United States: No Termination Of Commercial Agreements In The Case Of German Insolvency Proceedings?

Cancellation of commercial agreements under German insolvency law

Commercial agreements usually provide for extraordinary termination rights or even automatic cancellation in the case of insolvency of one of the parties. Such a cancellation right may, however, contradict the general principles of German insolvency law.

Regarding ongoing agreements, the insolvency administrator has a statutory choice to either continue or to terminate such an agreement pursuant to Sec. 103 of the German Insolvency Code (Insolvenzordnung – "InsO"). If prompted, the administrator has to exercise its right of choice without undue delay. Any provision excluding or limiting such option of the insolvency administrator is deemed void (sec. 119 InsO), thus, intending the continuation of the insolvent business for the benefit of all creditors. The contracting party, however, does not have a statutory choice to either continue or terminate the contract.

If a contract is assumed and continued by the administrator, he is entitled to the performance of the contracting party; reciprocally, the administrator has to perform in lieu of the debtor. In the distribution of assets of the insolvent undertaking amongst the creditors, claims arising under such an assumed contract have a priority status: they are paid in full and prior to any payment to any unsecured creditor.

If the insolvency administrator rejects the contract, the other party is not entitled to demand performance, but it may claim compensation for damages resulting from nonperformance. Such a claim for damages, however, does not have any priority, and is satisfied together and pro rata with all claims of unsecured creditors.

As the unilateral option right of the insolvency administrator creates a period of uncertainty for the other party, contractual extraordinary termination rights in case of insolvency are included as a general measure of precaution in standard terms and conditions or specific provisions of the contract. It is doubtful that such clauses will be upheld in court following a recent decision of the German Federal Court (Bundesgerichtshof – BGH).

New Decision of the German Federal Court (BGH)

The decision relates to an energy supply agreement providing for an automatic cancellation by the energy provider in the case of an insolvency filing. After filing for insolvency, the energy supplier insisted on the cancellation. Therefore, the preliminary insolvency administrator and the energy supplier concluded a new supply agreement. As the new agreement provided for a higher price, the administrator, however, took the view that the old agreement should continue, and later refused payment of the excess amount.

The German Federal Court followed such arguments, and declared that in the case of continuous supply of goods or energy, automatic termination clauses are null and void. The court held that such a clause frustrates the right of choice of the insolvency administrator to assume or reject a contract. As a consequence, the court held that the energy supplier is not entitled to claim payment of the higher energy price, but remains obliged to supply energy at the lower price until the insolvency administrator has taken his decision on whether to continue the agreement.

Practical consequences at least for continuous supply of goods or energy

The decision will particularly impact most types of commercial agreements (e.g., customer and supplier agreements). The court has explicitly ruled that agreements on the "continuous delivery of goods and energy" are affected. Thus, it can be assumed that all agreements on the delivery of any kinds of goods (raw materials, consumables, finished products, etc.) are affected. Therefore, many general terms and conditions of commercial agreements providing for extraordinary termination rights where the other party files for insolvency or ceases to make payments will be held invalid in an insolvency situation, and therefore have to be adopted.

Extension of ruling on all contracts?

As the decision specifically refers only to contracts regarding the continuous supply of goods or energy, it now gives rise to the question of whether this would be extended to other contracts. If the answer is "yes", new amendments against payment defaults in the case of insolvency of the other contractual party would be required. Some expect that the aforementioned ruling will be applied also to other types of contracts, unless the law explicitly provides for an extraordinary termination right in the case of an insolvency filing. Loan agreements will, however, not be affected, since they usually comprise termination clauses which relate to a point in time prior to insolvency filing (e.g., substantial deterioration in the financial situation of the borrower, or where the borrower is in default with payments of principal and interest).

What has to be done to protect the creditor?

The BGH has explicitly ruled that termination clauses are permitted in pre-insolvency scenarios. Therefore, a termination right could be agreed to in the case of a deterioration of the financial situation, which mainly is used in loan agreements. A "deterioration of the financial situation" may be defined, as the case may be; i.e., a loss of half of the share capital, a (balance sheet) over-indebtedness, a unilateral termination of bank loans by the bank, or even a statement by the auditor of the existence of substantial risks jeopardizing the company (bestandsgefährdende Risiken). However, unlike banks or other financial creditors, suppliers usually do not have any information about the financial situation of the customer. Thus, suppliers should seek to include in their commercial agreements relevant reporting covenants or, if more agreeable, at least a clear-cut definition of the deterioration of the financial situation. Such deterioration should lead to an information obligation on the affected party, at the same time giving rise to a termination right. A failure to inform the supplier should trigger claims for damages (which would, however, also qualify unsecured insolvency claims in the case of insolvency).

Also, termination rights linked to default in payments remain valid despite the new ruling by the BGH. Therefore, commercial agreements should entitle the supplier to an extraordinary termination in a case where the customer is in default with, e.g., two monthly payments.

Finally, any termination rights by operation of law remain unaffected. This particularly relates to simple (gratuitous) mandates (Auftrag), management contracts (Geschäftsbesorgungsverträge) and proxies (Vollmachten).

In addition, the creditor should, in order to protect his claims, prompt the insolvency administrator to take a decision early. Many times, goods are delivered, despite the opening of insolvency proceedings, with the assumption that they will be paid in full. Legal assurance may, however, only be given by the administrator – he has to decide, upon being prompted and without undue delay, whether a particular contract shall be assumed or not.

How can the creditor protect himself against clawbacks by an insolvency administrator?

Even the best termination clauses might prove to be useless if the administrator later challenges particular transactions which have been consummated on the verge of insolvency. Transactions performed within three months prior to the filing are particularly prone to clawback actions, if the creditor had knowledge of the illiquidity of the debtor at that point in time.

The insolvency administrator may, however, not challenge the payments in a case where the criteria of a so-called "transaction in cash" (Bargeschäft) are met. A "transaction in cash" requires a transaction to be at "at arm's length," and the delivery of goods and payment to occur within a short time frame of approximately two (2) weeks. Thus, a potential solution for suppliers could be to agree to a delivery upon prepayment only after the occurrence of a defined event. Such deliveries made shortly after the receipt of the prepayment will be regarded as "transaction in cash," and prepayments may not be challenged.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.