The termination of contracts in insolvency proceedings

It is not uncommon for contracts generally to stipulate, as grounds for termination, that one of the contracting parties is in a state of pre-insolvency, insolvency – in the broad sense – or is even already subject to insolvency proceedings.

In this regard, we should bear in mind that Royal Legislative Decree 1/2020 of 5 May, which approves the consolidated text of the Insolvency Act, hereinafter TRLC – and which had already been provided for in the legislation prior to the reform – sets out, in Article 156, the general principle regarding the validity of contracts with a view to ensuring that the entire contractual framework upon which a company bases its economic activity is not wasted, and thereby safeguarding the continuity of economically viable businesses which are facing financial difficulties.

Consequently, following the transposition of the Directive on Preventive Restructuring Frameworks, this principle has been reinforced, resulting in the the invalidity of all clauses contained in contracts entered into by the debtor prior to the declaration of insolvency proceedings – even if the liquidation phase has commenced – which make the termination of the contract conditional upon the insolvency of one of the parties. Moreover, the law also prohibits any clauses that provide for the suspension or modification of the obligations assumed by the parties when one of the aforementioned situations arises (a declaration of insolvency or the commencement of the liquidation phase). Thus, priority is given to the common interests of all creditors and the regulations in this area are harmonised at both the insolvency and pre-insolvency stages, as Articles 597 et seq., as well as Article 618, TRLC, the same principle regarding the continued validity of contracts during the phase of notification of the opening of negotiations and in restructuring plans.

However, we must distinguish between the effects on contracts involving reciprocal obligations depending on whether the obligations yet to be fulfilled lie with one of the contracting parties or with both parties. In the first case, the claim or debt attributable to the insolvent party shall be included in the insolvency estate’s assets or liabilities, as appropriate; in the second case, whilst this will not affect the validity of the contract in question, both parties must perform the agreed obligations, with the estate being responsible for those to which the insolvent party is bound.

Having said that, we must not forget that, as in any other case, Termination of the contract may be justified provided that there has been a breach by one of the parties. Insolvency legislation therefore distinguishes between whether the breach occurred before or after the declaration of insolvency. If the breach occurred prior to the declaration, this right may only be exercised in cases where the contract is of a continuing nature, and the creditor’s claim, as well as compensation for damages caused by such breach, shall be treated as a claim against the insolvency estate; conversely, if the breach occurred after the declaration of insolvency, either party may pursue a claim, and the claim, together with any corresponding compensation, shall be treated as a claim against the insolvency estate.

In either case, the action to set aside the contract must be brought before the insolvency judge and will be dealt with in accordance with the procedures for insolvency proceedings. One of the notable new developments arising from the transposition of the Directive on preventive restructuring frameworks is the inclusion of Article 164 of the TRLC, namely, concerning the enforcement of the unfulfilled contract, empowering the insolvent party or the insolvency practitioners, in the interests of the insolvency proceedings, to object to the continued validity of the breached contract with the special provision, in the event that the breach occurred subsequently, in which case the claimant must be offered payment from the insolvency estate within three months of the date of the judgment for the sums owed in respect of the services rendered; This same provision is set out in the pre-insolvency context, specifically in the Article 598 of the TRLC.

In conclusion, A state of pre-insolvency or insolvency does not, and cannot, in itself entail the termination of a contract Given the principle governing the continued validity of contracts as set out in insolvency legislation, whether in the pre-insolvency or insolvency stages, the termination of a contract must, in either case, be based on a breach of the debtor’s obligations. Therefore, Any clause which provides that the contract shall be terminated on the grounds that one of the parties is subject to insolvency proceedings or pre-insolvency proceedings shall be deemed null and void ab initio and shall be treated as if it had never been included..