Termination in the event of insolvency: Why standard insolvency-dependent termination clauses often fail and how they can be made effective

The law does not contain any conclusive provisions on the question of the validity of insolvency-dependent termination clauses. Essentially, there are two opposing views on this issue:

• One view holds that insolvency-dependent termination clauses are fundamentally invalid under sec. 119 InsO. The primary objective of the Insolvency Act is the collective satisfaction of creditors. Sections 103 and 105 InsO give the insolvency administrator the option of choosing to fulfil ongoing, reciprocal contracts and thus continuing the business economically. This purpose could be thwarted if the debtor's contractual partner were to withdraw from a contract that is favorable to the estate due to the insolvency, thereby undermining the insolvency administrator's right of choice.

   

• The opposing view considers insolvency-dependent termination clauses to be effective in principle. Termination clauses are not covered by sec. 119 InsO because such clauses relate to the existence of the contract, but not to its execution within the meaning of sections 103–118 InsO. Furthermore, the history of the norm's development argues against the invalidity of such clauses.

To date, the Federal Court of Justice has ruled on three cases concerning insolvency-dependent termination clauses, summarized as follows:

1. In its ruling of 15 November 2012 (Az. IX ZR 169/11), the Federal Court of Justice had to assess termination clauses in contracts for the ongoing supply of goods or energy in favor of a monetary creditor, which were linked to the filing for insolvency or the opening of insolvency proceedings. As a result, the Federal Court of Justice deemed these to be invalid within the meaning of sec. 119 InsO on the grounds that the provisions made excluded in advance the insolvency administrator's right of choice under sec. 103 InsO, for which there was no possibility to terminate/rescind provided for in special legislation in this case.

2. In its judgment of 7 April 2016 (Az. VII ZR 56/15), however, the Federal Court of Justice assessed a corresponding insolvency-dependent termination option included in a construction contract as valid, as this did not go beyond the statutory termination option under sec. 649 sentence 1 German Civil Code, according to which the client is entitled to terminate the contract for work and services at any time; in other words, because in this case there was a corresponding possibility to terminate/rescind provided for by special legislation. A contractual termination clause does not impair the insolvency administrator's right of choice if the termination option does not arise solely on the basis of insolvency, but is closely based on a statutory termination option.

3. In its latest judgment of 27 October 2022 (Az. IX ZR 213/21) on this issue, the Federal Court of Justice declared an insolvency-dependent termination clause to be invalid 

‘if the insolvency-dependent circumstance alone enables termination of the contract and the termination clause deviates in its prerequisites or legal consequences from statutory termination options, without there being legitimate reasons for these deviations from an objective point of view ex ante at the time of conclusion of the contract on the basis of the mutual interests of the parties.’

As a result, an insolvency-dependent termination clause should be effective under sec. 119 InsO if it either (i) corresponds to a possibility to terminate/rescind provided for by law or (ii) does not correspond to a possibility to terminate/rescind provided for by law but there are legitimate reasons for this.

In its ruling of 27 October 2022 (Az. IX ZR 213/21), the Federal Court of Justice left open the question of whether there was a legitimate reason in the case to be decided there. However, the Federal Court of Justice stated in general that termination clauses are regularly effective

• where the contracting parties pursue an objective that is justified under insolvency law in accordance with their interests at the time the contract is concluded within the autonomous structure of the contract (e.g. if the contract is concluded as part of a restructuring of the debtor and the clause serves to mitigate the risks of a failure of the restructuring);
• for which the law permits termination for good cause and the contractual formulation of the good causes is justified by a standardized assessment of interests for the cases regulated therein.
  • For the standardized assessment, the decisive factor is whether the risks associated with the insolvency jeopardize the further performance of the contract to an extent that, depending on the nature of the contractual obligations and the mutual interests of the parties, may constitute good cause when considered in isolation from the individual case.

On the other hand, termination clauses are generally ineffective if they

• link the termination of the contract to conditions that are less stringent than those deemed – by the legislator – insufficient for the period from the filing of the insolvency petition;
• are agreed in favor of a creditor of monetary performance, inter alia because he is already sufficiently protected by sec. 320 of the German Civil Code or – if he is obliged to make advance performance – by sec. 321 of the German Civil Code.

Furthermore, termination clauses may be subject to exercise control. If the party entitled to terminate the contract does not pursue legitimate interests – for example, if it uses the insolvency to enforce higher prices or if it wishes to withdraw from a contract whose performance would not be impeded by the insolvency – the exercise of the right of termination may be excluded in accordance with the principle of good faith.

In summary, contracting parties should not automatically rely on insolvency-dependent termination clauses being effective in an emergency, as their legal requirements – as shown – are very high in terms of both formulation and application.

Anyone wishing to agree such a clause effectively must carefully consider the specifics of the respective business relationship when drafting and carefully examine whether, from an objective point of view ex ante at the time of conclusion of the contract, such a provision is actually reasonable and enforceable in view of the specific assessment of interests. In particular, the following should be noted:

• In order to draft an effective termination clause in the event of insolvency, it should be closely aligned with the standards and case groups established by the Federal Court of Justice.
  In this respect, it should be noted that the Federal Court of Justice has formulated generally applicable principles for the effectiveness of insolvency-dependent termination clauses. Nevertheless, these standards must be applied separately to the respective type of contract (supply contract, authorized dealer contract, commercial agency contract, etc.), taking into account the specific features of this type of contract (its statutory termination options, the different distribution of interests, etc.).
   
• Even if a clause is permissible according to the above standards, it may still fail to comply with the provisions of sections 305 et seq. of the German Civil Code if the clause is not agreed in an individual contract but is used as a general term and condition.
  This could be the case in particular if the provision unreasonably disadvantages the contractual partner and/or is formulated in a non-transparent manner.

As a result, it is essential to check the termination clause for compatibility with the law on general terms and conditions on the one hand, and to adapt it to the specific contractual situation and interests on the other. If both aspects are adequately taken into account, a termination of the respective contracts is possible and the contractual partner of the insolvent partner gains the necessary economic security, as the existing obligations under the respective contract expire and it can be restructured.