Ipso facto”: The concept that clauses allowing for the termination of contracts purely for the insolvency of the contractual counterpart should be invalid, has long been an established principle of the Chapter 11 regime in the US.  However, in another example of trend suggesting that this approach may also be increasingly adopted in European jurisdictions where previously such clauses have been relied upon, Christian Stempfle of our Munich office provides an update on German case law below.

Many contracts include automatic or discretionary early termination provisions if insolvency-related events occur for one of the contractual parties (such as the filing for insolvency or the opening of insolvency proceedings with respect to one of the contractual parties).  The approach of courts to such provisions vary on a jurisdiction by jurisdiction basis.

Under German insolvency law, it is unclear whether such clauses are valid and can be enforced in the case of an insolvency.

In a recent case, one such clause was the subject of a lot of criticism by the German Federal Supreme Court (Bundesgerichtshof) and held to be invalid: termination based on said clause could not be enforced. The consequence is that the contract remains and the party relying on such insolvency-related termination clause is potentially liable for all damages the opposite party incurred as a result of such invalid termination.

In more detail, this was finding of the 9th senate of the Federal Supreme Court (docket-no.: IX ZR 169/11). The German Federal Supreme Court decided that insolvency-related termination clauses in contracts regarding the continuous delivery of goods or energy should be invalid if such termination is either triggered by the cessation  of payments, a request for the opening of insolvency proceedings or the opening of insolvency proceedings over the assets of the other contractual party.

The clause forming the basis of the underlying dispute had – in English translation – the following wording:

This contract shall automatically terminate without prior notice if the customer filed a request for the opening of insolvency proceedings or if, upon a request of a creditor, the preliminary insolvency proceedings will be started or opened.”

Whereas the lower courts – Hannover Regional Court/Court of Appeal Celle –upheld the above-quoted provision, the Federal Supreme Court, in an overruling judgment, found against the validity of such provision.

The core legal dispute at issue is: The insolvency administrator, once appointed by the insolvency court, has, in principle, the right to choose which contracts of the insolvent debtor he will perform (see sec. 103 German Insolvency Act – InsO). He can opt for performance or non-performance of the relevant contract.

According to sec. 119 InsO, any contractual provision excluding or limiting this right, is invalid.

However, inter alia the Munich Court of Appeal held that this provision shall not apply to so-called insolvency-related termination clauses. This because the insolvency administrator has to accept contracts as they stand when he is appointed as insolvency administrator of a specific company (unless the insolvency administrator has a right to challenge the relevant provision which was not the case in the underlying dispute here).

The Düsseldorf Court of Appeal, to the contrary, was opposed to the validity of such insolvency-related termination clauses since these, in their opinion, are in clear violation of the statutory prohibition in sec. 119 InsO unless such clauses repeat specific statutory insolvency-related termination rights.

The 9th senate of the Federal Supreme Court made clear that insolvency-related termination clauses (those which provide for the right to terminate a contract in case of a cessation of payment, the filing for insolvency or the opening of insolvency proceedings) in contracts for the continuous delivery of goods / energy are in breach of sec. 119 InsO and therefore invalid. In line with the Düsseldorf judgments, such invalidity, however, shall not apply if the insolvency-related termination clause only mirrors a statutory insolvency-related termination right.

The Federal Supreme Court, in his decision making process, was led by the purpose of the insolvency administrator’s right to opt for the performance/non-performance of contracts. This legal purpose is to protect the assets of the insolvent company and to increase such assets in the interest of a settlement of creditor claims parri passu. And such purpose would be obstructed if the contractual partner of the insolvent debtor, just because of its insolvency, could terminate a contract which is in the interest and to the benefit of the insolvent debtor.

In the Federal Supreme Court’s opinion, this does not lead to any disadvantage to the contractual partner of the insolvent company since this contractual partner then will receive payment for his deliveries in full as so-called preferred estate liability.

For today’s contractual practice, this means that insolvency-related termination clauses in bilateral contracts for delivery of goods or energy have the clear risk of being (held) invalid. Moreover, it is also to be expected that contracts for the provision of on-going services bear the same risk since there is no real argument to differentiate these contracts from the delivery of goods.

However, the discussion is not over yet. In Germany, the 9th and the 11th senates of the Federal Supreme Court, have to deal with insolvency-related disputes and questions. Though, it still remains to be seen which position the 11th senate of the Federal Supreme Court will take (it is not rare that these two senates expressed different views).

To reflect that risk in contractual practice, one may still include insolvency-related termination clauses, but be aware of the potential risk of invalidity, and provide for a clear severability clause according to which invalid or void contractual provisions shall not render the whole contract invalid or void and that such invalid or void provision shall be deemed replaced by a valid and enforceable one which meets the interests of the contractual parties best.

Last not least: against this background, one has to carefully consider whether to terminate a contract on the basis of the insolvency of the other contractual party. Should such termination be held invalid, then the terminating party would be liable for all damages caused to the insolvent contractual party by such termination. And insolvency administrators are legally obliged to pursue such legally unlimited claims for damages.