part II discusses the changes brought about by the Ordinance; and Part III looks into the judicial dicta on this issue.

Prior to the Code, the issue of operation of contracts (albeit, not termination of contracts) had been specifically addressed in the Sick Industrial Companies (Special Provisions) Act, 1985 (“SICA”). SICA conferred extremely wide powers on the Board for Industrial and Financial Reconstruction (“BIFR”) to regulate the contractual rights and obligations of the sick industrial company during the pendency of a reference under SICA. Under Section 22(3) of SICA, the BIFR could order the suspension of operation of ‘all or any of the contracts’ or ‘all or any of the rights, privileges, obligations and liabilities accruing or arising’ under a contract. This extensive authority to regulate the operation of contracts included within its umbrella not only contracts to which the sick industrial company was a party, but also contracts which were applicable to the sick industrial company (see Morgan Securities and Credit Pvt. Ltd. v. Modi Rubber Ltd.). It was, therefore, the BIFR’s prerogative to ascertain and customize the contractual obligations of the sick industrial company. The position under the Code, however, is different.

The commencement of CIRP in relation to a corporate debtor leads to the imposition of a moratorium under Section 14 of the Code. Sub-section (1) of Section 14 requires the Adjudicating Authority (i.e. the National Company Law Tribunal) to declare a moratorium inter alia on: a) the institution or continuation of any legal proceedings against the corporate debtor in any forum; b) transfer of assets by the corporate debtor; c) any action to enforce any security interest created by the corporate debtor; and d) the recovery of any property in the occupation or possession of the corporate debtor. Additionally, Section 14(2) precludes suspension or termination of supply of essential goods or services during the CIRP period.

Section 14, as it originally stood, did not contain any unambiguous provision prohibiting the termination of contracts by a contracting party during the CIRP period. In fact, besides empowering the insolvency professional to amend or modify existing contracts (Section 20(2)(b)), the originally enacted Code did not contain any provision on the effect of insolvency on the operation of contracts. This lacuna was conspicuous, given that the contractual rights and obligations of the corporate debtor can significantly impact the outcome of the insolvency resolution process. For instance, an exclusive right to supply power possessed by the corporate debtor pursuant to a contract may make the corporate debtor an attractive proposition for a prospective resolution applicant. However, if the contracting party terminates the contract during the CIRP, the committee of creditors may fail to find an appropriate buyer for the corporate debtor.

That said, the unamended Section 14(1) of the IBC was not entirely irrelevant to the issue of operation of contracts. As the most recent Report of the Insolvency Law Committee notes (Chapter I, para 8.5), given the extremely broad definition of ‘property’ in Section 3(27) of the Code, a license obtained from the government may constitute ‘property’. Consequently, the termination of such a license would be prohibited by sub-clause (d) of Section 14(1), which imposes a moratorium on “the recovery of any property by an owner or lessor where such property is occupied by or in the possession of the corporate debtor”. Further, in instances where the termination requires formal proceedings to be conducted before any authority, it would be prohibited by sub-clause (a) of Section 14(1) (see Chapter I, para 8.6 of the Report of the Insolvency Law Committee). At the same time, it can be no one’s case that the moratorium envisaged in unamended Section 14(1) prohibited the termination of all contracts to which the corporate debtor was a party. For instance, it would be absurd to suggest that an employee who does not wish to continue working for the corporate debtor was precluded from terminating his employment contract on account of the moratorium.

The absence of any specific provision dealing with the effect of the moratorium on the corporate debtor’s contractual obligations meant that unless the termination was secondarily struck by one of the four sub-clauses of Section 14(1), there would be no bar on a counter party terminating contracts, including in situations where the termination would paralyse the business of the corporate debtor. Moreover, in situations where Section 14(1) did get attracted resulting in a prohibition of termination, the prohibition would be absolute in nature; any default committed by the corporate debtor in performing its own obligations under the contract, whether before or during the CIRP, would be inconsequential. To illustrate, where the corporate debtor had the exclusive right under a power purchase agreement to supply power to the other party to the contract and defaulted in supplying power much before the commencement of CIRP, the default committed by the corporate debtor would be irrelevant if it was established that sub-clause (d) of Section 14(1) would prohibit the termination of the agreement by the counter party.

The legislative vacuum concerning the termination of contracts during a moratorium has, to some extent, been filled by the Insolvency and Bankruptcy Code (Amendment) Ordinance, 2019, which was promulgated pursuant to the recommendations of the Insolvency Law Committee. The amendments introduced by the Ordinance, 2019, have been retained by the Insolvency and Bankruptcy Code (Amendment) Act, 2020. These amendments shall be discussed in Part II.