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No escape | Why your termination-on-insolvency clause is unlikely to be effective under German law

Published on 11th Jul 2018

Many supply, construction or service contracts include a clause which allows either party to terminate the agreement, or provides that the agreement will terminate automatically, upon the occurrence of various insolvency-related events.

However, such clauses allowing for the termination of contracts purely for reason of insolvency of the other party are generally invalid under German insolvency law. Understanding how this might affect your contracts can help you to ensure that you are adequately protected through other contractual provisions, and to appreciate what your options are when a counterparty looks in danger of becoming insolvent.

Why are termination-on-insolvency provisions invalid?

Under German insolvency law, the insolvency administrator or, in case of a self-administration proceeding, the debtor has, in principle, the right to choose which contracts will be performed in the future. The administrator can opt for performance or non-performance of the relevant contract. If the administrator opts for performance of the contract they have to comply with all contractual obligations.

The rationale of the administrator's right to opt for (non-)performance of existing contracts is to avoid the immediate collapse of the debtor’s business as well as the destruction of any potential assets and to save favourable contracts for the insolvency estate.

Consequently, any agreements or clauses which exclude or restrict the applicability of the insolvency administrators’ right in advance are invalid by law. The statutory provision prohibiting such exclusion or restriction clauses is intended to allow the insolvency administrator to execute their insolvency-specific rights to the fullest extent.

What types of contracts are subject to these statutory rights?

The insolvency administrators’ right to opt for (non-) performance of existing contracts applies to reciprocal contracts but not unilateral contracts.

In addition, the right to opt for (non-) performance only applies to on-going contracts which have not yet been completely fulfilled. For example, the insolvency administrator cannot opt for non-performance of a sales contract where the seller has already delivered the object of purchase and the buyer has already paid the purchase price.

The types of contract which are subject to the insolvency administrators’ right to opt for (non-) performance of existing contracts include:

  • Sales contracts;
  • Supply contracts;
  • Service contracts;
  • Contracts for work;
  • Lease agreements for movable objects;
  • Licence agreements.

Special provisions apply to property/real estate lease agreements as well as employment contracts.

Which termination clauses are invalid?

As a general rule, any termination clause which is linked to insolvency-related events is invalid. Such insolvency related events may include:

  • the application for insolvency by the debtor or a creditor;
  • the initiation of preliminary insolvency proceedings;
  • the opening of insolvency proceedings; and
  • the appointment of a receiver or trustee.

In addition, the statutory criteria which define what qualifies as insolvency scenario under German law, namely illiquidity and over-indebtedness, are insolvency related events in this context.

By contrast, termination clauses which are linked to other non-insolvency related events such a default and material breaches of contract will be valid. Furthermore, termination clauses are valid if the law explicitly provides for a right of termination at any time. This is the case, for example, for construction agreements to which the German Civil Code (BGB) is applicable.

Following a decision of the German Supreme Court (Bundesgerichtshof) in 2016, construction agreements for which the parties have agreed on the applicability of the Construction Tendering and Contract Regulation (Vergabe- und Vertragsordnung für Bauleistungen - VOB/B), which provides for termination-on-insolvency provisions, can be terminated purely for reason of insolvency of the other party. This has long been disputed. The Supreme Court argued that the personal qualifications of the contractor, such as skills, efficiency and reliability, are of such importance for the customer that the customer cannot be expected to continue the construction agreement with an insolvency administrator.

Still disputed is the validity of termination clauses which are indirectly linked to insolvency-related events, for example, to a substantial deterioration in the financial situation of the other party. Apart from the uncertainty of the clause itself which can provide grounds for dispute, the clause could be considered as invalid as a substantial deterioration in the financial situation points to an insolvency scenario.

Can choice of law clauses in the contract provide an answer?

No. Even if the respective contract provides for the applicability of foreign law, German insolvency law is applicable in case insolvency proceedings have been opened in Germany. Whereas any non-insolvency related contractual disputes will still be governed by the law which was agreed between the parties, German insolvency law will be applicable to any insolvency specific matters, such as termination-on-insolvency provisions.

Forewarned is forearmed

Businesses trading in, or looking to expand into, Germany need to factor into the risk of not being able to escape contracts where the counterparty becomes insolvent. This needs to be kept in perspective, and will not necessarily require any change in approach in advance, but it is worth considering whether you need to build in any alternative contractual protections, or whether you might need to act more swiftly if you begin to notice the warning signs.

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* This article is current as of the date of its publication and does not necessarily reflect the present state of the law or relevant regulation.

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