A brake on termination?

Most of us practising in the world of commercial law will have heard of the principles of gratuitous alienation and unfair preference in the context of insolvency. These principles prevent debtors giving away assets for little or no value in order to deprive creditors of the value. However, would many of us recognise a right to terminate a contractual obligation on the happening of an “insolvency event” as potentially being invalid due to these principles?

It is commonplace for a wide variety of commercial contracts to contain such a right. Usually these termination provisions will allow parties to the contract to extinguish a variety of rights and obligations between them and also to rely on a range of a pre-agreed contractual remedies that bite following the insolvency event. There are a whole range of commercial circumstances where it is incredibly important that contractual obligations terminate on insolvency. It therefore goes without saying that being able to rely on these termination rights in many circumstances will be crucial.

The Folgate decision

A recent English case has highlighted that practitioners need to exercise much caution when drafting such provisions, as common law or statutory rights/protections granted to creditors of insolvent companies will potentially trump the terms of the contract.

In Folgate London Market Ltd v Chaucer Insurance plc [2011] EWCA Civ 328 the Court of Appeal ruled that a termination provision relating to an insolvency event could not be relied on to terminate certain indemnities given by a party to the contract. The case centred around various indemnities given under the terms of a personal injury settlement agreement. One party to the contract was placed in administration, which triggered a right that was invoked to terminate certain indemnities given in the contract. However, despite the insolvency event, Chaucer sought to rely on the indemnities contained in the agreement.

Relying on the English common law principle of “anti-deprivation”, the court agreed that the indemnities could be relied on and that the termination clause was invalid as it deprived the insolvent company (and of course its creditors) of a benefit/right without due compensation or consideration being paid.

Although this is an English case, the English principle has similarities to the Scots law concepts of gratuitous alienation and unfair preference on insolvency.

Deprivation of benefit

The Scottish law relating to gratuitous alienations is based both on common law principles and statutory rules. The period of time at or during which an asset is transferred, and the insolvency status of the debtor, is usually a key focus – and often retrospectively – when considering whether a gratuitous alienation has taken place in any given situation. This is because if the person giving away the asset was insolvent at that time or (relatively speaking) shortly after, the validity of the transfer of that asset could be disputed by creditors, trustees or administrators if due consideration was not paid.

Much of the case law and commentary on gratuitous alienations concentrates on heritable property and other obviously valuable assets. However, the Folgate decision highlights that these principles can equally be applied to contractual rights and other benefits that the insolvent company should have been able to enjoy. Thus in the same way as creditors potentially have rights to valuable assets that have been disposed of, the company potentially has rights to other intangible “assets” such as warranties and indemnities given in the context of a commercial contract.

The enforceability of these termination clauses is of particular relevance as they usually bring with them a host of pre-agreed remedies – such as the right to buy insolvent parties’ shares under the terms of a shareholders’ agreement, or the right to a pre-agreed division of assets in a joint venture agreement. If the terms of these types of remedies are not drafted with a firm focus on the principles of gratuitous alienation and unfair preference, our clients are likely to be in for a nasty surprise, as the remedy they are seeking to rely on may not be available if the termination clause does not operate or it deprives creditors of rights or assets that they would otherwise have access to.

Contractual terms providing for the termination of a contract on various insolvency events are extremely common, and the Folgate decision, although English, is an important reminder to Scots practitioners to bear in mind the interplay between the terms of the contract, the rights and obligations that they are attempting to create, and the statutory and common law context. In particular it should not be taken for granted that an insolvency event will necessarily lead to a right to terminate the contract or a right to rely on a pre-agreed termination remedy.