Spain: Early Termination Clauses Based on a Declaration of Insolvency Will no Longer be Enforceable in Spain

By Gabriel Núñez and Federico Tarín

Spain has recently reformed the existing insolvency regulations through Act 22/2003, of July 9 (hereinafter, the "Insolvency Act") and Organic Law 8/2003, of July 9. The Insolvency Act entirely reforms the Spanish regulations on insolvency, abolishing the former rules contained in the Spanish Commercial Code (of 1885) and the Suspension of Payments Law (of 1922). The reform seeks to unify and modernise all existing insolvency rules and procedures, introducing a single restructuring scheme called a "concurso" which applies to both commercial and non-commercial entities and individuals. The Insolvency Act will enter into force on September 1, 2004.

The purpose of this article is not to analyse the Insolvency Act as a whole, but to highlight a particular provision contained in Article 61.3 which renders unenforceable those contractual early termination clauses based on the declaration of insolvency of one of the parties (hereinafter, "Article 61.3").

It has become absolutely standard in Spanish banking practice to include in loan and credit facility agreements a clause giving lenders the right to terminate agreements early in cases of (i) declared bankruptcy or insolvency of the creditor or (ii) more general situations affecting the financial situation of the creditor, including, inter alia, receivership, inability to settle debts when due, negotiations for restructuring liabilities and any other acts or actions, judicial or private, capable of producing the same outcome.

These early termination rights are also normally found in other types of agreements, such as supply and joint venture agreements, and are intended to protect the parties from the associated risks should either of them be involved in a real or potential insolvency situation.

In financial agreements, this type of provision allows lenders to terminate the agreement early for two main purposes: (i) to be released from the obligation to provide further funds in the context of a credit facility agreement, and/or (ii) to request immediate repayment of loans or amounts withdrawn under credit facilities and, eventually, allow the enforcement of the guarantees before formal insolvency proceedings begin. In this respect, it is important to stress that according to the new Insolvency Act, the enforcement of security over assets relevant to the bankrupt’s business may be suspended.

Although it is a contentious issue, it may be said that early termination clauses based on insolvency, bankruptcy or even on the other "premonitory situations" mentioned above, have traditionally been admitted by most Spanish legal scholars and practitioners and have not come under particular attack in case-law until very recent cases. These kinds of clauses have been generally accepted on the basis of Article 1255 of the Spanish Civil Code which consecrates the "principle of the parties’ free will" (i.e. the parties may freely agree the terms and conditions they consider appropriate in the contracts they enter into, as long as they do not contravene the law, morals or public order).

Article 61.3 provides that:

This text has remained unchanged from the first drafts of the Insolvency Act and is clearly in line with one of the main targets of the reform: to try to satisfy creditors by attempting to overcome business and financial crises rather than liquidating the company.

Article 61.3 is part of a more complex regulatory system involving Articles 61, 62 and 63. In fact, the preceding Articles 61.1 and 61.2 of the Insolvency Act follow along the same lines, stating that agreements with reciprocal obligations shall remain in force even after insolvency has been judicially declared. Nevertheless, as regards protection of creditors, the Insolvency Act states that the obligations arising from these agreements will be satisfied from the bankrupt’s estate with preference over any other credits, i.e., they will not be considered a bankrupt credit. Only the judge may decide to terminate an agreement, and always provided that the affected parties are called to a hearing and that the best interests of the insolvent entity are respected. This notwithstanding, the parties still have the right to invoke Article 1124 of the Spanish Civil Code, which provides that the non-defaulting party may always terminate an agreement on the basis of the other party’s default.

In the end, Article 61.3 merely reinforces and strengthens the provisions of Articles 61.1 and 61.2 by rendering unenforceable all contractual clauses which provide for early termination on the basis of a declaration of insolvency. In other words, the parties cannot bypass the provisions of Articles 61.1 and 61.2 by means of contractual arrangements.

(a) Scope of the acts and situations included

The main substantive interpretation issue arises out of the conflict between Article 61.3 and the standard clauses for early termination which have been used in Spain up to now. The problem is whether all the situations which allow for early termination in such standard clauses would be unenforceable once the insolvency has been declared, or whether they would not be affected by the "declaration of insolvency ("concurso"). Should the first interpretation be correct, none of the situations normally included in the standard clauses would permit early termination of the agreement if the insolvency is eventually declared. According to the second alternative, agreements could be terminated early on the basis of any such agreed situations other than the declaration of insolvency.

The first alternative implies a loose interpretation of Article 61.3, which literally refers only to a "mere declaration of insolvency" and not to other events directly or indirectly related to the financial soundness of the parties. The basis for this expansive interpretation might be found in one of the principles of the reform (the continuity of the bankrupt’s business) which would be frustrated if all clauses triggering early termination rights other than the declaration of insolvency were admitted and enforceable. If the legislator has decided to deem unenforceable those contractual clauses providing for early termination in the event of a declaration of insolvency in order to ensure business continuity, how could early termination be accepted on the basis of less serious situations in which the insolvency has still not materialised?

However, there are also arguments to support a restrictive interpretation of Article 61.3 reducing it to its literal meaning: (i) expansive interpretations of legal restrictions on the parties’ free will are rarely accepted; (ii) a wide interpretation would result in an unacceptable level of legal uncertainty regarding the range of situations covered; (iii) Article 61.3 does not state that these clauses are "null and void" but merely that they will "be regarded as though they had not been established in the agreement", which may be interpreted as "clauses are not enforceable if and when the insolvency is declared"; and (iv) the Insolvency Act offers the bankrupt alternative measures aimed at avoiding or minimising business disruption, such as the rehabilitation of credit agreements terminated within the three months prior to the declaration of insolvency (Article 68) or the cancellation of any acts carried out by the bankrupt to the detriment of its assets within the two years prior to the declaration of Insolvency (Article 71).

(b) Retroactive effects

A second interpretative question is whether Article 61.3 applies only to agreements entered into after the date the Insolvency Act comes into force (September 1, 2004), or whether it also applies to agreements entered into before that date. In the former case, early termination clauses included in agreements entered into before September 1, 2004 will remain enforceable. This position is probably more consistent with the principle of legal certainty and more respectful of the parties’ will.

However, it is also true that the intention of the legislator to ensure business continuity would be substantially frustrated if Article 61.3 was not applicable to "existing agreements". The solution would be to take into account the date on which the insolvency is declared rather than the date of agreement, i.e. early termination clauses based on the declaration of insolvency will be unenforceable if insolvency is declared once the Insolvency Act is in force. The temporary provisions of the Insolvency Act do not include an express assessment in this regard, although the manner in which other aspects of the law are resolved and the inclusion of Article 61.3 within the section of the Insolvency Act referring to the "effects of the declaration of insolvency" would support this interpretation.

(c) Contracts subject to foreign law

Another interesting aspect is what happens with early termination clauses based on insolvency or similar situations where these clauses are contained in agreements governed by a law other than Spanish law.

The Insolvency Act merely states that the effects and consequences of the insolvency will be governed by Spanish law. The question is therefore whether the unenforceability of an early termination clause is an "effect" of the declaration of insolvency.

There are grounds to argue that Article 61.3 provides for an effect of the declaration of insolvency: if the insolvency is declared, the clauses affording the parties the right to terminate the relevant agreement on the basis of a mere declaration of insolvency will "be regarded as though they had not been established in the agreement". In other words, Article 61.3 would always apply where the insolvency proceedings are conducted in Spain.

However, Article 63.2 states that Articles 61 and 62 will not prejudice the application of laws which permit clauses whereby agreements may be terminated on the basis of insolvency or liquidation of a party. Article 63.2 may be interpreted as a conflict of laws rule and, thus, as a basis for excluding the application of Article 61.3 to agreements governed by a law other than Spanish law.

The Insolvency Act, in general, makes significant progress towards legal certainty and modernity, restoring confidence in the Spanish market and, in this respect, should be welcomed by financial institutions. However, the evident desire to protect business continuity which is at the root of the new regime, may also have negative consequences for lenders.

One of these consequences is Article 61.3 which introduces an important restriction on credit entities facing potential or actual insolvency of its creditors, as it clearly renders unenforceable contractual early termination clauses based on a declaration of insolvency. Its apparently simple wording also leaves the door open to many interpretations and uncertainties which will have a notable effect on the standard contractual practice of credit entities.