Most trading contracts contain specific terms setting out the consequences of a counterparty insolvency or other default. This article explores whether, and in what circumstances, it may be sensible to invoke rights under such clauses or whether it can be better to adopt a more “wait and see” attitude. We also look at drafting options prior to finalising contract terms.
When considering how to respond to a counterparty event of default (EOD), relevant considerations will include potential consequences:
- For the performance of this contract.
- For other contracts with the same counterparty.
- For related contracts with other counterparties – particularly if there is a supply chain.
In addition, decisions will need to be taken on the basis of what other practical options are available, if any.
It should always be remembered in relation to insolvency that under English law, insolvency of itself does not give the other party the right to terminate the contract without express contractual provision to this effect. The insolvent party’s action (or in-action) must amount to a repudiatory breach in order for a right to terminate the contract to arise.
The starting point, once an EOD has occurred, is to see whether the contract terms provide options for the non-defaulting party, or whether the consequences of an EOD are dictated without flexibility.
Automatic Early Termination (AET) clauses
AET clauses offer little or no flexibility. They are usually triggered without any action, not even a notice from the non-defaulting party. When an AET clause is triggered, the contract (and possibly all contracts between the contracting parties) will terminate. For physical supply contracts, trade finance agreements and financial transactions which hedge an underlying physical supply, the consequences of such termination may well be as adverse to the non-defaulting party as to the defaulting party. This is particularly the case where the EOD is an insolvency event (precisely the circumstances in which AET clauses were designed to operate) as the non-defaulting party may be left with significant unsecured claims in the insolvency proceedings. Such claims are usually long in resolution, and rarely result in more than a low percentage recovery.
Other EOD clauses, whilst not operating automatically, provide only for termination (with a resultant loss calculation or claim in damages). Again, this may place the non-defaulting party in an equally, if not more, difficult position than contract performance, depending on the circumstances.
Exercising the right to terminate
When deciding whether to exercise a right to terminate, the non-defaulting party should consider the following questions:
- Neither party will perform if the contract is terminated – is this realistic in a chain?
- If insolvency proceedings have already commenced, is it advantageous to terminate and be an unsecured creditor?
- Will termination actually lead to claims from other counterparties such as freight providers – is performance a better option?
- How risky would performance be – is there a risk of arrest/attachment of vessel/cargo by a third party creditor?
- Will any security bite on termination – and what is the form of security? A bank guarantee may still perform notwithstanding insolvency proceedings but a parent company guarantee may be of little value if the parent company is also affected by insolvency.
Cross default clauses
The above considerations deal with the consequences of terminating the affected contract. In addition, it is increasingly common for contracts to have a cross default clause. It may not be legally or commercially attractive for the non-defaulting party to trigger an EOD clause in one contract if the consequences are that other contracts with the defaulting party will thereby also be the subject of an EOD. (This is another reason why AET clauses can be problematic – the decision is taken out of the hands of the parties.)
Where the non-defaulting party is in the middle of a chain, terminating its supply or sale contract may trigger a breach of contracts made with other counterparties. Consideration should be given to the following scenarios where goods are in transit:
- Supplier in default
- Can alternative cargo be sourced?
- What are the underlying freight terms (if purchasing FOB)? Can load discharge port/laycan options be exercised to minimise loss?
- Can the supplier perform?
- Buyer in default
- Where are the goods?
- Can an alternative buyer be found?
- What are the underlying freight terms (if selling CIF/CFR)? Can alternative discharge port options be exercised to minimise loss?
- If the contract is terminated, there is a risk that the cargo will quickly become known in the market as distressed, which will have obvious price implications for any alternative sale.
Performing the contract
If the non-defaulting party is to consider performance (and if the EOD is one of insolvency, this may not be possible under local insolvency rules), it is also important to consider whether one or more of the following can be negotiated with the party in default:
- This is unlikely to be an option if the counterparty is in financial difficulty but may be possible for other types of default.
- If only one group entity is in default, assignment to another entity or even an unrelated entity might be possible. But – parties should be aware that local insolvency rules may prohibit this.
- Contract amendments
- Suspend performance.
- Amend payment terms.
- Amend transfer of title provisions.
Consideration should be given when drafting EOD clauses to giving flexibility to the non-defaulting party to elect to perform, possibly on amended terms, in certain specified circumstances, rather than merely providing for termination on notice. For the reasons explored in this article, it may be more advantageous to the non-defaulting party to suspend performance, or to amend delivery or payment terms, rather than to terminate the contract. This is particularly so where the relevant contract is in the middle of a contractual chain.